2009 GARP Practice (Source)

2009FRMPracticeExams

TableofContents
2009FRMLevelIPracticeExamCandidateAnswerSheet.............................................3 2009FRMLevelIPracticeExamQuestions ...................................................................5 2009FRMLevelIPracticeExamAnswerKey...............................................................19 2009FRMLevelIPracticeExamAnswers&Explanations...........................................21 2009FRMFullExamFRMPracticeExamICandidateAnswerSheet ..........................47 2009FRMFullExamFRMPracticeExamIQuestions..................................................49 2009FRMFullExamFRMPracticeExamIAnswerKey ...............................................65 2009FRMFullExamFRMPracticeExamIAnswers&Explanations ...........................67 2009FRMFullExamFRMPracticeExamIICandidateAnswerSheet .........................99 2009FRMFullExamFRMPracticeExamIIQuestions...............................................101 2009FRMFullExamFRMPracticeExamIIAnswerKey ............................................117 2009FRMFullExamFRMPracticeExamIIAnswers&Explanations ........................119
Introduction
TheFRMexamisapracticeorientedexamination.Itsquestionsarederivedfromacombination oftheory,assetforthinthecorereadings,andrealworldworkexperience.Candidatesare expectedtounderstandriskmanagementconceptsandapproachesandhowtheywouldapply toariskmanagersdaytodayactivities. The FRM examination is also a comprehensive examination, testing a risk professional on a numberofriskmanagementconceptsandapproaches.Itisveryrarethatariskmanagerwillbe facedwithanissuethatcanimmediatelybeslottedintoonecategory.Intherealworld,arisk manager must be able to identify any number of riskrelated issues and be able to deal with themeffectively. The2009FRMPracticeExamshavebeendevelopedtoaidcandidatesintheirpreparationfor the FRM Examination in November 2009. These practice exams are based on a sample of questionsfromthe2007FRMExaminationandarerepresentativeofthequestionsthatwillbe in the 2009 FRM Examination. Wherever necessary and possible, questions, answers and referenceshavebeenupdatedtobetterreflectthetopicsandcorereadingslistedinthe2009 FRMExaminationStudyGuide. The2009FRMLevelIPracticeExamandtheFRMFullExamPracticeExamsIandIIcontain40 and 50 multiplechoice questions, respectively. Note that the 2009 FRM Level I and Full Examination will consist of a morning and afternoon session containing 50 and 70 multiple choice questions, respectively. The practice exams were designed to be shorter to allow candidatestocalibratetheirpreparednesswithoutbeingoverwhelming.
Copyright2009GlobalAssociationofRiskProfessionals 1 Allrightsreserved.
The2009FRMPracticeExamsdonotnecessarilycoveralltopicstobetestedinthe2009FRM Examination. For a complete list of topics and core readings, candidates should refer to the 2009 FRM Examination Study Guide. Core readings were selected by the FRM Committee to assistcandidatesintheirreviewofthesubjectscoveredbytheexam.QuestionsfortheFRM examination are derived from the core readings. It is strongly suggested that candidates reviewthesereadingsindepthpriortosittingfortheexam.
SuggestedUseofPracticeExams
Tomaximizetheeffectivenessofthepracticeexams,candidatesareencouragedtofollow theserecommendations: Planadateandtimetotakeeachpracticeexam.Setdatesappropriatelytogive sufficientstudy/reviewtimebetweeneachpracticeexamandpriortotheactualexam. Simulatethetestenvironmentascloselyaspossible. o Takeeachpracticeexaminaquietplace. o Haveonlythepracticeexam,candidateanswersheet,calculator,andwriting instruments(pencils,erasers)available. o Minimizepossibledistractionsfromotherpeople,cellphonesandstudy material. o Allocate90minutesforeachpracticeexamandsetanalarmtoalertyouwhen 90minuteshavepassed.Completeeachexambutnotethequestionsanswered afterthe90minutemark. o FollowtheFRMcalculatorpolicy.YoumayonlyuseaTexasInstrumentsBAII Plus(includingtheBAIIPlusProfessional)calculatororaHewlettPackard12C (includingtheHP12CPlatinum)calculator. Aftercompletingeachpracticeexam, o Calculateyourscorebycomparingyouranswersheetwiththepracticeexam answerkey.Onlyincludequestionscompletedinthefirst90minutes. o UsethepracticeexamAnswers&Explanationstobetterunderstandcorrectand incorrectanswersandtoidentifytopicsthatrequireadditionalreview.Consult referencedcorereadingstoprepareforexam. o Pass/failstatusfortheactualexamisbasedonthedistributionofscoresfromall candidates,souseyourscoresonlytogaugeyourownprogressand preparedness.
2009FRMLevelIPracticeExam CandidateAnswerSheet
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d.
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2009FRMLevelIPracticeExam Questions

1. Tohedgeagainstfuture,unanticipated,andsignificantincreasesinborrowingrates,whichofthe followingalternativesoffersthegreatestflexibilityfortheborrower?
a. b. c. d.

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

3. ConsidertwostocksAandB.Assumetheirannualreturnsarejointlynormallydistributed,the marginaldistributionofeachstockhasmean2%andstandarddeviation10%,andthecorrelationis 0.9.WhatistheexpectedannualreturnofstockAiftheannualreturnofstockBis3%?
a. b. c. d.
2.9% 2% 1.1% 4.7%
4. InpricingaderivativeusingtheMonteCarlomethod,weneedtosimulateareasonablenumberof pathsforthepriceoftheunderlyingasset.Supposeweuseasimplemodelforthereturnofthe underlyingasset:
y(t)=drift*t+vol*t*e(t),ande(t)isdistributed~N(0,1),
wheredriftandvolareknownparametersandtisthestepsize. Thegenerationofeachpathrequiresanumberofsteps.Whichofthefollowingdescribesthe correctprocedure?
a. GeneratearandomnumberfromanormaldistributionN(0,1),usetheinversenormalfunction togete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedureuntilyouget thefulldesiredpath. b. GeneratearandomnumberfromanormaldistributionN(0,1),usethecumulativenormal functiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedure untilyougetthefulldesiredpath. c. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usetheinverse cumulativenormalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthe sameprocedureuntilyougetthefulldesiredpath. d. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usethecumulative normalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesame procedureuntilyougetthefulldesiredpath.

5. Ariskmanagerestimatesthedailyvariance(ht)usingaGARCHmodelondailyreturns(rt):
ht = 0 + 1r2t-1 + ht-1
Assumethemodelparametervaluesare0 = 0.005, = 0.04, = 0.94.Thelongrunannualized volatilityisapproximately: a. b. c. d.
25.00% 13.54% 72.72% 7.94%
6. AsinglestockhasapriceofUSD10andacurrentdailyvolatilityof2%.Usingthedeltanormal method,theVaRatthe95%confidencelevelofalongatthemoneycallonthisstockovera1day holdingperiodisapproximately:
a. b. c. d.
USD0.23 USD1.645 USD0.33 USD0.16
7. Aportfolioconsistsoftwozerocouponbonds,eachwithacurrentvalueofUSD10.Thefirstbond hasamodifieddurationof1yearandthesecondhasamodifieddurationof9years.Theyieldcurve isflatandallyieldsare5%.Assumeallmovesoftheyieldcurveareparallelshifts.Giventhatthe dailyvolatilityoftheyieldis1%,whichofthefollowingisthebestestimateoftheportfoliodailyVaR atthe95%confidencelevel?
a. b. c. d.

USD2.33 USD1.65 USD0.82 USD1.16
8. ConsiderthefollowingthreemethodsofestimatingtheP&Lofabulletbond:fullrepricing,duration (PV01),anddurationplusconvexity.RankingtheestimatedP&Limpactofalargenegativeyield shockfromthelowestP&LimpacttothehighestP&Limpact,whatistherankingofthemethodsto estimatetheP&Limpact?
a. b. c. d.

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

10. Ifthegoldleaserateishigherthantheriskfreerate,whatisthemarketstructureoftheforward marketforgold?
a. b. c. d.

Contango Backwardation Inversion Needmoreinformationtodetermine
11. Thepriceofa3yearzerocoupongovernmentbondis85.16.Thepriceofasimilar4yearbondis 79.81.Whatistheoneyearimpliedforwardratefromyear3toyear4?
a. b. c. d.

5.4% 5.5% 5.8% 6.7%
12. AportfoliomanagerhasabondpositionworthUSD100million.Thepositionhasamodified durationof8yearsandaconvexityof150years.Assumethatthetermstructureisflat.Byhow muchdoesthevalueofthepositionchangeifinterestratesincreaseby25basispoints?
a. b. c. d.

USD1,953,125 USD1,906,250 USD2,046,875 UDS2,187,500
13. Afirmisgoingtobuy10,000barrelsofWestTexasCrudeOil.Itplanstohedgethepurchaseusing theBrentCrudefuturescontract.Thecorrelationbetweenthespotandfuturespricesis0.72.The volatilityofthespotpriceis0.35peryear.ThevolatilityoftheBrentCrudefuturespriceis0.27per year.Whatisthehedgeratioforthefirm?
a. b. c. d.
0.5554 0.9333 1.2099 0.8198
14. ItisJune2ndandafundmanagerwithUSD10millioninvestedingovernmentbondsisconcerned thatinterestrateswillbehighlyvolatileoverthenextthreemonths.Themanagerdecidestouse theSeptemberTreasurybondfuturescontracttohedgethevalueoftheportfolio.Thecurrent futurespriceis95.0625.EachcontractisforthedeliveryofUSD100,000facevalueofbonds.The durationofthemanagersbondportfoliointhreemonthswillbe7.8years.Thecheapesttodeliver bondintheTreasurybondfuturescontractisexpectedtohaveadurationof8.4yearsatmaturityof thecontract.AtthematurityoftheTreasurybondfuturescontract,thedurationoftheunderlying benchmarkTreasurybondis9years.Whatpositionshouldthefundmanagerundertaketomitigate hisinterestrateriskexposure? a. Short94contracts b. Short98contracts c. Short105contracts d. Short113contracts

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

USD80,000 USD10,500,000 USD80,000,000 USD105,000,000
16. SupposethatAandBarerandomvariables,eachfollowsastandardnormaldistribution,andthe covariancebetweenAandBis0.35.Whatisthevarianceof(3A+2B)?
a. b. c. d.
15.10 14.47 9.20 17.20
17. ConsiderastockpriceSthatfollowsageometricBrownianmotiondS = S dt + S dz, with strictlypositiveand afixedvalue.Whichofthefollowingstatementsistrue?
a. b. c. d.

Ifthedriftisnegative,thepriceoneyearfromnowwillbebelowtodaysprice. Theinstantaneousrateofreturnonthestockfollowsauniformdistribution. ThestockpriceSfollowsalognormaldistribution. Thismodelimposesmeanreversion.
18. ThejointprobabilitydistributionofrandomvariablesXandYisgivenbyf(x,y)=kxyforx=1,2,3,y= 1,2,3,andkisapositiveconstant.WhatistheprobabilitythatX+Ywillexceed5?
a. b. c. d.

1/9 1/4 1/36 Cannotbedetermined
19. WhichofthefollowingstatementsregardingHypothesisTestingisincorrect?
a. Hypothesistestingisusedtomakeinferencesabouttheparametersofagivenpopulationon thebasisofstatisticscomputedforasamplethatisdrawnfromthatpopulation. b. TypeIIerrorreferstothefailuretorejectthenullhypothesiswhenitisactuallyfalse. c. Thepvaluedecisionruleistorejectthenullhypothesisifthepvalueisgreaterthanthe significancelevel. d. Allelsebeingequal,thedecreaseinthechanceofmakingaTypeIerrorcomesatthecostof increasingtheprobabilityofmakingaTypeIIerror.

20. Ifstockreturnsareindependentlyidenticallynormallydistributedandtheannualvolatilityis30%, thenthedailyVaRatthe99%confidencelevelofastockmarketportfolioisapproximately:
a. b. c. d.
2.41% 3.11% 4.40% 1.89%
21. ThecurrentvalueoftheS&P500indexis1457,andeachS&PfuturescontractisfordeliveryofUSD 250timestheindex.AlongonlyequityportfoliowithmarketvalueofUSD300,100,000hasbetaof 1.1.Toreducetheportfoliobetato0.75,howmanyS&Pfuturescontractshouldyousell?
a. b. c. d.

618contracts 288contracts 574contracts 906contracts
Thefollowinginformationshouldbeusedforthenexttwoquestions. OnJanuary1,ariskmanagerobservesthatthe1yearcontinuouslycompoundedinterestrateis5% andstoragecostsofacommodityproductAisUSD0.05perquarter(payableateachquarterend). HefurtherobservesthefollowingforwardpricesforproductA: March 5.35 June 5.90 September 5.30 December 5.22

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

23. WhatistheannualizedrateofreturnearnedonacashandcarrytradeenteredintoinMarchand closedoutinJune?
a. b. c. d.
8.9% 9.8% 35.7% 39.1%
24. AninvestorsellsaJune2008callofABCLimitedwithastrikepriceofUSD45forUSD3andbuysa June2008callofABCLimitedwithastrikepriceofUSD40forUSD5.Whatisthenameofthis strategyandthemaximumprofitandlosstheinvestorcouldincur? a. BearSpread,MaximumLossUSD2,MaximumProfitUSD3 b. BullSpread,MaximumLossUnlimited,MaximumProfitUSD3 c. BearSpread,MaximumLossUSD2,MaximumProfitUnlimited d. BullSpread,MaximumLossUSD2,MaximumProfitUSD3

25. WhichofthefollowingproblemsareNOTinherentdisadvantagesofthehistoricalsimulation approachtoestimatingVaR?
I. Itgivestoolittleweighttomorerecentobservations II. Forlongonlyportfolios,itislikelytounderstateVaRfollowingarecentstructuralincrease involatilities III. Italwaysignoresthefattailspresentinthedistributionofreturnsonmanyfinancialassets IV. Becauseofthedeltaapproximation,itinadequatelymeasurestheriskofnonlinear instruments
a. b. c. d.

IandIIonly IIonly I,IIIandIVonly IIIandIVonly
26. AbankholdsUSD60millionworthof10year6.5%couponbondsthataretradingatacleanpriceof 101.82.Thebankisworriedbytheexposureduetothesebondsbutcannotunwindthepositionfor fearofupsettingtheclient.Therefore,itpurchasesatotalreturnswap(TRS)inwhichitreceives annualLibor+100bpsinreturnforthemarktomarketreturnonthebond.Forthefirstyear,the Liborsetsat6.25%andbytheendoftheyearthecleanpriceofthebondsisat99.35.Thenet receipt/paymentforthebankinthetotalreturnswapwillbe:
a. b. c. d.
ReceiveUSD2.23million ReceiveUSD1.93million PayUSD1.93million PayUSD2.23million
27. Whichofthefollowingtrade(s)containbasisrisk?
Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsNov07NYMEXWTI CrudeOilcontracts II. Long1,000lotsNov07ICEBrentOilcontractsandlong2,000lotsNov07ICEBrentOilat themoneyput III. Long1,000lotsNov07BrentOilcontractsandshort1,000lotsDec07ICEBrentOil contracts IV. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsDec07NYMEXWTI CrudeOilcontracts
I.
a. b. c. d.

I&III II&IV III&IV I,III&IV
28. Accordingtoputcallparity,buyingaputoptiononastockisequivalentto:
a. b. c. d.

Buyingacalloptionandbuyingthestockwithfundsborrowedattheriskfreerate. Sellingacalloptionandbuyingthestockwithfundsborrowedattheriskfreerate. Buyingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate. Sellingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate.
29. A3monthfuturescontractonanequityindexiscurrentlypricedatUSD1000,theunderlyingindex stocksarevaluedatUSD990andpaydividendsatacontinuouslycompoundedrateof2percent andthecurrentcontinuouslycompoundedriskfreerateis4percent.Thepotentialarbitrageprofit percontract,giventhissetofdata,isclosestto
a. USD10.00 b. USD7.50 c. USD5.00 d. USD1.50
30. ResearchandmodelprojectionsindicatethataspecificeventislikelytomovetheCHFagainstthe USD.Whilethedirectionofthemoveishighlyuncertain,itishighlylikelythatmagnitudeofthe movewillbesignificant.Basedonthisinformation,whichofthefollowingstrategieswouldprovide thelargesteconomicbenefit?
a. LongacalloptiononUSD/CHFandshortaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate b. LongacalloptiononUSD/CHFandlongaputoptiononUSD/CHFwiththesamestrikepriceand expirationdate c. ShortacalloptiononUSD/CHFandlongaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate d. ShortacalloptiononUSD/CHFandshortaputoptiononUSD/CHFwiththesamestrikeprice andexpirationdate

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

Purchase2,602shares Sell2,602shares Purchase1,493shares Sell1,493shares
32. Whichofthefollowingstrategiescreatesacalendarspread? a. Sellacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice b. Buyacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice c. Sellacalloptionwithacertainstrikepriceandbuyashortermaturitycalloptionwiththesame strikeprice d. Buyacalloptionwithacertainstrikepriceandsellalongermaturitycalloptionwiththesame strikeprice
33. Whichofthefollowingunderlyingmacroeconomicconditionswouldleaveanemergingmarket mostvulnerabletothecontagioneffectsofacurrencycrisis?
a. b. c. d.

Largecurrentaccountsurplus,lowforeignexchangereserves,nonconvertiblecurrency Largecurrentaccountdeficit,lowforeignexchangereserves,fullyconvertiblecurrency Smallcurrentaccountdeficit,highforeignexchangereserves,nonconvertiblecurrency Largecurrentaccountsurplus,highforeignexchangereserves,fullyconvertiblecurrency
34. ConsideranFRA(forwardrateagreement)withthesamematurityandcompoundingfrequencyasa Eurodollarfuturescontract.TheFRAhasaLIBORunderlying.Whichofthefollowingstatementsare trueabouttherelationshipbetweentheforwardrateandthefuturesrate?
a. b. c. d.

Theyshouldbeexactlythesame Theforwardrateisnormallyhigherthanthefuturesrate Theforwardrateisnormallylowerthanthefuturesrate Theyhavenofixedrelationship
35. Yourbankisanactiveplayerinthecommoditymarket.Theviewoftheeconomistofthebankis thatinflationisexpectedtorisemoderatelyintheneartermandmarketvolatilityisexpectedto remainlow.Thetradersareadvisedtoundertakedealsonthemetalsexchangetoalignyourbook toconformwiththeexpectationsoftheeconomistofthebank.Asriskmanager,youareaskedto monitorthepositionsofthetraderstomakesurethattheyhavetheexposurestoinflationand marketvolatilitysoughtbythebank.Whichtraderhastakenanappropriatepositionamongthe tradersyouaremonitoring?
a. TraderAboughtacallandaput,bothwith90daystoexpirationandwithstrikepriceequalto theexistingspotlevel b. TraderBboughtaputoptionwithadownandinknockinfeature c. TraderCboughtacalloptionattheexistingspotlevelsandsoldacallatahigherstrikeprice, bothwith90daystoexpiration d. TraderDsoldacallandboughtaputattheexistinglevels,bothwith90daystoexpiration

36. TheinformationratiooftheSteroleUSFundfor2006againsttheS&P500,itsbenchmarkindex,is1. Forthesametimeperiod,thefundsSharperatiois2,thefundhasatrackingerrorof7%against theS&P500,andthestandarddeviationoffundreturnsis5%.TheriskfreerateintheUSis4%. CalculatethereturnfortheS&P500duringthetimeperiod.
a. b. c. d.
3.5% 7% 11% 14%
37. Afundmanagerrecentlyreceivedareportontheperformanceofhisportfoliooverthelastyear. Accordingtothereport,theportfolioreturnis9.3%,withastandarddeviationof13.5%,andabeta of0.83.Theriskfreerateis3.2%,thesemistandarddeviationL(Rp)oftheportfoliois8.4%,andthe trackingerroroftheportfoliotothebenchmarkindexis2.8%.Whatisthedifferencebetweenthe valueofthefundsSortinoratio(computedrelativetotheriskfreerate)anditsSharperatio?
a. b. c. d.

0.274 1.727 0.653 0.378
38. Whichofthefollowingstatementsaboutthelinearregressionofthereturnofaportfoliooverthe returnofitsbenchmarkpresentedbelowarecorrect?
Portfolioparameter Value Beta 1.25 Alpha 0.26 Coefficientofdetermination 0.66 Standarddeviationoferror 2.42
I. Thecorrelationis0.71 II. 34%ofthevariationintheportfolioreturnisexplainedbyvariationinthebenchmark return III. Theportfolioisthedependentvariable IV. Foranestimatedportfolioreturnof12%,theconfidenceintervalat95%is[7.16%;16.84%]
a. b. c. d.
IIandIV IIIandIV I,IIandIII II,IIIandIV
39. YourBoardofDirectorswantsacomprehensivereviewofeachbusinessunitsoperationalrisk activities.Astheheadofthecorporateoperationalriskunit,youknowthatlittlehasbeendoneto implementanoperationalriskprocessatthebusinessunitlevelandthatyouneedtoimmediately comeupwithaframework.Whichofthefollowingstatementsoffersthebeststrategy?
TheauditcommitteeoftheBoardshouldfirstdefineitsobjectivestoensurethatallthe firmsbusinessunitsoperationalriskprogramsareprovidingrequiredinformation II. Theauditingdepartmentistobechargedwithdevelopinganoperationalriskprogramfor eachbusinessunit,withthebusinessunitbeingmadeclearlyawarethattheywillbeheld accountableforitsimplementation III. Thatyourdepartmentimmediatelyassesstheoperationalriskforeachbusinessunitusing independentdatafeedstoensuretheinformationfedintotheassessmentcannotbe manipulated IV. Aseniormanagerfromeachprofitcenteristobechargedwithdevelopingtheirown operationalriskselfassessmentprogrambasedonguidelinesyouprovide.
I.
a. b. c. d.

Ionly IandIVonly IandIIIonly IVonly
40. Whichofthefollowingriskmanagementstrategiesofafirmwhichhasprincipalpaymentstomake onitsdebtinoneyearthatsubstantiallyexceedthemarketvalueofitsassetsismostlikelytobein theinterestoftheshareholders?
a. b. c. d.
Reductionoftheoverallrisklevelofthefirm Increaseoftheoverallrisklevelofthefirm Keepthesamerisklevel Itisimpossibletosaywhichriskmanagementstrategytheshareholdersprefer
ENDOF2009FRMLevelIPRACTICEEXAM
2009FRMLevelIPracticeExam AnswerKey
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d.
2009FRMLevelIPracticeExam Answers&Explanations

a. b. c. d.
CORRECT:D
Thequestionfocusesonflexiblemanagementofborrowingexpenses.Whileafixedforfloating swapcouldreduceborrowingexpenses,itisalongtermcontractualcommitmenttoexchange payments.Ifinterestratesdecline,theborrowermaygrossuptotheagreedfixedrate.Aninterest ratecollarisacombinationofaninterestratefloorandcap,i.e.,itlocksintheinterestexpenses withinatightrange.Moreover,collarsusuallyofferinterestrateprotectionatoneparticularpoint oftimeunlessseveralcontractswithdifferentmaturitiesareexchanged.Acallswaptiongivesthe companytherighttoenterintoaswapwhentheborrowingexpensesexceedacertainreference rate.Ifthereferencerateisbelowtheborrowingexpenses,theoptionisnotexercised.
Reference:Hull,Chapter7.

2. AninvestmentbankusestheExponentiallyWeightedMovingAverage(EWMA)techniquewith lambdaof0.9tomodelthedailyvolatilityofasecurity.Thecurrentestimateofthedailyvolatilityis 1.5%.TheclosingpriceofthesecurityisUSD20yesterdayandUSD18today.Usingcontinuously compoundedreturns,whatistheupdatedestimateofthevolatility?
a. b. c. d.
5.44% 3.62% 2.96% 1.31%
CORRECT:B Thecurrentreturnofthesecurityis=ln(18/20)=10.536%.
UsinganEWMAmodel,theupdatedvolatilityisgivenas: V(t) ={lambda*((V[t1]^2)+(1lambda)*(currentreturn^2)}^0.5 ={0.9 *((0.015^2)+(10.9)*(0.10536^2)}^0.5 =3.62% INCORRECT:AForgetstosquarethevolatilityterms INCORRECT:CForgetstosquarethevolatilitytermsandtotakethesquarerootoftheresulting variance,thenmiscalculatesconversiontopercentage. INCORRECT:DForgetstotakethesquarerootofthevariance,thenmiscalculatesconversionto percentage. Reference:Hull,Chapter21.

3. ConsidertwostocksAandB.Assumetheirannualreturnsarejointlynormallydistributed,the marginaldistributionofeachstockhasmean2%andstandarddeviation10%,andthecorrelationis 0.9.WhatistheexpectedannualreturnofstockAiftheannualreturnofstockBis3%? a. 2.9% b. 2% c. 1.1% d. 4.7%
CORRECT:A E[ra | rb = x] = a + (abab/2a)(x b) = 0.02+0.9*(0.030.02)=0.029 Reference:DamodarGujarati,Chap2,3.

4. InpricingaderivativeusingtheMonteCarlomethod,weneedtosimulateareasonablenumberof pathsforthepriceoftheunderlyingasset.Supposeweuseasimplemodelforthereturnofthe underlyingasset: y(t)=drift*t+vol*t*e(t),ande(t)isdistributed~N(0,1), wheredriftandvolareknownparametersand t isthestepsize.
Thegenerationofeachpathrequiresanumberofsteps.Whichofthefollowingdescribesthe correctprocedure?
a. GeneratearandomnumberfromanormaldistributionN(0,1),usetheinversenormalfunction togete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedureuntilyouget thefulldesiredpath. b. GeneratearandomnumberfromanormaldistributionN(0,1),usethecumulativenormal functiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedure untilyougetthefulldesiredpath. c. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usetheinverse cumulativenormalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthe sameprocedureuntilyougetthefulldesiredpath. d. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usethecumulative normalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesame procedureuntilyougetthefulldesiredpath.
CORRECT:C Thisquestionwantstotestifthecandidateknowsthebasicstepstogenerateaverysimplepath: answeringthisquestionmeansthatthecandidatewouldbeabletobuildasimplespreadsheet showingtheMonteCarlologic. Thecorrectprocedureistheonedescribedinc);whilea),b)andd)arenonsensicalcalculations. Reference:PhilippeJorion,ValueatRisk,TheNewBenchmarkforManagingFinancialRisk,3rdedition (NewYork:McGrawHill,2007),Chapter12.

5. Ariskmanagerestimatesthedailyvariance(ht)usingaGARCHmodelondailyreturns(rt): ht=0+1r2t1+ht1 Assumethemodelparametervaluesare0 =0.005,1=0.04,=0.94.Thelongrunannualized volatilityisapproximately: a. 25.00% b. 13.54% c. 72.72% d. 7.94%
CORRECT:D
Thelongrunvarianceis0.005/(10.040.94)=0.005/0.02=0.25.Thedailyvolisthusthesquare root,or0.5%andannualvol7.935%. INCORRECT:AThedailyvarianceisindeed0.25%,andthedailyvolatility0.5%butthisneedstobe annualized. INCORRECT:BMiscalculatesvarianceassqrt(0.04/(10.940.005))*15.87=13.54% INCORRECT:CMiscalculatesvarianceas0.04/(10.940.005)=72.72% Reference:Hull,Chapter21.
a. b. c. d.
USD0.23 USD1.645 USD0.33 USD0.16
CORRECT:D ThisquestionrequirescandidatestoknowtheformulaforthedeltanormalVaRapproximation,and alsotoknowthatthedeltaofanatthemoneycallis0.5. VaR =| | 1.645 S = 0.5 1.645 0.02 10 = 0.1645 . INCORRECT:AWegetAbyusing2.326insteadof1.645. INCORRECT:BWegetBifweuse2insteadof2%forthevolatility. INCORRECT:CWegetCifweuseadeltaof1. Reference:Allenetal,Chapter3,8689

a. b. c. d.
USD2.33 USD1.65 USD0.82 USD1.16
CORRECT:B ThisquestionassessescandidatesabilitiestoapplythedurationVaRformulatotwobonds simultaneouslyandtorecallthatthedurationofazerocouponbondisequaltothebondmaturity. UsinganobviousextensionofJorionsequation9.5
VaR = D1 V1 1.645 + D2 V2 1.645 = ( D1 V1 + D2 V2 ) 1.645 = ( D1 + D2 ) 10 1.645 = 10 10 1.645 0.01 = 1.645

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

a. b. c. d.
Durationplusconvexity,duration,fullrepricing Fullrepricing,durationplusconvexity,duration Duration,durationplusconvexity,fullrepricing Duration,fullrepricing,durationplusconvexity
CORRECT:C Theprice/yieldlinewithyieldonthexaxisandpriceontheyaxisisconvextotheorigin.The durationatanyyieldlevelisthetangenttothatcurve.Therefore,exceptattheexactpointof tangency,durationwillalwaysunderestimatethepricechange. INCORRECT:ADurationwillalwaysunderestimatepricechangefornegativeyieldshocks INCORRECT:BFullrepricingwillnevergenerateasmallerpositivepricechangethanduration becausedurationrepresentsthepointoftangency INCORRECT:DFullrepricingwillgenerateahigherpriceforalargenegativeyieldchangethanwill durationplusconvexity Reference:Allen,Boudoukh,Saunders,Chapter3
9. Considerapositionina5yearreceivefixedswapthatmakesannualpaymentsonaUSD100million notional.Thefloatingleghasjustbeenreset.Thetermstructureisflatat5%,theMacaulay durationofa5yearparbondis4.5years,andtheannualvolatilityofyieldchangesis100bp.Your bestestimateoftheswapsVaRwith95%confidenceoverthenextmonthis a. USD1.6million b. USD2.0million c. USD5.5million d. USD7.1million CORRECT:A Becausethefloatingrateleghasjustbeenreset,itsdurationis1.Netdurationis4.51=3.5year,or modifieddurationof3.5/1.05=3.33.The95%VaRofmonthlychangesinyieldsis1.65*1%/12= 0.48%.Multiplying,thisgivesUSD100*0.48%*3.33=USD1.588 INCORRECT:BThisusesanetdurationof4.5yearsandignoresthedurationofthefloatingrate leg. INCORRECT:CThisistheannualVaR,butshouldbetranslatedtoamonthlyhorizon. INCORRECT:DThisistheannualVaRcomputedbyignoringthedurationofthefloatingrateleg. Reference:Allenetal. 10. Ifthegoldleaserateishigherthantheriskfreerate,whatisthemarketstructureoftheforward marketforgold?
a. b. c. d.
CORRECT:B Aleaseratehigherthantheriskfeeratewillforceanegativelyslopedforwardcurve,i.e. backwardation INCORRECT:ATheforwardprice=spot*exp(riskfreerateleaserate).Iftheleaserateishigher thantheriskfreerate,forwardswillbelowerthanspot,implyingcontango INCORRECT:CTheterminversionisusedtodescribeyieldcurves,notcommodityforwards INCORRECT:DThereisenoughinformationinthequestiontoprovideananswer Reference:MacDonald,Chapter6

a. b. c. d.
5.4% 5.5% 5.8% 6.7%
CORRECT:D
1 + Forward rate = Price of three bond 85.16 = = 1.067034 Price of four year bond 79.81
Forward rate = 0.067034 or 6.7%
INCORRECT:AThisisB/C INCORRECT:BThisisthereturnofthe3yearbond INCORRECT:CThisisthereturnofthe4yearbond Reference:Tuckman

a. b. c. d.
USD1,953,125 USD1,906,250 USD2,046,875 USD2,187,500
CORRECT:A
V = - D mod y V + 0.5 Convexity y 2 V V = - 8 0.0025 100M + 0.5 150 (0.0025) 2 100M V = - 2M + 46,875 V = - 1,953,125
INCORRECT:BOmits0.5fromthesecondterm INCORRECT:CSubtractsthesecondterm INCORRECT:DMakesbothmistakes Reference:Tuckman
a. b. c. d.
0.5554 0.9333 1.2099 0.8198
CORRECT:B
0.35 N = 0.72 0.27 N= 0.9333
INCORRECT:AInvertsthespotvolatilityandthefuturesvolatility INCORRECT:CUsesvariances INCORRECT:DUsessquarerootsofthevolatilities Reference:Hull,Chapter3

14. ItisJune2ndandafundmanagerwithUSD10millioninvestedingovernmentbondsisconcerned thatinterestrateswillbehighlyvolatileoverthenextthreemonths.Themanagerdecidestouse theSeptemberTreasurybondfuturescontracttohedgethevalueoftheportfolio.Thecurrent futurespriceis95.0625.EachcontractisforthedeliveryofUSD100,000facevalueofbonds.The durationofthemanagersbondportfoliointhreemonthswillbe7.8years.Thecheapesttodeliver bondintheTreasurybondfuturescontractisexpectedtohaveadurationof8.4yearsatmaturityof thecontract.AtthematurityoftheTreasurybondfuturescontract,thedurationoftheunderlying benchmarkTreasurybondis9years.Whatpositionshouldthefundmanagerundertaketomitigate hisinterestrateriskexposure?
a. b. c. d.
Short94contracts Short98contracts Short105contracts Short113contracts
CORRECT:B.
10,000,000 7.8 N= 95,062.50 8.4
N = 97.68 or 98 contracts
INCORRECT:AThisismadeup. INCORRECT:CThisleavesoutthedurations INCORRECT:DThisinvertsthedurations Reference:Tuckman

a. b. c. d.
USD80,000 USD10,500,000 USD80,000,000 USD105,000,000
CORRECT:D USD105,000,000x.076/100=USD79,800,whichisprettyclosetothedesiredDV01ofUSD80,000. Tosolveforthehedge,solveforFintheequationUSD80,000=Fx.076/100,givingF=105,263,158 INCORRECT:ASellingthisamountwouldoffsetaDV01ofonlyUSD80,000x.076/100=USD61 INCORRECT:BUSD10,500,000x.076/100=USD7,980 INCORRECT:CUSD80,000,000x.076/100=USD60,800 Reference:Tuckman,Chapter5

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

17. ConsiderastockpriceSthatfollowsageometricBrownianmotiondS = S dt + S dz, with strictlypositiveand afixedvalue.Whichofthefollowingstatementsistrue?
a. b. c. d.
Ifthedrift isnegative,thepriceoneyearfromnowwillbebelowtodaysprice. Theinstantaneousrateofreturnonthestockfollowsauniformdistribution. ThestockpriceSfollowsalognormaldistribution. Thismodelimposesmeanreversion.
CORRECT:C INCORRECT:ATheexpectedpriceislessthantodaysprice,butnotthepriceinallthestatesof world. INCORRECT:BTheinstantaneousrateofreturnonthestockfollowsnormaldistribution. INCORRECT:DThismodeldoesnotimposemeanreversion. Reference:PhilippeJorion,ValueatRisk:TheNewBenchmarkforManagingFinancialRisk,3 ed. (NewYork:McGrawHill,2007).Chapter12

rd
a. b. c. d.
1/9 1/4 1/36 Cannotbedetermined
CORRECT:B Note that
f ( x, y) = 1
x =1 y =1
Substitutingthevariousvaluesofxandy,wegetf(1,1)=k,f(1,2)=2k,f(1,3)=3k,f(2,1)=2k,f(2,2)=4k, f(2,3)=6k,f(3,1)=3k,f(3,2)=6k,andf(3,3)=9k.Therefore, k1+2k+3k+2k+4k+6k+3k+6k+9k=1 sothat,36k=1andk=1/36. P(X+Y>5)=f(3,3)=1/36x3x3=1/4 Reference:DamodarGujarati

CORRECT:C ThetruestatementistorejectHoifthepvalueissmallerthanthesignificancelevel. INCORRECT:AStatementAiscorrectregardingtheprimaryuseofHypothesisTesting. INCORRECT:BStatementBiscorrectregardingthedefinitionoftypeIIerror. INCORRECT:DStatementDiscorrectbecausetypeIerrorandtypeIIerrorareintradeoff. Reference:DamodarGujarati
a. b. c. d.
2.41% 3.11% 4.40% 1.89%
CORRECT:C The1dayvolatilityiss*(1/252)^0.5=0.3*0.629941=0.018898.TheVaRatthe99%confidence levelisthenequalto2.32635*0.018898=4.40% INCORRECT:AOnegetsAifoneuses1.645insteadof2.326 INCORRECT:BOnegetsBifoneusesthemonthlyvolatilityinsteadofthedailyone INCORRECT:DOnegetsDisthedailyvolatility Reference:Allen,BoudoukhandSaunders,2004,chapter1,p68

a. b. c. d.
CORRECT:B Noofcontracts=[0.751.1)/1]*[300,100,000/{250*1,457}]=288.36 sell288contracts INCORRECT:A617.9135209=1*(0.75)*(300100000/(250*1457)) INCORRECT:C561.74=1(0.75/1.1)*(300100000/(250*1457)) INCORRECT:D906.273164=1*(1.1)*(300100000/(250*1457)) Reference:Hull,Options,FuturesandOtherDerivatives,Chapter3and4;AnthonySaunders, FinancialInstitutionsManagement,Chapter10
Thefollowinginformationshouldbeusedforthenexttwoquestions. OnJanuary1,ariskmanagerobservesthatthe1yearcontinuouslycompoundedinterestrateis5% andstoragecostsofacommodityproductAisUSD0.05perquarter(payableateachquarterend). HefurtherobservesthefollowingforwardpricesforproductA: March 5.35 June 5.90 September 5.30 December 5.22
22. GiventhefollowingexplanationofsupplyanddemandforcommodityproductAhowwouldyou bestdescribeitsforwardpricecurvefromJunetoDecember?
Marketdescription Explanation Backwardation ExcessdemandforAinearlysummer Backwardation Supplyisexpectedtodeclineaftersummer Contango ExcessdemandforAinearlysummer Contango Supplyisexpectedtodeclineaftersummer CORRECT:A Aiscorrectwhenfurthertermcommodityforwardshavelowerpricethanneartermforwards,the marketissaidtobeinbackwardation.PossibleexplanationcanbeseasonalityofproductA excessdemandinearlysummercausesJuneforwardstohavehigherprice INCORRECT:BMarketdescriptioniscorrect,butexplanationisnotexpecteddeclineinsupply shouldincreasefurthertermcommodityforwardprice INCORRECT:CWrongmarketdescriptionofcontango INCORRECT:DWrongmarketdescriptionofcontango Reference:RobertLMcDonald,DerivativesMarkets,Chapter6

a. b. c. d.
a. b. c. d.
8.9% 9.8% 35.7% 39.1%
CORRECT:C
Byformula F0,T = S0erT + C, where F0,T = Juneforwardprice, S0 = Marchforwardprice,r=risk freeinterestrate,T=lengthofcashandcarry,C=storagecost Solving5.90=5.35er*3/12+0.05 Solutionisr=35.7% INCORRECT:A8.9=LN((5.90.05)/5.35)(forgetstoannualizethereturn) INCORRECT:B9.8=LN((5.9)/5.35)(forgetstoincludethestoragecostandtoannualizethereturn) INCORRECT:D39.1=(12/3)LN((5.9)/5.35)0.05(forgetstoincludethestoragecost) Reference:RobertLMcDonald,DerivativesMarkets,Chapter6

24. AninvestorsellsaJune2008callofABCLimitedwithastrikepriceofUSD45forUSD3andbuysa June2008callofABCLimitedwithastrikepriceofUSD40forUSD5.Whatisthenameofthis strategyandthemaximumprofitandlosstheinvestorcouldincur?
a. b. c. d.
BearSpread,MaximumLossUSD2,MaximumProfitUSD3 BullSpread,MaximumLossUnlimited,MaximumProfitUSD3 BearSpread,MaximumLossUSD2,MaximumProfitUnlimited BullSpread,MaximumLossUSD2,MaximumProfitUSD3
CORRECT:D BuyingacalloptionatlowerstockpriceandsellingcalloptionathigherstrikepriceiscalledasBull Spread.BearSpreadisbuyingthecalloptionathigherpriceandsellingthecallatlowerstrikeprice. TheCostofstrategywillbeUSD3USD5=USD2 ThePayoff,whenStockpriceSTUSD40willbeUSD2(thecostofstrategy)asnoneoftheoption willbeexercised. ThePayoff,whenstockpriceST45,(asbothoptionswillbeexercise)willbeUSD5, SincethecostofstrategyisUSD3,henceprofitwillbeUSD5USD2=USD3 WhenStockpriceisUSD40<ST>USD45,Onlythecalloptionboughtbytheinvestorwouldbe exercisedhencethepayoffwillbeST40,sincethecostofstrategyisUSD3,TheNetprofitwillbe ST43,whichwouldalwaysbelowerthanUSD3. Reference:Hull.Chapter10TradingStrategiesInvolvingOptions.
I. Itgivestoolittleweighttomorerecentobservations II. Forlongonlyportfolios,itislikelytounderstateVaRfollowingarecentstructuralincrease involatilities III. Italwaysignoresthefattailspresentinthedistributionofreturnsonmanyfinancial assets IV. Becauseofthedeltaapproximation,itinadequatelymeasurestheriskofnonlinear instruments
a. b. c. d.
CORRECT:C ThedisadvantagewiththeHistoricalSimulationModelisthatitmaynotrecognizethechangesin volatilityandcorrelationfollowingrecentstructuralchanges.Themodelcanbeadjustedsothatit givesmoreweighttorecentobservations.Theotheroptions,i.e.III&IV,aredisadvantagesofMonte CarlomethodandDeltanormalmethod. Reference:Allenetal.

a. b. c. d.
ReceiveUSD2.23million. ReceiveUSD1.93million. PayUSD1.93million. PayUSD2.23million.
CORRECT:B
Itstheresultofthiscalculation:thenotionalamountis60millionUSD.Thereforethebankwill receivetheinterestpaymentlinkedtotheLIBORrate:60millionUSD*(6,25%+100bp)=4.35 millionUSD. Thebankwillpaythefixedcouponplusthechangeinthevalueofthebond:60millionUSD*6.5%+ 60million*(99.35%101.82%)=2.418millionUSD. Hencethetotalnetamountthebankwillreceiveis:4.35millionUSD2.418millionUSD=1.932 millionUSD. Reference:Hull,Chapter7 27. Whichofthefollowingtrade(s)containbasisrisk?
I. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsNov07NYMEXWTI CrudeOilcontracts II. Long1,000lotsNov07ICEBrentOilcontractsandlong2,000lotsNov07ICEBrentOilat themoneyput III. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsDec07ICEBrentOil contracts IV. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsDec07NYMEXWTI CrudeOilcontracts
a. b. c. d.
I&III II&IV IIII&IV I,III&IV
CORRECT:D BasisRiskisspreadrisk,whicharisefromtradingthespread(longandshort2positivelycorrelated assetsorsameassetwithdifferentexpiration) iisspreadtradeinhighlycorrelatedassetwithsameexpirationmonth iifaceswithgammaandvegarisk iiiisspreadtradeintradingtheflatteningoftheforwardcurve ivisspreadtradeintrading2assetswithdifferentexpirationdate Reference:RobertL.McDonald,DerivativesMarkets(Boston:AddisonWesley,2003),Chapter6.
Buyingacalloptionandbuyingthestockwithfundsborrowedattheriskfreerate. Sellingacalloptionandbuyingthestockwithfundsborrowedattheriskfreerate. Buyingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate. Sellingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate. CORRECT:C Buyingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate.Putcallparity statesP=CS+XeRT INCORRECT:ABuyingacalloptioniscorrect,buttherestofthestatementisincorrect. INCORRECT:BTheentirestatementisincorrect. INCORRECT:DSellingacalloptionisincorrect,buttherestofthestatementiscorrect. Reference:Hull,Chapter10

a. b. c. d.
a. b. c. d.
USD10.00 USD7.50 USD5.00 USD1.50
CORRECT:C Accordingtothefundamentalpricingrelationshipbetweenspotassetsandtheassociatedfutures, thefuturesprice,topreventarbitrage,shouldequal990xe(0.040.02)x0.25or995.Hence,the futurescontractisovervalued,indicatingitshouldbesoldandtheindexshouldbepurchasedforan arbitrageprofitofUSD1000USD995=USD5 Reference:Hull,Chapters2,36.

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

a. b. c. d.
Purchase2,602shares. Sell2,602shares. Purchase1,493shares. Sell1,493shares.
CORRECT:A Numberofcalls=200contractsx100=20,000calls.
Numberofshares =(Numberofcalls)x(NewdeltaOlddelta) =20,000x(0.70400.5739) =+2,602shares Positivesignindicatesthatthemanagershouldpurchasenewshares. INCORRECT:BTheformulaisincorrect,i.e.olddeltaminusnewdelta INCORRECT:CThenumberofshares(insteadofnumberofcalls)isusedinthecalculation INCORRECT:DAsperexplanationinCaboveandsignerror Reference:HullChapters9and10 32. Whichofthefollowingstrategiescreatesacalendarspread?
a. Sellacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice b. Buyacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice c. Sellacalloptionwithacertainstrikepriceandbuyashortermaturitycalloptionwiththesame strikeprice d. Buyacalloptionwithacertainstrikepriceandsellalongermaturitycalloptionwiththesame strikeprice
CORRECT:A INCORRECT:BAsbuyacalloption INCORRECT:CAsbuyashortermaturitycalloption INCORRECT:DAsthisisareversecalendarspread Reference:JohnHull,Chapter10.

a. b. c. d.
CORRECT:B
INCORRECT:ALargecurrentaccountsurplusandnonconvertiblecurrencywouldprotectthelocal currency INCORRECT:CHighforeignexchangereservesandnonconvertiblecurrencywouldprotectthelocal currency INCORRECT:DLargecurrentaccountsurplusandhighforeignexchangewouldprotectthelocal currency Reference:Saunders,Chapter15,ForeignExchangeRisk

a. b. c. d.
Theyshouldbeexactlythesame Theforwardrateisnormallyhigherthanthefuturesrate Theforwardrateisnormallylowerthanthefuturesrate Theyhavenofixedrelationship
CORRECT:C AsEurodollarfuturescontractismarkedtomarketandsettleddaily,normallyforwardrateis adjustedlower,socalledconvexityadjustment,by: Forwardrate=Futuresrate
1 2 T1T2 2
Reference:Hull,Chapter6. 35. Yourbankisanactiveplayerinthecommoditymarket.Theviewoftheeconomistofthebankis thatinflationisexpectedtorisemoderatelyintheneartermandmarketvolatilityisexpectedto remainlow.Thetradersareadvisedtoundertakedealsonthemetalsexchangetoalignyourbook toconformwiththeexpectationsoftheeconomistofthebank.Asriskmanager,youareaskedto monitorthepositionsofthetraderstomakesurethattheyhavetheexposurestoinflationand marketvolatilitysoughtbythebank.Whichtraderhastakenanappropriatepositionamongthe tradersyouaremonitoring?
a. TraderAboughtacallandaput,bothwith90daystoexpirationandwithstrikepriceequalto theexistingspotlevel b. TraderBboughtaputoptionwithadownandinknockinfeature c. TraderCboughtacalloptionattheexistingspotlevelsandsoldacallatahigherstrikeprice, bothwith90daystoexpiration d. TraderDsoldacallandboughtaputattheexistinglevels,bothwith90daystoexpiration
CORRECT:C CIscorrect,asthestrategypopularlyknownasthebullspreadwillresultinpositivepayoffwhenthe spotrises.Asinflationincreases,spotlevelsincommoditiesareexpectedtorise.Sellingacallat higherlevelwillreducethecostofthestrategy.Althoughitmaylimittheupside,butthatwouldbe inlinewiththeviewasonlyamoderateriseisexpectedinspot. INCORRECT:AIsincorrect,asthestrategypopularlyknownasastraddleistobeusedwhenthe viewisthatthevolatilityinthemarketwillrise,andthereisnodirectionalviewonthespot INCORRECT:BIsincorrect,astheaboveoptionwillbesuitablewhenthespotisexpectedtofall fromtheexistinglevels INCORRECT:DIsincorrect,asthepayoffinthiscaseissimilartoshortpositioninspotandwould makesensewhentheunderlyingisexpectedtofall Reference:Hull,Chapter10.

36. TheinformationratiooftheSteroleUSFundfor2006againsttheS&P500,itsbenchmarkindex,is1. Forthesametimeperiod,thefundsSharperatiois2,thefundhasatrackingerrorof7% against theS&P 500,andthestandarddeviationoffundreturnsis5%.TheriskfreerateintheUSis4%. CalculatethereturnfortheS&P500duringthetimeperiod. a. 3.5% b. 7% c. 11% d. 14%
CORRECT:B SharpeRatio=2 (FundReturnRiskFreeRate)/SD=2 (FundReturn4%)/5%=2 FundReturn=14% InformationRatio=1 (FundReturnS&P500Return)/TrackingError=1 (14%S&P500Return)/7%=1 S&P500Return=7% INCORRECT:AIncorrectlydividesS&P500Returnby2 INCORRECT:CThecandidatemightusetheTrackingErrorastheNumeratorinboththeRatios
SharpeRatio=2 (FundReturnRiskFreeRate)/TrackingError=2 (FundReturn4%)/7%=2 FundReturn=18% InformationRatio=1 (FundReturnS&P500Return)/TrackingError=1 (18%S&P500Return)/7%=1 S&P500Return=11% INCORRECT:DThecandidatecanstopwiththefundreturncalculation,andendupwith14% SharpeRatio=2 (FundReturnRiskFreeRate)/SD=2 (FundReturn4%)/5%=2 FundReturn=14% Reference:AmencandLeSourd,PortfolioTheoryandPerformanceAnalysis.Chapter4

a. b. c. d.
0.274 1.727 0.653 0.378
CORRECT:A
Sharperatioequalsto
R p RF
(R p )
9 .3 % 3 .2 % = 0.452 13.5%
WhileSortinoratioequalsto
R p RF
L ( RP )
9.3% 3.2% = 0.726 8.4%
Trackingerrorisusedtocalculatethevalueoftheinformationratio,whichisdefinedas
R p RB
( RP RB )
, Thecalculationofinformationratioisnotrequiredinthisquestion.
0.7260.452=0.274 INCORRECT:B2.1780.452=1.727
INCORRECT:C0.7260.0.73=0.653(0.073=(.0930.032)/0.83 INCORRECT:D0.730.452=0.378 Reference:AmencandLeSourd,PortfolioTheoryandPerformanceAnalysis.Chapter4

38. Whichofthefollowingstatementsaboutthelinearregressionofthereturnofaportfoliooverthe returnofitsbenchmarkpresentedbelowarecorrect? Portfolioparameter Value Beta 1.25 Alpha 0.26 Coefficientofdetermination 0.66 Standarddeviationoferror 2.42
I. Thecorrelationis0.71 II. 34%ofthevariationintheportfolioreturnisexplainedbyvariationinthebenchmarkreturn III. Theportfolioisthedependentvariable IV. Foranestimatedportfolioreturnof12%,theconfidenceintervalat95%is[7.16%;16.84%]
IIandIV IIIandIV I,IIandIII II,IIIandIV CORRECT:B Theportfolioreturnisthedependentvariableandforanestimatedportfolioreturnof12%,the95% confidenceintervalis[12%2*2.42%,12%+2*2.42%]or[7.16%,16.84%]. However,thecorrelationisthesquarerootofthecoefficientofdeterminationandisthereforeequal to0.81,and66%ofthevariationintheportfolioreturnsisexplainedbyvariationinthebenchmark return. Reference:AmencandLeSourd,PortfolioTheoryandPerformanceAnalysis.Chapter4
a. b. c. d.
39. YourBoardofDirectorswantsacomprehensivereviewofeachbusinessunitsoperationalrisk activities.Astheheadofthecorporateoperationalriskunit,youknowthatlittlehasbeendoneto implementanoperationalriskprocessatthebusinessunitlevelandthatyouneedtoimmediately comeupwithaframework.Whichofthefollowingstatementsoffersthebeststrategy?
I. TheauditcommitteeoftheBoardshouldfirstdefineitsobjectivestoensurethatallthe firmsbusinessunitsoperationalriskprogramsareprovidingrequiredinformation II. Theauditingdepartmentistobechargedwithdevelopinganoperationalriskprogramfor eachbusinessunit,withthebusinessunitbeingmadeclearlyawarethattheywillbeheld accountableforitsimplementation III. Thatyourdepartmentimmediatelyassesstheoperationalriskforeachbusinessunit usingindependentdatafeedstoensuretheinformationfedintotheassessmentcannot bemanipulated IV. Aseniormanagerfromeachprofitcenteristobechargedwithdevelopingtheirown operationalriskselfassessmentprogrambasedonguidelinesyouprovide.
a. b. c. d.
Ionly IandIVonly IandIIIonly IVonly
CORRECT:D Thebeststrategyfordevelopinganoperationalriskframeworkistoempowerbusinessunitswith theresponsibility,accountabilityandauthoritytomanagetheirownoperationalrisks.Thebusiness unitsknowtheirrisksthebest. INCORRECT:AIisnottheresponsibilityoftheAuditCommitteeoftheBoard INCORRECT:BTheauditingdepartmentisnotthebestassessorofanindividualbusinessunitsrisk, infactmanyauditstaffdonotfullyunderstandtherisksofmanyofafirmsactivities INCORRECT:CIIIisduplicativeandshouldnotcomefromthecorporatedepartment Reference:RiskManagementandCapitalAdequacy,Gallati,2003.
40. Whichofthefollowingriskmanagementstrategiesofafirmwhichhasprincipalpaymentstomake onitsdebtinoneyearthatsubstantiallyexceedthemarketvalueofitsassetsismostlikelytobein theinterestoftheshareholders?
a. b. c. d.
Reductionoftheoverallrisklevelofthefirm Increaseoftheoverallrisklevelofthefirm Keepthesamerisklevel Itisimpossibletosaywhichriskmanagementstrategytheshareholdersprefer
CORRECT:B Onceafirmisindistress,itisnotintheinterestsofshareholderstoreducerisk.Ifthefirmstaysin distressandeventuallydefaults,shareholderswillendupwithworthlessshares.Inthese circumstances,managementintentonmaximizingshareholdervaluewillseekoutnewrisks. Reference:RiskManagementandDerivatives,Stulz,2003

ENDOF2009FRMLevelIPRACTICEEXAM Questions&Explanations
2009FRMFullExamPracticeExamI CandidateAnswerSheet
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. 26. 27. 28. 29. 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. a. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. b. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. c. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d. d.
2009FRMPracticeExams Thispageisintentionallyleftblank.
2009FRMFullExamPracticeExamI Questions

1. Giventheinformationprovidedinthetablebelow,whatistheportfolioVaR,atthe99%confidence level,ofthefollowing100millionCHFequallyweightedinvestmentportfolio?
Asset Stocks Bonds

Expected Return 24.00% 15.00%
Volatility 18% 6%
Correlation Stocks 1 0.1 Bonds 1
a. b. c. d.
27.96millionCHF 22.77millionCHF 20.97millionCHF 13.98millionCHF

2. YouareaskedbyyourbosstoestimatetheexposureofahedgefundtotheS&P500.Thoughthe fundclaimstomarktomarketweekly,itdoesnotdosoandmarkstomarketonceamonth.The fundalsodoesnottellinvestorsthatitsimplyholdsanETFwhichisindexedtotheS&P500.Because oftheclaimsofthehedgefund,youdecidetoestimatethemarketexposurebyregressingweekly returnsofthefundontheweeklyreturnoftheS&P500.Whichofthefollowingpropertiescorrectly describesapropertyofyourregressionestimates?
a. ThebetaofyourregressionwillbeonebecausethefundholdstheS&P500. b. Thebetaofyourregressionwillbezerobecausethefundreturnsarenotsynchronouswiththe S&P500returns. c. Theinterceptofyourregressionwillbepositive,showingthatthefundhasapositivealpha whenestimatedusinganOLSregression. d. Thebetawillbemisestimatedbecausehedgefundexposuresarenonlinear.
3. ThefollowingtableshowsthecompositionoftheGARPBondFund.Whataretheportfolioduration andportfolioyieldofthefund?
GARP Bond Fund Rating Amount Duration Mn USD in years AAA Company A 600 1.5 Company B 300 4 Company C 200 2.5 AA Company D 400 4 Company E 350 0.5 A Company F 150 1.5
Total 2000
Rating valuation matrix Years 0-1 Rating AAA 6.25% AA 6.75% A 7.75% 1-2 6.75% 7.35% 8.45% 2-3 7.35% 8.05% 9.15%
3-4 8.00% 8.80% 9.85%
a. b. c. d.
14years,46.1% 2.3years,7.5% 2.3years,7.7% 4.4years,15.4%%
4. AninvestmentbankusestheExponentiallyWeightedMovingAverage(EWMA)techniquewith lambdaof0.9tomodelthedailyvolatilityofasecurity.Thecurrentestimateofthedailyvolatilityis 1.5%.TheclosingpriceofthesecurityisUSD20yesterdayandUSD18today.Usingcontinuously compoundedreturns,whatistheupdatedestimateofthevolatility? a. 5.44% b. 3.62% c. 2.96% d. 1.31%

a. b. c. d.
2.9% 2% 1.1% 4.7%
6. InpricingaderivativeusingtheMonteCarlomethod,weneedtosimulateareasonablenumberof pathsforthepriceoftheunderlyingasset.Supposeweuseasimplemodelforthereturnofthe underlyingasset: y(t)=drift*t+vol*t*e(t),ande(t)isdistributed~N(0,1), wheredriftandvolareknownparametersandtisthestepsize. Thegenerationofeachpathrequiresanumberofsteps.Whichofthefollowingdescribesthe correctprocedure? a. GeneratearandomnumberfromanormaldistributionN(0,1),usetheinversenormalfunction togete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedureuntilyouget thefulldesiredpath. b. GeneratearandomnumberfromanormaldistributionN(0,1),usethecumulativenormal functiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedure untilyougetthefulldesiredpath. c. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usetheinverse cumulativenormalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthe sameprocedureuntilyougetthefulldesiredpath. d. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usethecumulative normalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesame procedureuntilyougetthefulldesiredpath.
a. b. c. d.
5.10 14.47 9.20 17.20
8. YoudonthaveaccesstoKMVsdata.Yourbosswantsyoutotellhimyourestimateofthe probabilityofdefaultofacredit.Todoso,youusetheMertonModelbecausethecredityouare consideringhasnosystematicrisk.InMertonsModel,thedistancetodefault(DD)andthe expecteddefaultfrequency(EDF)are
a. b. c. d.
positivelyandlinearlyrelated negativelyandlinearlyrelated positivelyandnonlinearlyrelated negativelyandnonlinearlyrelated
9. SupposetherateonCompanyAsoneyearzerocouponbondis10.0%andtheoneyearTbillrate is8.0%.AssumetheTbillisrisklessandtheprobabilityofdefaultofCompanyAsbondis10%. WhatistheLGDofCompanyAsbond?
a. b. c. d.

18.18% 81.82% 20.01% 79.99%
10. Abankisconsideringwaysofsignificantlyreducingoreliminatingitscreditexposuretodefaultsona loanportfoliosothatthebanksshareholdersdonotabsorbthelossesarisingfromsuchdefaults. Ignoringinstitutionalissues(e.g.,tax,accounting,capitalrequirements),threeofthefollowing programshaveasimilarimpactonthecreditriskofthebank.Whichalternativefailstoreduce creditrisk?
a. b. c. d.

Selltheloanportfolioinitsentiretytoanotherbank. Borrowtofinanceanadditionalriskreservetosupplementexistingloanlossreserves. Securitizetheloanportfolio. Buycreditprotectionontheloanportfoliowithcreditdefaultswaps.
11. ConsiderastockpriceSthatfollowsageometricBrownianmotion dS = S dt + S dz, with strictlypositiveand afixedvalue.Whichofthefollowingstatementsistrue?
a. b. c. d.
12. ThejointprobabilitydistributionofrandomvariablesXandYisgivenbyf(x,y)=kxyforx=1,2,3,y= 1,2,3,andkisapositiveconstant.WhatistheprobabilitythatX+Ywillexceed5? a. 1/9 b. 1/4 c. 1/36 d. Cannotbedetermined


a. b. c. d.

2.41% 3.11% 4.40% 1.89%
a. b. c. d.

USD0.23 USD1.645 USD0.33 USD0.16
a. b. c. d.

USD2.33 USD1.65 USD0.82 USD1.16
a. durationplusconvexity,duration,fullrepricing b. fullrepricing,durationplusconvexity,duration c. duration,durationplusconvexity,fullrepricing d. duration,fullrepricing,durationplusconvexity 18. Considerapositionina5yearreceivefixedswapthatmakesannualpaymentsonaUSD100million notional.Thefloatingleghasjustbeenreset.Thetermstructureisflatat5%,theMacaulay durationofa5yearparbondis4.5years,andtheannualvolatilityofyieldchangesis100bp.Your bestestimateoftheswapsVaRwith95%confidenceoverthenextmonthis
a. b. c. d.
USD1.6million USD2.0million USD5.5million USD7.1million
19. Ifthegoldleaserateishigherthantheriskfreerate,whatisthemarketstructureoftheforward marketforgold?
a. b. c. d.
a. b. c. d.

5.4% 5.5% 5.8% 6.7%
a. b. c. d.

USD1,953,125 USD1,906,250 USD2,046,875 USD2,187,500
a. b. c. d.

8.9% 9.8% 35.7% 39.1%
23. AninvestorsellsaJune2008callofABCLimitedwithastrikepriceofUSD45forUSD3andbuysa June2008callofABCLimitedwithastrikepriceofUSD40forUSD5.Whatisthenameofthis strategyandthemaximumprofitandlosstheinvestorcouldincur?
a. b. c. d.

BearSpread,MaximumLossUSD2,MaximumProfitUSD3 BullSpread,MaximumLossUnlimited,MaximumProfitUSD3 BearSpread,MaximumLossUSD2,MaximumProfitUnlimited BullSpread,MaximumLossUSD2,MaximumProfitUSD3
I. Itgivestoolittleweighttomorerecentobservations II. Forlongonlyportfolios,itislikelytounderstateVaRfollowingarecentstructuralincreasein volatilities III. Italwaysignoresthefattailspresentinthedistributionofreturnsonmanyfinancialassets IV. Becauseofthedeltaapproximation,itinadequatelymeasurestheriskofnonlinear instruments a. b. c. d.

a. b. c. d.
ReceiveUSD2.23million ReceiveUSD1.93million PayUSD1.93million PayUSD2.23million
I. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsNov07NYMEXWTICrude Oilcontracts II. Long1,000lotsNov07ICEBrentOilcontractsandlong2,000lotsNov07ICEBrentOilatthe moneyput III. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsDec07ICEBrentOil contracts IV. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsDec07NYMEXWTICrude Oilcontracts
a. b. c. d.

I&III II&IV IIII&IV I,III&IV
27. Accordingtoputcallparity,buyingaputoptiononastockisequivalentto: a. Buyingacalloptionandbuyingthestockwithfundsborrowedattheriskfreerate. b. Sellingacalloptionandbuyingthestockwithfundsborrowedattheriskfreerate. c. Buyingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate. d. Sellingacalloption,sellingthestockandinvestingtheproceedsattheriskfreerate.

a. b. c. d.

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

a. b. c. d.

Purchase2,602shares Sell2,602shares Purchase1,493shares Sell1,493shares
31. Whichofthefollowingstrategiescreatesacalendarspread? a. Sellacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice. b. Buyacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice. c. Sellacalloptionwithacertainstrikepriceandbuyashortermaturitycalloptionwiththesame strikeprice. d. Buyacalloptionwithacertainstrikepriceandsellalongermaturitycalloptionwiththesame strikeprice.

a. b. c. d.

a. b. c. d.
Theyshouldbeexactlythesame. Theforwardrateisnormallyhigherthanthefuturesrate. Theforwardrateisnormallylowerthanthefuturesrate. Theyhavenofixedrelationship.

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

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

a. b. c. d.

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

3.5% 7% 11% 14%
a. b. c. d.
0.274 1.727 0.653 0.378
40. YourfirmhasnopriorderivativestradeswithitscounterpartySuperBank.Yourbosswantsyouto evaluatesometradessheisconsidering.Inparticular,shewantstoknowwhichofthefollowing tradeswillincreaseyourfirmscreditriskexposuretoSuperBank:
I. buyingaputoption II. sellingaputoption III. buyingaforwardcontract IV. sellingaforwardcontract
a. b. c. d.

I.andIIonly IIandIVonly IIIandIVonly I,IIIandIVonly
41. Considerthefollowingoneperiodtransitionmatrix:
Initial Period State
A B Default
NextPeriodState A B 95% 5% 10% 80% 0% 0%
Default 0% 10% 100%
IfacompanyisoriginallyinStateA,whatistheprobabilitythatthecompanywillhavedefaulted strictlybeforethefourthtransitionperiodfromnow?
a. b. c. d.

0.875% 0.500% 1.375% 1.875%
42. Asanapproximation,itistruethat
a. b. c. d.
Defaultswapspread=Returnofariskybond+Returnofariskfreebond Defaultswapspread=ReturnofariskybondReturnofariskfreebond Defaultswapspread=ReturnofariskybondxReturnofariskfreebond Defaultswapspread=Returnofariskybondx(1Returnofariskfreebond)

43. InaCDO,theSPVistypically
a. b. c. d.

AAArated Arated BBBrated Notrated
44. Atraderwhoseriskyouaremonitoringtellsyouthathewantstobenefitfromacreditspread wideningduetoarecession.Whichofthefollowingwouldbegoodtradesforhisstrategy?
a. Golongriskybondsandshortriskfreebondsatthebeginningoftherecession. b. Shortriskybondsandgolongriskfreebondsatthebeginningoftherecession. c. Sellcreditdefaultswapsonbondswithalowcreditqualityandbuycreditdefaultswapson bondswithahighercreditqualityatthebeginningoftherecession. d. Sellcreditdefaultswapsonbondswithlowcreditqualityandgolonglowcreditqualitybonds. 45. BankBhasaEUR100millionloanportfolioandhassetasideareservetocoverthefirstEUR20 millionindefaultrelatedlosses.IfthebankwantstoacquireprotectionfortheremainingEUR80 millioninriskexposure,whichofthefollowingsolutionswouldworkandwouldexposethebankto theleastamountofcounterpartyrisk?
a. BuycreditprotectioninaseniorsubordinatedCDSthatcoversEUR80millioninlossesabove thefirstEUR20million. b. BuycreditinsuranceforlossesuptoEUR80millioninexcessofEUR20millionontheloan portfolio. c. Issueacreditlinkednoteinwhichinterestandprincipalmaybewithheldfrominvestorsto coveruptoEUR80millioninlossesabovethefirstEUR20millionontheloanportfolio. d. Allthreeoftheabovechoicesworkandexposethebanktothesameamountofcounterparty risk.

46. Mr.Rosenqvist,AssetManageratBCDBank,holdsaportfolioofSEK200million.Theportfolio consistsofBBBratedbonds.Assumethattheoneyearprobabilityofdefaultis4%,therecovery rateis60%,anddefaultsareuncorrelatedoveryears.Whatisthe2yearcumulativeexpectedcredit lossonMr.Rosenqvistsportfolio?
a. b. c. d.
SEK6.35million SEK6.40million SEK9.48million SEK9.60million
47. UsingtheMertonmodel,thevalueofthedebtincreasesifallotherparametersarefixedand
I. Thevalueofthefirmdecreases II. Therisklessinterestratedecreases III. Timetomaturityincreases IV. Thevolatilityofthefirmvaluedecreases
a. b. c. d.

IandIIonly IandIVonly IIandIIIonly IIandIVonly
a. b. c. d.

0.5554 0.9333 1.2099 0.8198
a. b. c. d.

Short94contracts Short98contracts Short105contracts Short113contracts
a. b. c. d.
USD80,000 USD10,500,000 USD80,000,000 USD105,000,000
ENDOF2009FRMFULLEXAMPRACTICEEXAMI

2009FRMFullExamPracticeExamI AnswerKey

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

2009FRMFullExamPracticeExamI Answers&Explanations
1. Giventheinformationprovidedinthetablebelow,whatistheportfolioVaR,atthe99%confidence level,ofthefollowing100millionCHFequallyweightedinvestmentportfolio?
Asset Stocks Bonds
Expected Return 24.00% 15.00%
Volatility 18% 6%
Correlation Stocks 1 0.1 Bonds 1
a. b. c. d.
27.96millionCHF 22.77millionCHF 20.97millionCHF 13.98millionCHF
CORRECT:B Thevarianceoftheequallyweightedportfoliois0.5^2*0.18^2+0.5^2*0.06^2+2*0.5*0.5*0.1 *0.18*0.06=0.081+0.0009+0.0005=0.00954.Thevolatilityisthen9.77%.TheportfolioVaRor theriskbudgetis2.33*9.77%*100millionCHF=22.77millionCHF. Reference:Allenetal.Chapters2,3.

2. YouareaskedbyyourbosstoestimatetheexposureofahedgefundtotheS&P500.Thoughthe fundclaimstomarktomarketweekly,itdoesnotdosoandmarkstomarketonceamonth.The fundalsodoesnottellinvestorsthatitsimplyholdsanETFwhichisindexedtotheS&P500.Because oftheclaimsofthehedgefund,youdecidetoestimatethemarketexposurebyregressingweekly returnsofthefundontheweeklyreturnoftheS&P500.Whichofthefollowingpropertiescorrectly describesapropertyofyourregressionestimates?
a. ThebetaofyourregressionwillbeonebecausethefundholdstheS&P500. b. Thebetaofyourregressionwillbezerobecausethefundreturnsarenotsynchronouswiththe S&P500returns. c. Theinterceptofyourregressionwillbepositive,showingthatthefundhasapositivealpha whenestimatedusinganOLSregression. d. Thebetawillbemisestimatedbecausehedgefundexposuresarenonlinear.
CORRECT:C Thealphaisspuriousandresultsfromthefactthatreturnsarenonsynchronous.d.isincorrect becausethetrueexposureislinear.Thebetaisgreaterthanzeroandlessthanonebecauseofnon synchroneity. Reference:AmencandLeSourd,PortfolioTheoryandPerformanceAnalysis.Chapter4

3. ThefollowingtableshowsthecompositionoftheGARPBondFund.Whataretheportfolioduration andportfolioyieldofthefund?
GARP Bond Fund Rating Amount Duration Mn USD in years AAA Company A 600 1.5 Company B 300 4 Company C 200 2.5 AA Company D 400 4 Company E 350 0.5 A Company F 150 1.5
Total 2000
Rating valuation matrix Years 0-1 Rating AAA 6.25% AA 6.75% A 7.75% 1-2 6.75% 7.35% 8.45% 2-3 7.35% 8.05% 9.15%
3-4 8.00% 8.80% 9.85%
a. b. c. d.
14years,46.1% 2.3years,7.5% 2.3years,7.7% 4.4years,15.4%%
Thecalculationofportfoliodurationandportfolioyieldisbasedontheproportionalweightageof respectivecompanytoitsdurationandyield.Theportfoliodurationandportfolioyieldaftermapping theyieldfromratingmatrixisasfollows; CORRECT:B
Thisanswerreflectstheproportionofamounttakenasweightstocalculatetheportfolioduration andportfolioyield.
GARP Bond Fund Amount Proportion % Duration Yield AAA Co A 600 30% 1.5 6.75% Co B 300 15% 4 8.00% Co C 200 10% 2.5 7.35% AA Co D 400 20% 4 8.80% Co E 350 18% 0.5 6.75% A Co F 150 8% 1.5 8.45% Total 2000 100% 2.30 7.54%
INCORRECT:AIfthecandidatedoesasimpleadditionofthedurationandthemappedyield,he wouldgetthisanswer. INCORRECT:CThoughtheportfoliodurationiscorrect,butitisarrivedbytakingsimpleaverageof duration.However,ifthecandidatewouldtakesimpleaverageofmappedyieldinsteadof proportionhisanswerwouldbe7.7%andnot7.5% INCORRECT:DIfthecandidateaveragesbasedonratingclasses(3AAA/AA/A)insteadofthe companies,hewouldgetthisanswer. Reference:Tuckman;Chapter6.

4. AninvestmentbankusestheExponentiallyWeightedMovingAverage(EWMA)techniquewith lambdaof0.9tomodelthedailyvolatilityofasecurity.Thecurrentestimateofthedailyvolatilityis 1.5%.TheclosingpriceofthesecurityisUSD20yesterdayandUSD18today.Usingcontinuously compoundedreturns,whatistheupdatedestimateofthevolatility?
a. b. c. d.
5.44% 3.62% 2.96% 1.31%
CORRECT:B Thecurrentreturnofthesecurityis=ln(18/20)=10.536%.UsinganEWMAmodel,theupdated volatilityisgivenas:V(t) ={lambda*((V[t1]^2)+(1lambda)*(currentreturn^2)}^0.5 ={0.9*((0.015^2)+(10.9)*(0.10536^2)}^0.5

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

a. b. c. d.
2.9% 2% 1.1% 4.7%
CORRECT:A
E[ra|rb=x]=a+(abab/ a)(xb)=0.02+0.9*(0.030.02)=0.029
Reference:DamodarGujarati,chapter2.

6. InpricingaderivativeusingtheMonteCarlomethod,weneedtosimulateareasonablenumberof pathsforthepriceoftheunderlyingasset.Supposeweuseasimplemodelforthereturnofthe underlyingasset:
y(t)=drift*t+vol*t*e(t),ande(t)isdistributed~N(0,1), wheredriftandvolareknownparametersandtisthestepsize. Thegenerationofeachpathrequiresanumberofsteps.Whichofthefollowingdescribesthe correctprocedure? a. GeneratearandomnumberfromanormaldistributionN(0,1),usetheinversenormalfunction togete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedureuntilyouget thefulldesiredpath.
b. GeneratearandomnumberfromanormaldistributionN(0,1),usethecumulativenormal functiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesameprocedure untilyougetthefulldesiredpath. c. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usetheinverse cumulativenormalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthe sameprocedureuntilyougetthefulldesiredpath. d. Generatearandomnumberfromauniformdistributiondefinedin[0,1],usethecumulative normalfunctiontogete(t),whichwillbefedintothemodeltogety(t).Repeatthesame procedureuntilyougetthefulldesiredpath.
CORRECT:C Thisquestionwantstotestifthecandidateknowsthebasicstepstogenerateaverysimplepath: answeringthisquestionmeansthatthecandidatewouldbeabletobuildasimplespreadsheet showingtheMonteCarlologic.Thecorrectprocedureistheonedescribedinc);whilea),b)andd) arenonsensicalcalculations. Reference:PhilippeJorion,ValueatRisk,TheNewBenchmarkforManagingFinancialRisk,3rdedition (NewYork:McGrawHill,2007),Chapter12.

15.10 14.47 9.20 17.20 CORRECT:D Sinceeachvariableisstandardized,itsvarianceis1.ThereforeV(3A+2B)=9V(A)+4V(B)+2x3x2 xCov(A,B)=9+4+4.2=17.2 INCORRECT:A9+4+6*0.35=15.1 INCORRECT:B9+4+12*0.35^2= INCORRECT:C3+2+12*0.35=9.2 Reference:DamodarGujarati
a. b. c. d.
8. YoudonthaveaccesstoKMVsdata.Yourbosswantsyoutotellhimyourestimateofthe probabilityofdefaultofacredit.Todoso,youusetheMertonModelbecausethecredityouare consideringhasnosystematicrisk.InMertonsModel,thedistancetodefault(DD)andthe expecteddefaultfrequency(EDF)are
a. b. c. d.
positivelyandlinearlyrelated negativelyandlinearlyrelated positivelyandnonlinearlyrelated negativelyandnonlinearlyrelated
CORRECT:D Theriskneutralprobabilityofdefault,EDF,intheMertonModelis1N(d2).Thehigherthedistance
ln(
todefault,DDDDd2= thecontrary,thelowerDD,thehigherEDFis.Therelationshipisnonlinear.WhentheDDislow,EDF ishigh.IfDDisimminent,EDFishighaswell.Similarly,ifDDishigh,EDFissmallandnotimminent Reference:DeServignyandRenault,MeasuringandManagingCreditRisk,Chapter3.

V 1 ) 2 T V rT 2 De V T ,thelowertheriskneutralprobabilityofdefaultis.On
9. SupposetherateonCompanyAsoneyearzerocouponbondis10.0%andtheoneyearTbillrate is8.0%.AssumetheTbillisrisklessandtheprobabilityofdefaultofCompanyAsbondis10%. WhatistheLGDofCompanyAsbond?
18.18% 81.82% 20.01% 79.99% CORRECT:A (1+10%)*(1PD)+(1+10%)*PD*(1LGD)=1+8% 1.1x0.9+1.1x0.10x(1LGD)=1.08 0.99+0.11x(1LGD)=1.08 0.11x(1LGD)=1.080.99 (1LGD)=(1.080.99)/0.11 LGD=1(1.080.99)/0.11=18.18% or
a. b. c. d.
LGD=1((1+rf)(1+r)x(1PD))/((1+r)xPD) Reference:DeServignyandRenault,MeasuringandManagingCreditRisk,Chapter3,4.

10. Abankisconsideringwaysofsignificantlyreducingoreliminatingitscreditexposuretodefaultsona loanportfoliosothatthebanksshareholdersdonotabsorbthelossesarisingfromsuchdefaults. Ignoringinstitutionalissues(e.g.,tax,accounting,capitalrequirements),threeofthefollowing programshaveasimilarimpactonthecreditriskofthebank.Whichalternativefailstoreduce creditrisk?
a. b. c. d.
Selltheloanportfolioinitsentiretytoanotherbank. Borrowtofinanceanadditionalriskreservetosupplementexistingloanlossreserves. Securitizetheloanportfolio. Buycreditprotectionontheloanportfoliowithcreditdefaultswaps.
CORRECT:B Allthreeoftheotherchoicesareeconomicallyequivalent.Sellingloanstoanexternalparty eliminatesallcreditriskfortheinstitution.Similarly,securitizingtheloanportfolioremovesthe loansfromthebanksbooksandeliminatesthecreditriskfortheinstitution.Buyingcredit protectionusingcreditdefaultswapswillofferprotectionagainstcreditrisk.Thisalternativeimplies counterpartyrisk.Borrowingdoesnotworkinthelongrunbecauseshareholdersstillatsomepoint havetotakethehitfordefaultrelatedlosses.Additionally,theincreasedborrowingtofinancethe loanlossreserveswillincreasetheriskfortheshareholders. Reference:Culp,Chapter16

11. ConsiderastockpriceSthatfollowsageometricBrownianmotiondS=Sdt+ Sdz,withstrictly positiveandafixedvalue.Whichofthefollowingstatementsistrue?
a. b. c. d.
CORRECT:C
INCORRECT:ATheexpectedpriceislessthantodaysprice,butnotthepriceinallthestatesof world. INCORRECT:BTheinstantaneousrateofreturnonthestockfollowsnormaldistribution. INCORRECT:DThismodeldoesnotimposemeanreversion. Reference:PhilippeJorion,ValueatRisk:TheNewBenchmarkforManagingFinancialRisk,3 ed. (NewYork:McGrawHill,2007).Chapter12

rd
a. 1/9 b. 1/4 c. 1/36 d. Cannotbedetermined CORRECT:B Notethat
f ( x, y) = 1 .
x =1 y =1
Substitutingthevariousvaluesofxandy,wegetf(1,1)=k,f(1,2)=2k,f(1,3)=3k,f(2,1)=2k,f(2,2)=4k, f(2,3)=6k,f(3,1)=3k,f(3,2)=6k,andf(3,3)=9k.Therefore, k1+2k+3k+2k+4k+6k+3k+6k+9k=1 sothat,36k=1andk=1/36. P(X+Y>5)=f(3,3)=1/36x3x3=1/4 Reference:DamodarGujarati

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

a. b. c. d.
2.41% 3.11% 4.40% 1.89%
CORRECT:C The1dayvolatilityiss*(1/252)^0.5=0.3*0.629941=0.018898.TheVaRatthe99%confidence levelisthenequalto2.32635*0.018898=4.40% INCORRECT:AOnegetsAifoneuses1.645insteadof2.326, INCORRECT:BOnegetsBifoneusesthemonthlyvolatilityinsteadofthedailyone INCORRECT:DOnegetsDisthedailyvolatility. Reference:Allen,BoudoukhandSaunders,2004,chapter1,p68

a. b. c. d.
USD0.23 USD1.645 USD0.33 USD0.16
CORRECT:D
ThisquestionrequirescandidatestoknowtheformulaforthedeltanormalVaRapproximation,and alsotoknowthatthedeltaofanatthemoneycallis0.5. VaR =| | 1.645 S = 0.5 1.645 0.02 10 = 0.1645 . INCORRECT:AWegetAbyusing2.326insteadof1.645 INCORRECT:BWegetBifweuse2insteadof2%forthevolatility INCORRECT:CWegetCifweuseadeltaof1 Reference:Allenetal,Chapter3

a. b. c. d.
USD2.33. USD1.65. USD0.82. USD1.16
CORRECT:B ThisquestionassessescandidatesabilitiestoapplythedurationVaRformulatotwobonds simultaneouslyandtorecallthatthedurationofazerocouponbondisequaltothebondmaturity. UsinganobviousextensionofJorionsequation9.5
VaR = D1 V1 1.645 + D2 V2 1.645 = ( D1 V1 + D2 V2 ) 1.645 = ( D1 + D2 ) 10 1.645 = 10 10 1.645 0.01 = 1.645

INCORRECT:AIsthe99%confidencelevelVaR INCORRECT:CArisesifthecandidatemistakenlydividesthecorrectanswerbythenumberofbonds INCORRECT:DMakesbothmistakes Reference:Tuckman
a. b. c. d.
durationplusconvexity,duration,fullrepricing fullrepricing,durationplusconvexity,duration duration,durationplusconvexity,fullrepricing duration,fullrepricing,durationplusconvexity
CORRECT:C Theprice/yieldlinewithyieldonthexaxisandpriceontheyaxisisconvextotheorigin.The durationatanyyieldlevelisthetangenttothatcurve.Therefore,exceptattheexactpointof tangency,durationwillalwaysunderestimatethepricechange. INCORRECT:ADurationwillalwaysunderestimatepricechangefornegativeyieldshocks INCORRECT:BFullrepricingwillnevergenerateasmallerpositivepricechangethanduration becausedurationrepresentsthepointoftangency INCORRECT:DFullrepricingwillgenerateahigherpriceforalargenegativeyieldchangethanwil durationplusconvexity Reference:Allen,Boudoukh,Saunders,Chapter3

18. Considerapositionina5yearreceivefixedswapthatmakesannualpaymentsonaUSD100million notional.Thefloatingleghasjustbeenreset.Thetermstructureisflatat5%,theMacaulay durationofa5yearparbondis4.5years,andtheannualvolatilityofyieldchangesis100bp.Your bestestimateoftheswapsVaRwith95%confidenceoverthenextmonthis
a. b. c. d.
CORRECT:A Becausethefloatingrateleghasjustbeenreset,itsdurationis1.Netdurationis4.51=3.5year,or modifieddurationof3.5/1.05=3.33.The95%VaRofmonthlychangesinyieldsis1.65*1%/12= 0.48%.Multiplying,thisgivesUSD100*0.48%*3.33=USD1.588
INCORRECT:BThisusesanetdurationof4.5yearsandignoresthedurationofthefloatingrate leg. INCORRECT:CThisistheannualVaR,butshouldbetranslatedtoamonthlyhorizon. INCORRECT:DThisistheannualVaRcomputedbyignoringthedurationofthefloatingrateleg. Reference:Hull,Chapter,Chapter7 19. Ifthegoldleaserateishigherthantheriskfreerate,whatisthemarketstructureoftheforward marketforgold?
a. b. c. d.
CORRECT:B Aleaseratehigherthantheriskfeeratewillforceanegativelyslopedforwardcurve,i.e. backwardation INCORRECT:ATheforwardprice=spot*exp(riskfreerateleaserate).Iftheleaserateishigher thantheriskfreerate,forwardswillbelowerthanspot,implyingcontango INCORRECT:CTheterminversionisusedtodescribeyieldcurves,notcommodityforwards INCORRECT:DThereisenoughinformationinthequestiontoprovideananswer Reference:MacDonald,Chapter6

a. b. c. d.
5.4% 5.5% 5.8% 6.7%
CORRECT:D
1 + Forward rate = 85.16 Price of three bond = = 1.067034 Price of four year bond 79.81
Forward rate = 0.067034 or 6.7%
INCORRECT:AIsacombinationofBandC INCORRECT:BIsthereturnofthe3yearbond INCORRECT:CIsthereturnofthe4yearbond Reference:Hull,Tuckman

a. b. c. d.
USD1,953,125 USD1,906,250 USD2,046,875 USD2,187,500
CORRECT:A
V = - D mod y V + 0.5 Convexity y 2 V V = - 8 0.0025 100M + 0.5 150 (0.0025) 2 100M V = - 2M + 46,875 V = - 1,953,125
INCORRECT:BOmits0.5fromthesecondterm INCORRECT:CSubtractsthesecondterm INCORRECT:DMakesbothmistakes Reference:Tuckman 22. WhatistheannualizedrateofreturnearnedonacashandcarrytradeenteredintoinMarchand closedoutinJune? a. 8.9% b. 9.8% c. 35.7% d. 39.1%
CORRECT:C ByformulaF0,T=S0erT+C,whereF0,T=Juneforwardprice,S0=Marchforwardprice,r=riskfree interestrate,T=lengthofcashandcarry,C=storagecost Solving5.90=5.35er*3/12+0.05 Solutionisr=35.7% INCORRECT:A8.9=LN((5.90.05)/5.35)(forgetstoannualizethereturn) INCORRECT:B9.8=LN((5.9)/5.35)(forgetstoincludethestoragecostandtoannualizethereturn) INCORRECT:D39.1=(12/3)LN((5.9)/5.35)0.05(forgetstoincludethestoragecost) Reference:RobertLMcDonald,DerivativesMarkets,Chapter6

23. AninvestorsellsaJune2008callofABCLimitedwithastrikepriceofUSD45forUSD3andbuysa June2008callofABCLimitedwithastrikepriceofUSD40forUSD5.Whatisthenameofthis strategyandthemaximumprofitandlosstheinvestorcouldincur? a. BearSpread,MaximumLossUSD2,MaximumProfitUSD3 b. BullSpread,MaximumLossUnlimited,MaximumProfitUSD3 c. BearSpread,MaximumLossUSD2,MaximumProfitUnlimited d. BullSpread,MaximumLossUSD2,MaximumProfitUSD3
CORRECT:D BuyingacalloptionatlowerstockpriceandsellingcalloptionathigherstrikepriceiscalledasBull Spread.BearSpreadisbuyingthecalloptionathigherpriceandsellingthecallatlowerstrikeprice. TheCostofstrategywillbeUSD3USD5=USD2 ThePayoff,whenStockpriceSTUSD40willbeUSD2(thecostofstrategy)asnoneoftheoption willbeexercised. ThePayoff,whenstockpriceST45,(asbothoptionswillbeexercise)willbeUSD5, SincethecostofstrategyisUSD3,henceprofitwillbeUSD5USD2=USD3 WhenStockpriceisUSD40<ST>USD45,Onlythecalloptionboughtbytheinvestorwouldbe exercisedhencethepayoffwillbeST40,sincethecostofstrategyisUSD3,TheNetprofitwillbe ST43,whichwouldalwaysbelowerthanUSD3. Reference:Hull,Chapter10TradingStrategiesInvolvingOptions.
I. Itgivestoolittleweighttomorerecentobservations II. Forlongonlyportfolios,itislikelytounderstateVaRfollowingarecentstructuralincreasein volatilities III. Italwaysignoresthefattailspresentinthedistributionofreturnsonmanyfinancialassets IV. Becauseofthedeltaapproximation,itinadequatelymeasurestheriskofnonlinear instruments
a. b. c. d.
CORRECT:C ThedisadvantagewiththeHistoricalSimulationModelisthatitmaynotrecognizethechangesin volatilityandcorrelationfollowingrecentstructuralchanges.Themodelcanbeadjustedsothatit givesmoreweighttorecentobservations.Theotheroptions,i.e.III&IV,aredisadvantagesofMonte CarlomethodandDeltanormalmethod. Reference:Allenetal.Chapters2,3. 25. AbankholdsUSD60millionworthof10year6.5%couponbondsthataretradingatacleanpriceof 101.82.Thebankisworriedbytheexposureduetothesebondsbutcannotunwindthepositionfor fearofupsettingtheclient.Therefore,itpurchasesatotalreturnswap(TRS)inwhichitreceives annualLibor+100bpsinreturnforthemarktomarketreturnonthebond.Forthefirstyear,the Liborsetsat6.25%andbytheendoftheyearthecleanpriceofthebondsisat99.35.Thenet receipt/paymentforthebankinthetotalreturnswapwillbe:
a. ReceiveUSD2.23million. b. ReceiveUSD1.93million. c. PayUSD1.93million. d. PayUSD2.23million. CORRECT:B
itstheresultofthiscalculation:thenotionalamountis60millionUSD.Thereforethebankwill receivetheinterestpaymentlinkedtotheLIBORrate:60millionUSD*(6,25%+100bp)=4.35 millionUSD. Thebankwillpaythefixedcouponplusthechangeinthevalueofthebond:60millionUSD*6.5%+ 60million*(99.35%101.82%)=2.418millionUSD. Hencethetotalnetamountthebankwillreceiveis:4.35millionUSD2.418millionUSD=1.932 millionUSD. Reference:HullChapter7Swaps

I. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsNov07NYMEXWTI CrudeOilcontracts II. Long1,000lotsNov07ICEBrentOilcontractsandlong2,000lotsNov07ICEBrentOilat themoneyput III. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsDec07ICEBrentOil contracts IV. Long1,000lotsNov07ICEBrentOilcontractsandshort1,000lotsDec07NYMEXWTI CrudeOilcontracts
I&III II&IV IIII&IV I,III&IV CORRECT:D BasisRiskisspreadrisk,whicharisefromtradingthespread(longandshort2positivelycorrelated assetsorsameassetwithdifferentexpiration) Iisspreadtradeinhighlycorrelatedassetwithsameexpirationmonth IIfaceswithgammaandvegarisk IIIisspreadtradeintradingtheflatteningoftheforwardcurve IVisspreadtradeintrading2assetswithdifferentexpirationdate Reference:RobertL.McDonald,DerivativesMarkets(Boston:AddisonWesley,2003),Chapter6.
a. b. c. d.

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

a. b. c. d.
USD10.00 USD7.50 USD5.00 USD1.50
CORRECT:C Accordingtothefundamentalpricingrelationshipbetweenspotassetsandtheassociatedfutures, thefuturesprice,topreventarbitrage,shouldequal990xe(0.040.02)x0.25or995.Hence,the futurescontractisovervalued,indicatingitshouldbesoldandtheindexshouldbepurchasedforan arbitrageprofitofUSD1000USD995=USD5 Reference:Hull,Options,Futures,andOtherDerivatives,6 ed.Chapter5

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

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

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

31. Whichofthefollowingstrategiescreatesacalendarspread? a. Sellacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice. b. Buyacalloptionwithacertainstrikepriceandbuyalongermaturitycalloptionwiththesame strikeprice. c. Sellacalloptionwithacertainstrikepriceandbuyashortermaturitycalloptionwiththesame strikeprice. d. Buyacalloptionwithacertainstrikepriceandsellalongermaturitycalloptionwiththesame strikeprice.
CORRECT:A INCORRECT:BAsbuyacalloption. INCORRECT:CAsbuyashortermaturitycalloption INCORRECT:DAsthisisareversecalendarspread. Reference:Hull.

a. b. c. d.
CORRECT:B
INCORRECT:ALargecurrentaccountsurplusandnonconvertiblecurrencywouldprotectthelocal currency INCORRECT:CHighforeignexchangereservesandnonconvertiblecurrencywouldprotectthelocal currency INCORRECT:DLargecurrentaccountsurplusandhighforeignexchangewouldprotectthelocal currency Reference:Saunders,Chapter15,ForeignExchangeRisk
a. b. c. d.
Theyshouldbeexactlythesame. Theforwardrateisnormallyhigherthanthefuturesrate. Theforwardrateisnormallylowerthanthefuturesrate. Theyhavenofixedrelationship.
CORRECT:C AsEurodollarfuturescontractismarkedtomarketandsettleddaily,normallyforwardrateis adjustedlower,socalledconvexityadjustment,by: Forwardrate=Futuresrate 2T1T2 Reference:Hull.

1 2
a. TraderAboughtacallandaput,bothwith90daystoexpirationandwithstrikepriceequalto theexistingspotlevel. b. TraderBboughtaputoptionwithadownandinknockinfeature. c. TraderCboughtacalloptionattheexistingspotlevelsandsoldacallatahigherstrikeprice, bothwith90daystoexpiration. d. TraderDsoldacallandboughtaputattheexistinglevels,bothwith90daystoexpiration.

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

35. Consideringoptionsgenerally(i.e.,notonlyplainvanillacallsandputs),whichofthefollowing statementsaboutvegaiscorrect?
Anoptionholdercanneverbeveganegative. Adeepinthemoneyupandoutcalloptionhasanegativevega. Adeepoutofmoneyupandoutcalloptionhasanegativevega. Adeepoutofmoneydigitaloptionhasanegativevega. CORRECT:B DeepinthemoneyUpandOutcalloptionbecauseanincreaseinthevolatilityofsuchoptionsleads totheincreasingchancesofoptioneitherbeingknockedout(ifthepriceincreasesbeyondthe barrier)orloosingitsmoneyness(ifthepricesfalls)andhencetheincreasingvolatilitytendstohave negativeimpactonthepriceoftheoption. INCORRECT:AAsanoptionholdercanbeVeganegativeasshownabove. INCORRECT:ChavepositiveVegaasanincreaseinthevolatilitywouldincreasethechancesof gettingtowardsmoneynessandhencepositiveVegafromaholdersperspective. INCORRECT:DhavepositiveVegaasanincreaseinthevolatilitywouldincreasethechancesof gettingtowardsmoneynessandhencepositiveVegafromaholdersperspective. Reference:Hull,Chapters17,1824.

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

37. Assumingotherthingsconstant,bondsofequalmaturitywillstillhavedifferentDV01perUSD100 facevalue.TheirDV01perUSD100facevaluewillbeinthefollowingsequenceofhighestvalueto lowestvalue:
a. Zerocouponbonds,parbonds,premiumbonds b. premiumbonds,parbonds,zerocouponbonds c. Premiumbonds,zerocouponbonds,parbonds d. Zerocouponbonds,premiumbonds,parbonds CORRECT:B DV01iscertainmultipleofDirtyPrice(whichincludesCoupons)andnotCleanPrice.Thus,itis proportionaltoBasePrice,whichisDirtyPrice.Ordinarily,PremiumBondwillhavethehighest (dirty)pricefollowedbyParBondandwiththeleastpriceofZeroCouponBond.Hence,DV01of PremiumBondisthehighestwhilethatofZeroCouponBondsisthelowest. INCORRECT:APremiumBondwillhaveahigherBasePriceandhencehigherDV01thanthatof ZeroCouponBond. INCORRECT:CBasePriceofParBondishigherthanthatofZeroCouponBondandhence,itsDV01 cannotbelessthanthatofZeroCouponBond.
INCORRECT:DDV01perUSD100FaceValueisanAbsoluteAmountofUSDbasedonactualBase PriceChange.Ordinarily,BasePriceofaZeroCouponBondwillbelowerthanthatofPar&Premium Bond.Hence,DV01ofZeroCouponBondislessthanthatofPremiumBondofsamematurity. Reference:Tuckman,FixedIncomeSecurities,Chapter5.

38. TheinformationratiooftheSteroleUSFundfor2006againsttheS&P500,itsbenchmarkindex,is1. Forthesametimeperiod,thefundsSharperatiois2,thefundhasatrackingerrorof7%against theS&P500,andthestandarddeviationoffundreturnsis5%.TheriskfreerateintheUSis4%. CalculatethereturnfortheS&P500duringthetimeperiod. a. 3.5% b. 7% c. 11% d. 14%
CORRECT:B SharpeRatio=2 (FundReturnRiskFreeRate)/SD=2 (FundReturn4%)/5%=2 FundReturn=14% InformationRatio=1 (FundReturnS&P500Return)/TrackingError=1 (14%S&P500Return)/7%=1 S&P500Return=7% INCORRECT:AIncorrectlydividesS&P500Returnby2 INCORRECT:CThecandidatemightusetheTrackingErrorastheNumeratorinboththeRatios. SharpeRatio=2 (FundReturnRiskFreeRate)/TrackingError=2 (FundReturn4%)/7%=2 FundReturn=18% InformationRatio=1 (FundReturnS&P500Return)/TrackingError=1 (18%S&P500Return)/7%=1 S&P500Return=11% INCORRECT:DThecandidatecanstopwiththefundreturncalculation,andendupwith14%. SharpeRatio=2
(FundReturnRiskFreeRate)/SD=2 (FundReturn4%)/5%=2 FundReturn=14% Reference:AmencandLeSourd,PortfolioTheoryandPerformanceAnalysis.Chapter4

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

Sharperatioequalsto
R p RF
(R p )
9 .3 % 3 .2 % = 0.452 13.5%
WhileSortinoratioequalsto
R p RF
L ( RP )
9.3% 3.2% = 0.726 8.4%
Trackingerrorisusedtocalculatethevalueoftheinformationratio,whichisdefinedas
R p RB
( RP RB )
,Thecalculationofinformationratioisnotrequiredinthisquestion.
INCORRECT:B2.1780.452=1.727 INCORRECT:C0.7260.0.73=0.653(0.073=(.0930.032)/0.83) INCORRECT:D0.0730.452=0.378 Reference:AmencandLeSourd,PortfolioTheoryandPerformanceAnalysis.Chapter4

40. YourfirmhasnopriorderivativestradeswithitscounterpartySuperBank.Yourbosswantsyouto evaluatesometradessheisconsidering.Inparticular,shewantstoknowwhichofthefollowing tradeswillincreaseyourfirmscreditriskexposuretoSuperBank: I. buyingaputoption II. sellingaputoption III. buyingaforwardcontract IV. sellingaforwardcontract
a. b. c. d.
I.andIIonly IIandIVonly IIIandIVonly I,IIIandIVonly
CORRECT:D Thistestsunderstandingofthetypeofpositionsthatcreatecreditrisk(andlinkstothefollowing question).Thekeyistoevaluateeachofthecomponenttrades.Buyingaputoptioncreatescredit risk.Buyingorsellingforwardcontractscreatescreditrisk.However,sellinganoptiondoesnot createcreditriskyouarenotsubjecttotheperformanceofthecounterparty. Reference:HullChapter22,StulzChapter18.

41. Considerthefollowingoneperiodtransitionmatrix:
Initial Period State
A B Default
NextPeriodState A B 95% 5% 10% 80% 0% 0%
Default 0% 10% 100%
IfacompanyisoriginallyinStateA,whatistheprobabilitythatthecompanywillhavedefaulted strictlybeforethefourthtransitionperiodfromnow?
a. 0.875% b. 0.500% c. 1.375% d. 1.875% CORRECT:C
Theeasiestwaytodeterminetheanswerwouldbetomakethisasquarematrixincludingdefaultin initialstate.Thenselfmultiplyingthematrixthreetimesyieldsthreeperiodtransitionmatrix.We canalsomanuallydothecalculation; Afteryear1thereisa0%chanceofdefaultand5%chanceofbeinginstateB. Afteryear2thereis95%*5%+80%*5%chanceofbeinginstateBand5%*10%chanceofdefault. Afteryear3thereisa(95%*5%+80%*5%)*10%additionalchanceofdefault.AnswerAassumes justoneyear INCORRECT:AOnlyconsidersthethirdyeartransitionfromBtodefault. INCORRECT:BOnlyconsidersthesecondyeartransitionfromBtodefault. INCORRECT:DMistakenlydoublesthesecondyeartransitionfromBtodefault. Reference:DeServignyandRenault,MeasuringandManagingCreditRisk,Chapter2,Appendix2A, page4952.
42. Asanapproximation,itistruethat
a. b. c. d.
Defaultswapspread=Returnofariskybond+Returnofariskfreebond Defaultswapspread=ReturnofariskybondReturnofariskfreebond Defaultswapspread=ReturnofariskybondxReturnofariskfreebond Defaultswapspread=Returnofariskybondx(1Returnofariskfreebond)
CORRECT:B Thebuyerofariskybondcanhedgethecreditriskoftheriskybondusingadefaultswap.Entering intotheswaptradereducescreditrisk.Toprecludearbitrage,thebuyeroftheriskbondhasto receivethesamereturnastheriskfreeasset,or: Returnofariskybond=Returnofariskfreebond+Defaultswapspread Reference:Hull,Chapter23.

43. InaCDO,theSPVistypically
a. b. c. d.
AAArated Arated BBBrated Notrated
CORRECT:A
InaCDOtransaction,theSpecialPurposeVehiclearespecialentitiesoffinancialinstitutionsandare usuallyAAArated.TheSPVandtheinstitutionarelegallydistinctandcreditqualitydeteriorationof thefinancialinstitutiondoesnotaffecttheSPV.InthiscaseSPVcounterpartyriskislow,whichis desiredbytheinvestor. Reference:Hullchapter23,CulpChapters16,17,18.

44. Atraderwhoseriskyouaremonitoringtellsyouthathewantstobenefitfromacreditspread wideningduetoarecession.Whichofthefollowingwouldbegoodtradesforhisstrategy?
a. Golongriskybondsandshortriskfreebondsatthebeginningoftherecession. b. Shortriskybondsandgolongriskfreebondsatthebeginningoftherecession. c. Sellcreditdefaultswapsonbondswithalowcreditqualityandbuycreditdefaultswapson bondswithahighercreditqualityatthebeginningoftherecession. d. Sellcreditdefaultswapsonbondswithlowcreditqualityandgolonglowcreditqualitybonds.
CORRECT:B Shortingriskybondsandgoinglonginriskfreebondsatthebeginningoftherecessionisthecorrect answer.Duringarecession,creditspreadstypicallystartwidening,andfinancingalongpositionin riskfreebondsthroughdecliningcreditqualityriskybondsreducestheeffectivefinancingcost. INCORRECT:AGoinglonginriskybondsandshortingriskfreebondsatthebeginningofthe recessionisincorrect.Thisstrategyispreferableatthebeginningofaneconomicexpansion,when thecreditspreadtypicallystartstightening. INCORRECT:CSellingcreditdefaultswapsonbondswithacertaincreditqualityandbuyingcredit defaultswapsonbondswithahighercreditqualityatthebeginningoftherecessionwouldbe preferableatthebeginningofaneconomicexpansion. INCORRECT:DSellingcreditdefaultswapsonbondswithlowcreditqualityandgoinglonginlow creditqualitybondseffectivelymagnifiesthecreditrisk,whichunderdeterioratingcreditconditions shouldbeavoided. Reference:Culp,Chapter12,13,16.

45. BankBhasaEUR100millionloanportfolioandhassetasideareservetocoverthefirstEUR20 millionindefaultrelatedlosses.IfthebankwantstoacquireprotectionfortheremainingEUR80 millioninriskexposure,whichofthefollowingsolutionswouldworkandwouldexposethebankto theleastamountofcounterpartyrisk?
a. BuycreditprotectioninaseniorsubordinatedCDSthatcoversEUR80millioninlossesabove thefirstEUR20million. b. BuycreditinsuranceforlossesuptoEUR80millioninexcessofEUR20millionontheloan portfolio. c. Issueacreditlinkednoteinwhichinterestandprincipalmaybewithheldfrominvestorsto coveruptoEUR80millioninlossesabovethefirstEUR20millionontheloanportfolio. d. Allthreeoftheabovechoicesworkandexposethebanktothesameamountofcounterparty risk.
CORRECT:C BothCDSandinsuranceareunfunded,andexposethebanktotheriskofnonperformancebythe CDSprotectionsellerortheinsurancecompanyofferingcreditinsurance.Whenissuingacredit linkednote,however,thecashhasbeenpaidinupfrontbyinvestorstothebank,eliminating counterpartyrisk. Reference:Culp,Chapter16

46. Mr.Rosenqvist,AssetManageratBCDBank,holdsaportfolioofSEK200million.Theportfolio consistsofBBBratedbonds.Assumethattheoneyearprobabilityofdefaultis4%,therecovery rateis60%,anddefaultsareuncorrelatedoveryears.Whatisthe2yearcumulativeexpectedcredit lossonMr.Rosenqvistsportfolio?
a. b. c. d.
SEK6.35million SEK6.40million SEK9.48million SEK9.60million
CORRECT:A TheCreditLossYear1isSEKmillion[200*4%*(160%)]=3.2andtheCreditLossYear2isSEK million[(2003.2)*4%*(160%)]=3.15.Thecumulativeexpectedlossover2yearsthanis3.2+ 3.15=6.35. INCORRECT:BDoesnottakeintoaccountthecreditlossyear1whencalculatingthelossforyear2.
INCORRECT:CWronglyinterpretstherecoveryrateasameasureofcreditloss,whilecreditloss equals(1recoveryrate).Inthiscaseitequals(10.60)=40%. INCORRECT:DIsacombinationofmistakeBandC. Reference:deServignyandRenault,MeasuringandManagingCreditRisk.

47. UsingtheMertonmodel,thevalueofthedebtincreasesifallotherparametersarefixedand
I. Thevalueofthefirmdecreases II. Therisklessinterestratedecreases III. Timetomaturityincreases IV. Thevolatilityofthefirmvaluedecreases
a. b. c. d.
IandIIonly IandIVonly IIandIIIonly IIandIVonly
CORRECT:D Accordingtothemodel,thevalueofthebondisB=VS,whereVisthevalueoftheassetsandSis thevalueoftheequity,orKertN(d2)+Vx(1N(d1)).d1=ln(V/Kert)/T+T/2andd2=1d1.Value ofthedebtwillincreaseifinterestratesdecreasesandvolatilityofthefirmdecreases. INCORRECT:AIIistruebutIisfalse.Valueofthedebtwillincreaseifvalueofthefirmincreases. Thevalueofthedebtwillincreaseifinterestratedecreases. INCORRECT:BVistruebutIisfalse. INCORRECT:CIIistruebutIIIisfalse.Thevalueofthedebtwillincreaseofthetimetomaturity decreases Reference:Stulz,RiskManagement&Derivatives,Chapter18,p.580 deServignyandRenault,MeasuringandManagingCreditRisk.


a. b. c. d.
0.5554 0.9333 1.2099 0.8198
CORRECT:B
0.35 N = 0.72 0.27 N= 0.9333
INCORRECT:AInvertsthespotvolatilityandthefuturesvolatility. INCORRECT:CUsesvariances INCORRECT:DUsessquarerootsofthevolatilities. Reference:Hull,Chapter3

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

10,000,000 7.8 N= 95,062.50 8.4
N = 97.68 or 98 contracts
INCORRECT:AIsmadeup.
INCORRECT:CLeavesoutthedurations INCORRECT:DInvertsthedurations. Reference:Hull,Chapter6.

a. b. c. d.
USD80,000 USD10,500,000 USD80,000,000 USD105,000,000
CORRECT:D USD105,000,000x.076/100=USD79,800,whichisprettyclosetothedesiredDV01ofUSD80,000. Tosolveforthehedge,solveforFintheequationUSD80,000=Fx.076/100,givingF=105,263,158. INCORRECT:ASellingthisamountwouldoffsetaDV01ofonlyUSD80,000x.076/100=USD61. INCORRECT:BUSD10,500,000x.076/100=USD7,980. INCORRECT:CUSD80,000,000x.076/100=USD60,800. Reference:Tuckman
ENDOF2009FRMFULLEXAMPRACTICEEXAMI Questions&Explanations

2009FRMFullExamPracticeExamII CandidateAnswerSheet

2009FRMFullExamPracticeExamII Questions
a. b. c. d.
2. Theriskfreerateis5%peryearandacorporatebondyields6%peryear.Assumingarecoveryrate of75%onthecorporatebond,whatistheapproximatemarketimpliedoneyearprobabilityof defaultofthecorporatebond? a. 1.33% b. 4.00% c. 8.00% d. 1.60%
3. ThefollowingtablefromFitchRatingsshowsthenumberofratedissuersmigratingbetweentwo ratingscategoriesduringoneyear.Basedonthisinformation,whatistheprobabilitythatanissue witharatingofAatthebeginningoftheyearwillbedowngradedbytheendoftheyear?
Year 0 rating
Year1rating AAA AAA 45 AA 3 A 2 BBB 0 Default 0
AA 4 30 5 1 0
A 2 4 40 2 0
BBB 0 3 2 30 0
Default 0 2 3 1 0
Total 51 42 52 34 0
a. b. c. d.
13.46% 13.44% 9.62% 3.85%
4. BetaBankownsaportfolioof10AAratedbondswithatotalvalueof200millionUSD.Theoneyear probabilityofdefaultforeachissueris5%andtherecoveryrateforeachissueequals40%.Theone yearexpectedlossoftheportfoliois:
a. b. c. d.
5. RiskAverseBank(RAB)hasmadealoanofUSD100millionat8%perannum.RABwantstoenter intoatotalreturnswapunderwhichitwillpaytheinterestontheloanplusthechangeinthemark tomarketvalueoftheloanandinexchange,RABwillgetLIBOR+30basispoints.Settlement paymentsaremadeannually.WhatisthecashflowforRABonthefirstsettlementdateifthemark tomarketvalueoftheloanfallsby2%andLIBORis6%?
a. b. c. d.
NetinflowofUSD0.3million NetoutflowofUSD0.3million NetinflowofUSD1.7million NetoutflowofUSD1.7million
6. Determinethepercentageofthefollowingportfoliothatisinvestmentgrade:
Moody's Rating Aa2 A3 Caa1 Baa3 Ba1 D Aaa A1 Baa1 Aa3
Percentage of Portfolio 25% 10% 2% 10% 5% 3% 10% 15% 10% 10%
a. b. c. d.
70% 80% 90% 95%
7. Aspartofacurrencyhedgingstrategy,aU.S.portfoliomanagerenteredaoneyearforward contractwithabanktodeliverEUR5,000,000forUSdollarsattheendoftheyear.Atthebeginning oftheyear,theoneyearforwardratewas0.9216USD/EUR.Sixmonthsintothecontractthespot rateis0.9201USD/EUR,theU.S.interestrateis6.5%,andtheEurointerestrateis6.25%.Ifthe currentspotrate(0.9201USD/EUR)weretocontinueforthenextsixmonths,whatisthecreditrisk thattheportfoliomanagerwouldbearatmaturity?
a. b. c. d.

USD7,042 USD7,264 USD7,273 USD7,500
8. Realizingthebenefitsofnettingofthecounterpartyexposuremaybechallengingbecauseof:
a. b. c. d.

Potentialdowngradeorwithdrawalofthecounterpartyrating Differencesinratingsbetweentheratingagencies Tradesbeingbookedindifferentjurisdictions Crossproductnetting
9. Inpricingafirsttodefaultcreditbasketswap,whichofthefollowingistrue,allelsebeingequal?
a. b. c. d.

Thelowerthecorrelationbetweentheassetsofthebasket,thelowerthepremium. Thelowerthecorrelationbetweentheassetsofthebasket,thehigherthepremium. Thehigherthecorrelationbetweentheassetsofthebasket,thehigherthepremium. Thecorrelationbetweentheassetshasnoimpactinthepremiumofafirsttodefaultcredit basketswap.
10. ThespreadonaoneyearBBBratedbondrelativetotheriskfreetreasuryofsimilarmaturityis2%. Itisestimatedthatthecontributiontothisspreadbyallnoncreditfactors(e.g.,liquidityrisk,taxes) is0.8%.Assumingthelossgivendefaultratefortheunderlyingcreditis60%,whatisapproximately theimplieddefaultprobabilityforthisbond?
a. b. c. d.

3.33% 5.00% 3.00% 2.00%
11. YouaregiventhefollowinginformationaboutfirmA:
MarketValueofAssetattime0=1000 MarketValueofAssetattime1=1200 ShorttermDebt=500 LongtermDebt=300 AnnualizedAssetVolatility=10% AccordingtotheKMVmodel,whataretheDefaultPointandtheDistancetoDefaultattime1? Default Distanceto Point Default a. 800 3.33 b. 650 7.50 c. 650 4.58 d. 500 5.83
12. SupposethereturnonUStreasuriesis3%andariskybondiscurrentlyyielding15%.Atraderyou superviseclaimsthathewouldbeabletomakeanarbitragetradeearning5%usingUStreasuries, theriskybondandthecreditdefaultswap.Whichofthefollowingcouldbethetradersstrategy andwhatisthecreditdefaultswappremium?Assumetherearenotransactioncosts.
a. b. c. d.

Golongthetreasury,shorttheriskybond,andbuythecreditdefaultswapwithpremiumof6%. Golongthetreasury,shorttheriskybond,andsellthecreditdefaultswapwithpremiumof7%. Shortthetreasury,investintheriskybond,andsellthecreditdefaultswapwithpremiumof6%. Shortthetreasury,investintheriskybond,andbuythecreditdefaultswapwithpremiumof 7%.
13. BankAmakesa10millionUSDfiveyearloanandwantstooffsetthecreditexposuretotheobligor. Afiveyearcreditdefaultswapwiththeloanasthereferenceassettradesonthemarketataswap premiumof50basispointspaidquarterly.InordertohedgeitscreditexposureBankA:
a. b. c. d.

Sellsthe5yearCDSandreceivesaquarterlypaymentofUSD50,000. Buysthe5yearCDSandmakesaquarterlypaymentofUSD12,500. Buysthe5yearCDSandreceivesaquarterlypaymentofUSD12,500. Sellsthe5yearCDSandmakesaquarterlypaymentofUSD50,000.
14. Abankisconsideringbuying(i.e.sellingprotectionon)aAAAratedsuperseniortranche[10% 11%]ofasyntheticCDOreferencinganinvestmentgradeportfolio.Thepricingofthetranche assumesafixedrecoveryof40%forallnames.Allelsebeingequal,whichoneofthefollowingfour changeswillmaketheprincipalinvestedmorerisky?
a. b. c. d.

Anincreaseinsubordinationof1%,i.e.investinginthe[11%12%]tranche Anincreaseinthetranchethicknessfrom1%to3%,i.e.investinginthe[10%13%]tranche Usingarecoveryrateassumptionof50% Anincreaseindefaultcorrelationbetweennamesintheportfolio
15. Twobanksenterintoafiveyearfirsttodefaultbasketcreditdefaultswaptransaction.Thebasket containsthreeuncorrelatedcredits,W,XandY,eachwithaUSUSD25millionnotionalamount.The protectionsellerhastosettleonthecreditthatdefaultsfirstduringthetransaction.Afterthat,the protectionsellerhasnoobligationandthetransactionterminates.Supposethecreditshavethe following5yearcumulativeprobabilityofdefaults. 5YearProbabilities Credit ofDefault W 9.68% X 8.97% Y 8.02% Whichofthefollowingistheprobabilityofatleastonedefaultinthebasketduringthe5years? a. 8.02% b. 9.68% c. 24.38% d. 26.67%

16. BankAhasexposureto100millionUSDofdebtissuedbyCompanyR.BankAentersintoacredit defaultswaptransactionwithBankBtohedgeitsdebtexposuretoCompanyR.BankBwouldfully compensateBankAifCompanyRdefaultsinexchangeforapremium.Assumethatthedefaultsof BankA,BankBandCompanyRareindependentandthattheirdefaultprobabilitiesare0.3%,0.5% and3.6%,respectively.WhatistheprobabilitythatBankAwillsufferacreditlossinitsexposureto CompanyR?
a. b. c. d.
3.6% 4.1% 0.0180% 0.0108%
17. A3yearcreditlinkednotewithunderlyingcompanyZhasaLIBOR+60bpssemiannualcoupon. ThefacevalueoftheCLNisUSD100.LIBORis5%forallmaturities.Current3yearcreditdefault swap(CDS)spreadforcompanyZis90bps.ThefairvalueoftheCLNisclosestto:
a. b. c. d.

USD99.19 USD100.00 USD101.65 USD111.05
18. Ariskmanagerestimatesthedailyvariance(ht)usingaGARCHmodelondailyreturns(rt): ht=0+1r2t1+ht1 Assumethemodelparametervaluesare0 =0.005, =0.04,=0.94.Thelongrunannualized volatilityisapproximately: a. 25.00% b. 13.54% c. 72.72% d. 7.94%

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

HKD167,760 HKD279,600 HKD197,400 HKD1,977,070
20. Considerthefollowingpotentialoperationalrisks.Duetoaroguetrader,weestimatethatovera1 yearperiodthereisa10%chancewecouldloseanywherebetween0and100MM(equal probabilityforallpointswithinthatrangeand0probabilityofanylossesoutsidethatrange).Due tomodelrisk,weestimatethatovera1yearperiodthereisa20%chancethatwewilllose25MM normallydistributedwithastandarddeviationof5MM.Whichofthefollowingstatementsis true?
a. Theexpectedlossfromaroguetraderislessthantheexpectedlossfrommodelrisk. b. Theexpectedlossfromaroguetraderisgreaterthantheexpectedlossfrommodelrisk. c. Themaximumunexpectedlossfromaroguetraderatthe95%confidencelevelislessthanthe maximumunexpectedlossatthe95%confidencelevelfrommodelrisk. d. Themaximumunexpectedlossatthe95%levelfromaroguetraderisgreaterthanthe maximumunexpectedlossatthe95%levelfrommodelrisk.

21. Whichofthefollowingstatementsaboutliquidityriskelasticity(LRE)isincorrect?
a. Incalculatingthesensitivityofafirmsnetassetstoachangeinitsfundingliquiditypremium, LREassumesaparallelshiftinfundingcostsacrossallmaturities. b. LREisprimarilyusefulforexaminingmarginalchangesinfundingcostsonanetasset/liability position. c. TheLREisacashflowliquidityriskmeasure,notapresentvalueliquidityriskmeasure. d. TheLREisonlyreliableforsmallchangesininterestcosts.

22. Theriskoftheoccurrenceofasignificantdifferencebetweenthemarktomodelvalueofacomplex and/orilliquidinstrument,andthepriceatwhichthesameinstrumentisrevealedtohavetradedin themarketisreferredtoas:
a. b. c. d.

DynamicRisk LiquidityRisk MarktoMarketRisk ModelRisk
23. Whichofthefollowingstatementsregardingeconomiccapitalaretrue?
I. Economiccapitalisdesignedtoprovideacushionagainstunexpectedlossesataspecified confidenceleveloverasettimehorizon. II. Sinceregulatorycapitalmodelsandeconomiccapitalmodelshavedifferentobjectives, economiccapitalmodelscannothelpregulatorsinsettingregulatorycapital requirements. III. Firmswhosecapitalexceedstheirrequiredregulatorycapitalarefirmsthatemploytheir capitalinefficientlyandtheirshareholderswouldbenefitiftheyusedsomeoftheircapital torepurchasesharesorincreasedividends. IV. Economiccapitalcanbeusedtovalidateafirmsregulatorycapitalrequirementagainst itsownassessmentoftherisksitisrunning.
a. b. c. d.
IIIandIVonly I,IIandIIIonly I,IIIandIVonly IandIVonly
24. YouareananalystatBankAlpha.YouweregiventhetasktodeterminewhetherunderBaselIIyour bankcanusethesimplifiedapproachtoreportoptionsexposureinsteadoftheintermediate approach.Whichofthefollowingcriteriawouldyourbankhavetosatisfyinorderforittousethe simplifiedapproach?
a. Thebankpurchasesandwritesoptionsandhassignificantoptiontrading. b. Thebankwritesoptionsbutitsoptionstradingisinsignificantinrelationtoitsoverallbusiness activities. c. Thebankpurchasesandwritesoptionsbutitsoptiontradingisinsignificant. d. Thebanksolelypurchasesoptionsanditsoptionstradingisinsignificantinrelationtoitsoverall businessactivities.
25. Yourbankisusingtheinternalmodelsapproachtoestimateitsgeneralmarketriskcharge.The multiplicationfactork,setbytheregulator,is3andbanksareallowedtousethesquarerootrule toscaledailyVaR.Thepreviousdays1dayVaRestimateisEUR3million,andtheaverageofthe dailyVaRoverthelast60daysisEUR2million.Giventheaboveinformation,whatwillbethe marketriskchargeforyourbank? a. EUR18.97million b. EUR9.49million c. EUR6.32million d. EUR28.46million
26. UndertheBaselIICapitalAccord,banksthathaveobtainedpriorregulatoryapprovalcanusethe internalmodelsapproachtoestimatetheirmarketriskcapitalrequirement.Whatapproachor methodologyisusedundertheinternalmodelsapproachtocomputecapitalrequirements?
a. b. c. d.

Stresstestingandbacktesting. Internalratingandvendormodels. VaRmethodology Expectedtailloss,asVaRisnotacoherentmeasureofrisk.
27. BankZ,amediumsizebank,usesonlyoperationallossdatafrominternalrecordstomodelitsloss distributionfromoperationalriskevents.Thebankrevieweditsrecordsand,afterconfirmingthat theywerecompleterecordsofitshistoricallossesandthatitslossescouldbeapproximatedbya uniformdistribution,itdecidedagainstusingexternallossdatatoestimateitslossdistribution. Basedonthatdecision,whichofthefollowingstatementsiscorrect?
a. TheestimatedlossdistributionlikelyoverstatesBankZsrealriskbecausemanyincidencesin thepastwerelikelyoneoff. b. TheestimatedlossdistributionlikelyaccuratelyrepresentsBankZsrealriskbecausethe recordsareaccurateandcomplete. c. TheestimatedlossdistributionlikelyunderstatesBankZsrealriskbecausethebankhasnot experiencedahugeloss. d. TheestimatedlossdistributionlikelyisthebestestimateofBankZsrealriskbecausethereisno betterlossdataforthebankthanitsown.

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

Overthelast250days,themeanlossisUSD60million. Overthelast250days,thereisnoexceedence. Overthelast250days,thereare8exceedences. Overthelast250days,thelargestlossisUSD500million.
29. Tohandlethefinancingofalargecomplexproject,yourbankisestablishingaspecialpurposeentity (SPE)forwhichyourbankwillactastrustee.Whichofthefollowingcouldresultinliabilitytoyour bankthroughitsroleastrustee?
a. TheSPEwasformedtotakeadvantageofapreferablelegaljurisdiction. b. TheSPEprimarypurposewastoallowforthedeferralofincometaxes. c. TheSPEcontrolswereunabletodeterminewhetheritsinvestorsusedfundsderivedfrom legitimatebusinessopportunities. d. TheSPEstructureprovidedforfewercreditorsandareducedlikelihoodthattheprojectwould beforcedintobankruptcy.

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

Itignorestheinterestriskassociatedwiththebanksloans. Itassumesmarket,credit,andoperationalriskshavezerocorrelation. Itignoresstrategicrisks. Itusesatendayhorizonformarketrisk.
31. ThebankyouworkforhasaRAROCmodel.TheRAROCmodel,computedforeachspecificactivity, measurestheratiooftheexpectedyearlynetincometotheyearlyVaRriskestimate.Youareasked toestimatetheRAROCofitsUSD500millionloanbusiness.Theaverageinterestrateis10%.All loanshavethesameProbabilityofDefault,PD,of2%withaLossGivenDefault,LGD,of50%. OperatingcostsareUSD10million.ThefundingcostofthebusinessisUSD30million.RAROCis estimatedusingacreditVaRforloanbusinesses.Inthiscase,theappropriatecreditVaRforthe loansis7.5%.Theeconomiccapitalisinvestedandearns6%.TheRAROCis:
a. b. c. d.
32.67% 13.33% 19.33% 46.00%
32. WhichofthefollowingstatementsregardingBaselIInonadvancedapproachesisincorrect?
a. Thestandardizedapproachusesdatafromthelastthreeyearsofgrossincometoobtaina banksoperationalriskcapitalcharge. b. Thestandardizedapproachmakesitadvantageousforabanktobooklossesearlyifdoingso reducesthisyearsgrossincomesufficientlytomakeitnegative. c. Thestandardizedapproachdividesthebankintobusinesslinesandusesdatafromthelast threeyearsofabusinesslinesgrossincomeandabetafactortoobtaintheregulatorycapital forthatbusinessline. d. Corporatefinance,tradingandsales,andpaymentandsettlementarethebusinesslineswith thehighestregulatorycapitalrequirements.

33. WhichoneofthefollowingstatementsdoesnotapplytotheBaselIIAdvancedMeasurement Approach(AMA)foroperationalrisk?
a. Incontrasttocreditriskregulatorycapitalforcorporateloans,banksusingtheAMAapproach mayhavetosetasidecapitalforbothexpectedandunexpectedoperationalrisklosses. b. IncontrasttothecreditriskIRBapproaches,banksusingtheAMAapproachmayestimatethe correlationbetweendifferenttypesofoperationalrisksiftheirmodelssatisfyregulatory requirements. c. Toevaluateexposuretohighseverityoperationalriskevents,banksusingtheAMAapproach mayuseeitherscenarioanalysisofexpertopinion,orVaRmodelestimatesbasedoninternal datausingextremevaluetheory. d. Reportingofoperationalriskexposuretoseniormanagementisanecessaryconditionfora banksabilitytousetheAMAapproach.

34. Whichofthefollowingapproachesforcalculatingoperationalriskcapitalchargesleadstoahigher capitalchargeforagivenaccountingincomeasriskincreases?
a. b. c. d.

Thebasicindicatorapproach Thestandardizedapproach Theadvancedmeasurementapproach(AMA) Alloftheabove
35. Whichofthefollowingisnotincludedasanelementincalculatingoperationalriskcapitalunderthe AdvancedMeasurementApproach?
a. b. c. d.

Externaldata Keyriskindicators Factorsreflectingthebusinessenvironment Scenarioanalysis
36. YourfirmsfixedincomeportfoliohasinterestonlyCMOs(IO),callablecorporatebonds,inverse floaters,noncallablecorporatebonds.Yourbosswantstoknowwhichofthefollowingsecuritiescan losevalueasyieldsdecline.
a. b. c. d.

callablecorporateonly inversefloateronly IOandcallablecorporatebond IOandnoncallablecorporatebond
37. Abankwouldliketoestimatethenumberofoperationalriskeventsduetoproblemswithtellers (largemistakes,fraud,andsoon).Thebankdecidestomodeltelleroperationalriskeventsasa PoissonProcesswithrate (numberofeventsperyear).Withthismodel,telleroperationalrisk eventsareassumedtooccurindependentlyofoneanotherandthenumberoftelleroperationalrisk eventsinayearisPoissondistributedwithmean.OtherpropertiesofaPoissondistributionwith mean include:
Variance: Skewness: Excesskurtosis
0.5 1/
Basedonhistoricaldataregardingthenumberoftelleroperationalriskeventsthatoccurredin previousyears,thebankdeterminesthattheaveragenumberofeventshasbeen5peryearand decidestosetto5.Whichofthefollowingistrueregardingthatmodel? a. Thevarianceofthenumberoftelleroperationaleventsinayearis25. b. Thecorrespondingexponentialdistributionthatdescribesthetimebetweentwoteller operationalriskeventshasameanvalueof0.25years. c. Themodelisnotappropriateifatellerismorelikelytohaveanoperationalriskeventbecause hisfriendwhoisalsoatellerhasbeencaughtstealing. d. Thenumberoftelleroperationalriskeventsinayearcannotexceed25.

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

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

USD325 USD275 USD254 USD229
40. Supposeyouaregiventhefollowinginformationabouttheoperationalrisklossesatyourbank.
Frequencydistribution Probability Frequency 0.5 0 0.3 1 0.2 2
SeverityDistribution Probability Severity 0.6 USD1,000 0.3 USD10,000 0.1 USD100,000
WhatistheestimateoftheVaRatthe95%confidencelevel,assumingthatthefrequencyand severitydistributionsareindependent?
a. b. c. d.
USD200,000 USD110,000 USD100,000 USD101,000
41. Tocontrolrisktakingbytraders,yourbanklinkstradercompensationwiththeircompliancewith imposedVaRlimitsontheirtradingbook.Whyshouldyourbankbecarefulintyingcompensation totheVaRofeachtrader?
a. Itencouragestraderstoselectpositionswithlowestimatedrisks,whichleadstoan underestimationoftheVaRlimits. b. Itencouragestraderstoselectpositionswithlowestimatedrisks,whichleadstoan overestimationoftheVaRlimits. c. Itencouragestraderstoselectpositionswithhighestimatedrisks,whichleadstoan underestimationoftheVaRlimits. d. Itencouragestraderstoselectpositionswithhighestimatedrisks,whichleadstoan overestimationoftheVaRlimits.

42. Thesurplusofapensionfundismostimportantfor:
a. b. c. d.

Adefinedcontributionfund Adefinedbenefitfund Ayoungworkforce Asponsoringcompanywithstrongfinancialstatusthatoperatesindifferentindustries
43. Amutualfundinvestingincommonstockshasadoptedaliquidityriskmeasurelimitingeachofits holdingstoamaximumof30%ofitsthirtydayaveragevaluetraded.IfthefundsizeisUSD3billion, whatisthemaximumweightthatthefundcanholdinastockwithathirtydayaveragevaluetraded ofUSD2.4million?
a. b. c. d.

24.00% 0.08% 0.024% 80.0%
44. Aninvestorisinvestigatingthreehedgefundsaspotentialinvestments.HedgefundAisanequity marketneutralfund,Bisaglobalmacrofundwithemphasisonequitymarkets,andCisa convertiblearbitragefund.Whichanswercorrectlyspecifiesthefundswiththehighestexposureto aworldwidevalueweightedequityindexandtoacreditdefaultswapsindex? Highestequityindexexposure Highestcreditdefaultswapindexexposure a. A B b. A C c. B A d. B C
45. Whichofthefollowingisnotanapproachfordetectingstyledriftofhedgefunds?
a. b. c. d.

Performanceattribution Peergroupcomparison Cashflowanalysis Communicationwithfundmanager
46. Allofthefollowingstrategiesareexamplesofcapitalstructurearbitrage,except:
a. Longpositioninthebondsissuedbythecompany,andshortpositioninthecompanysstock. b. Shortpositioninthebondsissuedbythecompany,andlongpositioninthecompanysstock. c. Longpositioninacreditdefaultswaponthecompanyandwritingputoptionsonthecompanys stock. d. Shortpositioninthepreferredstockissuedbythecompanyandwritingcalloptionsonthe companysstock.

47. Youhavebeenaskedtoevaluatetheperformanceoftwohedgefunds:GlobalAssetManagementI andInternationalMomentumII.BotharebenchmarkedtoMSCIEAFE.Whichofthetwofundshad ahigherrelativeRiskAdjustedPerformance(RAP)lastyear,andwhatistheRAP?
ThevolatilityofEAFEis17.5%andtheannualizedperformanceis10.6%.Theriskfreerateis3.5%. Fund Volatility AnnualizedPerformance GlobalAssetManagementI 24.5% 12.5% InternationalMomentumII 27.3% 13.6%
a. b. c. d.

GlobalAssetManagement,4.85% GlobalAssetManagement,6.16% InternationalMomentum,5.42% InternationalMomentum,1.18%
48. OnJanuary1,2006,apensionfundhasassetsofEUR100billionandisfullyinvestedintheequity market.IthasEUR85billioninliabilities.During2006,theequitymarketdeclinedby15%andyields increasedby1.2%.Ifthemodifieddurationoftheliabilitiesis12.5,whatisthepensionfunds surplusonDecember31,2006?
a. b. c. d.
EUR15.00billion EUR12.93billion EUR12.75billion EUR12.57billion
49. WhichofthefollowingstatementsregardingExtremeValueTheory(EVT)isincorrect?

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

50. Consideraportfoliowith40%investedinassetXand60%investedinassetY.Themeanand varianceofreturnonXare0and25respectively.ThemeanandvarianceofreturnonYare1and 121respectively.ThecorrelationcoefficientbetweenXandYis0.3.Whatisthenearestvaluefor portfoliovolatility? e. f. g. h. 9.51% 8.60% 13.38% 7.45%
ENDOF2009FRMFULLEXAMPRACTICEEXAMI
2009FRMFullExamPracticeExamII AnswerKey
2009FRMFullExamPracticeExamII Answers&Explanations

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

2. Theriskfreerateis5%peryearandacorporatebondyields6%peryear.Assumingarecoveryrate of75%onthecorporatebond,whatistheapproximatemarketimpliedoneyearprobabilityof defaultofthecorporatebond?
a. b. c. d.
1.33% 4.00% 8.00% 1.60%
CORRECT:B Usingtheapproximationmethod,the1yearprobabilityofdefaultis(6%5%)/(10.75)=4% INCORRECT:AThisiscalculatedusing(6%5%)/0.75=1.33%

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

3. ThefollowingtablefromFitchRatingsshowsthenumberofratedissuersmigratingbetweentwo ratingscategoriesduringoneyear.Basedonthisinformation,whatistheprobabilitythatanissue witharatingofAatthebeginningoftheyearwillbedowngradedbytheendoftheyear?

Year1rating AAA AAA 45 AA 3 A 2 BBB 0 Default 0 AA 4 30 5 1 0 A 2 4 40 2 0 BBB 0 3 2 30 0 Default 0 2 3 1 0 Total 51 42 52 34 0
Year0 rating
a. b. c. d.
13.46% 13.44% 9.62% 3.85%
CORRECT:C TotalNumberofAratedissuances=52 ProbabilityofAratedissuesdowngradedtoBBB(P1)=2/52=0.0385 ProbabilityofAratedissuesdowngradedtoDefault(P2)=3/52=0.0577 ProbabilityofAratedissuestobedowngradedinoneyear=P1+P2=0.0962=9.62%. INCORRECT:AIsthenumberofupgradesfromA(2+5)/52=13.46% INCORRECT:BIsthenumberofdowngradestoA2/51+4/42=3.92%+9.52%=13.44% INCORRECT:DIsthenumberofdowngradestoBBB2/52=3.85% Reference:Hull,Chapter22.
4. BetaBankownsaportfolioof10AAratedbondswithatotalvalueof200millionUSD.Theoneyear probabilityofdefaultforeachissueris5%andtherecoveryrateforeachissueequals40%.Theone yearexpectedlossoftheportfoliois:
a. b. c. d.
CORRECT:C ExpectedLossequalsexposuremultipliedbytheriskofdefaultandbytherecoveryrate,or E(L)=Exposure*PD*(1RecoveryRate) E(L)=200millionUSDx5%x60%=6millionUSD. Correlationamongstissuersdoesnotmatterforcomputingexpectedlosses. INCORRECT:AIncorrectlysetE(L)=200*0.05*0.4=4.0 INCORRECT:BIncorrectlysetE(L)=200*0.05*0.5=5.0 INCORRECT:DIncorrectlysetE(L)=200*0.05*0.8=8.0 Reference:Hull,Chapter22.

5. RiskAverseBank(RAB)hasmadealoanofUSD100millionat8%perannum.RABwantstoenter intoatotalreturnswapunderwhichitwillpaytheinterestontheloanplusthechangeinthemark tomarketvalueoftheloanandinexchange,RABwillgetLIBOR+30basispoints.Settlement paymentsaremadeannually.WhatisthecashflowforRABonthefirstsettlementdateifthemark tomarketvalueoftheloanfallsby2%andLIBORis6%?
a. b. c. d.
NetinflowofUSD0.3million NetoutflowofUSD0.3million NetinflowofUSD1.7million NetoutflowofUSD1.7million
CORRECT:A RABistheTRORpayerandpaystotheTRORreceivertheinterestitreceivesontheloanadjustedfor changesinthevalueoftheunderlyingloan.Ifthevalueoftheunderlyingloanincreases,RABasthe TRORpayerpaystotheTRORreceivertheinterestearnedontheloanaswellastheprice appreciation.Conversely,ifthevalueoftheunderlyingloandecreases,RABastheTRORpayerpays totheTRORreceivertheinterestearnedontheloanlessthepricedepreciation.Inreturn,astheTOR payer,itreceivesLIBORplusspreadfromtheTRORreceiver.

Attheendofthefirstyear,RABwillpaytheinterestearnedontheloan,8millionUSD.Theloan valuedeclinedby2millionUSD,thusthereturnearnedbyRABis6millionUSD;thisisthepayment madebyRABtotheTRORreceiver. TheTRORreceiveswillpaytoRABLIBORplus30basispointsi.e.6.3%witha6%LIBOR;6.3%of100 millionUSD=6.3millionUSD. Sothepaymentsare+6.3millionUSD6.0millionUSDor+0.3millionUSD. Reference:Stulz,RiskManagement&Derivatives.Chapter18CreditRisksandCreditDerivatives 6. Determinethepercentageofthefollowingportfoliothatisinvestmentgrade:
Moody's Rating Aa2 A3 Caa1 Baa3 Ba1 D Aaa A1 Baa1 Aa3
Percentage of Portfolio 25% 10% 2% 10% 5% 3% 10% 15% 10% 10%
a. b. c. d.
70% 80% 90% 95%
CORRECT:C NoninvestmentgradeassetsarethoseratedbelowBaa3.ThusCaa1with2%,Ba1with5%,andD with3%,oratotalof10%arenoninvestmentgrade.Thustheinvestmentgradepartshouldequal 90%. Reference:Hull,Chapter22.
7. Aspartofacurrencyhedgingstrategy,aU.S.portfoliomanagerenteredaoneyearforward contractwithabanktodeliverEUR5,000,000forUSdollarsattheendoftheyear.Atthebeginning oftheyear,theoneyearforwardratewas0.9216USD/EUR.Sixmonthsintothecontractthespot rateis0.9201USD/EUR,theU.S.interestrateis6.5%,andtheEurointerestrateis6.25%.Ifthe currentspotrate(0.9201USD/EUR)weretocontinueforthenextsixmonths,whatisthecreditrisk thattheportfoliomanagerwouldbearatmaturity?
a. b. c. d.
USD7,042 USD7,264 USD7,273 USD7,500
CORRECT:D Valuetothemanageratthesettlementdate=contractcashflowspotmarketcashflow[bothat contractmaturity]. Contractcashflow =EUR5,000,000x0.9216USD/EUR=4,608,000USD Spotmarketcashflow =Theamounttheportfoliomanagercouldreceiveifthespotrateafter6 monthsremainedineffectuntilthesettlementdate =EUR5,000,000x0.9201USD/EUR=4,600,500USD Valuetothemanager =USD4,608,000USD4,600,500=USD7,500 Asthevalueispositive,thebankowesthisamounttotheportfoliomanager.Sincethequestionasks theamountofcreditriskatmaturity,weneednotdiscountthisbacktosixmonths. INCORRECT:AThisanswerisarrivedatbydiscountingthecorrectanswerfortwelvemonthsatthe USDinterestrate,whichisnotarequirementofthequestion. INCORRECT:BThisanswerisarrivedatbydiscountingthecorrectanswerforsixmonthsattheUSD interestrate,whichisnotarequirementofthequestion. INCORRECT:CThecorrectanswerdiscountedattheEurorateforsixmonth. Reference:Stulz,RiskManagementandDerivatives,Chapter18

8. Realizingthebenefitsofnettingofthecounterpartyexposuremaybechallengingbecauseof:
a. b. c. d.
Potentialdowngradeorwithdrawalofthecounterpartyrating Differencesinratingsbetweentheratingagencies Tradesbeingbookedindifferentjurisdictions Crossproductnetting
CORRECT:C
Thispresentsalegalchallengetoenforcingnettingagreement INCORRECT:AThesecrediteventsdonotmakenettingmorechallenging INCORRECT:BRatingsarenotrequiredtoestablishnetting INCORRECT:DOncontrary,crossproductnettingallowstorealizemorebenefitsinreducing exposuretocounterparty Reference:Culp

9. Inpricingafirsttodefaultcreditbasketswap,whichofthefollowingistrue,allelsebeingequal?
a. b. c. d.
Thelowerthecorrelationbetweentheassetsofthebasket,thelowerthepremium. Thelowerthecorrelationbetweentheassetsofthebasket,thehigherthepremium. Thehigherthecorrelationbetweentheassetsofthebasket,thehigherthepremium. Thecorrelationbetweentheassetshasnoimpactinthepremiumofafirsttodefaultcredit basketswap.
CORRECT:B Thelowerthecorrelationbetweentheassetsofthebasket,thehigherthepremium. Inthecaseofafirsttodefaultswap,acrediteventoccursthefirsttimeanyoftheentitiesdefaults. Thisswapprovidesdefaultprotectionagainstlossesrelatedtothisfirstdefault,butnottoany subsequentdefaults.Thus,thequestioniswhetherthelevelofcorrelationbetweenassetsofthe basketincreasesordecreasesthelikelihoodofthetriggeringevent.Ifthecorrelationbetweenthe assetsinacreditbasketswapislower,thebasketwouldbeexposedtogreaterdefaultrisk.For example,thebasketcontainsassetsfromdifferentsectors,thenthebasketwouldbeexposedtothe defaultriskofeachandeverysectorinthebasket.Ifthebasketonlycontainsassetsfromonesector, thenthecorrelationishigher,andthedefaultriskislower. Reference:Hull,22,23

10. ThespreadonaoneyearBBBratedbondrelativetotheriskfreetreasuryofsimilarmaturityis2%. Itisestimatedthatthecontributiontothisspreadbyallnoncreditfactors(e.g.,liquidityrisk,taxes) is0.8%.Assumingthelossgivendefaultratefortheunderlyingcreditis60%,whatisapproximately theimplieddefaultprobabilityforthisbond?
a. b. c. d.
3.33% 5.00% 3.00% 2.00%
CORRECT:D Theprobabilityofdefaultequalsthecreditriskspreaddividedbythelossgivendefault.PD=spread /LGDHere,thespreadduetocreditriskequals2.0%0.8%or1.2%andthelossgivendefaultis 60%.Theprobabilityofdefaultisthen2%. INCORRECT:AIncorrectlysetsPD=2.0/0.6=3.33. INCORRECT:BIncorrectlysetsPD=2.0/0.4=5.0. INCORRECT:DIncorrectlysetsPD=1.2/0.4=3.00. Reference:deServignyandRenault,MeasuringandManagingCreditRisk,(NewYork:McGrawHill, 2004)chapter3,4

11. YouaregiventhefollowinginformationaboutfirmA:
MarketValueofAssetattime0=1000 MarketValueofAssetattime1=1200 ShorttermDebt=500 LongtermDebt=300 AnnualizedAssetVolatility=10%
AccordingtotheKMVmodel,whataretheDefaultPointandtheDistancetoDefaultattime1? Default Distanceto Point Default a. 800 3.33 b. 650 7.50 c. 650 4.58 d. 500 5.83 CORRECT:C AccordingtoKMV, DefaultPoint=STD+LTD=500+1/2(300)=650. Distancetodefault
=(Marketvalueofassetattime1DefaultPoint)/AnnualizedAssetvolatilityattime1 =(1200650)/(1200*0.1) =4.58 INCORRECT:AIncorrectlysetsDefaultPointasSTD+LTDinstead(500+300). INCORRECT:BIncorrectlysetsDefaultPointvalueasLTD,distancetodefault=(1200STD)/120= 7.50 INCORRECT:DIncorrectlysetsDefaultPointasSTDonly,distancetodefault=(1200500)/120= 5.83 Reference:deServignyandRenault,MeasuringandManagingCreditRisk,Chapter4.

12. SupposethereturnonUStreasuriesis3%andariskybondiscurrentlyyielding15%.Atraderyou superviseclaimsthathewouldbeabletomakeanarbitragetradeearning5%usingUStreasuries, theriskybondandthecreditdefaultswap.Whichofthefollowingcouldbethetradersstrategy andwhatisthecreditdefaultswappremium?Assumetherearenotransactioncosts.
a. b. c. d.
Golongthetreasury,shorttheriskybond,andbuythecreditdefaultswapwithpremiumof6%. Golongthetreasury,shorttheriskybond,andsellthecreditdefaultswapwithpremiumof7%. Shortthetreasury,investintheriskybond,andsellthecreditdefaultswapwithpremiumof6%. Shortthetreasury,investintheriskybond,andbuythecreditdefaultswapwithpremiumof 7%.
CORRECT:D Topreventarbitrage,thereturnontheriskfreegovernmentbondmustequalthereturnontherisky bondlessthepremiumonthedefaultswap,ortheriskcorporatebondreturnmustequalthereturn ontheriskfreegovernmentbondandthecreditdefaultswappremium. Riskfreebondreturn=riskybondreturndefaultswappremium. Inthiscase,adjustmentforthearbitrageprofitchangestherelationshipto Arbitrageprofit=riskybondreturndefaultswappremiumriskfreegovernmentbondreturn Riskfreebondreturn=3% Riskybondreturn=15% Defaultswappremium=X% ArbitrageProfit=5%. Theshortpositionintreasurycosts3%,returnfromtheriskycorporatebondis15%,thedefault swappremiumis7%,endsupinanarbitrageprofitof5%(3%+15%7%).Thisisavalidarbitrage strategy. Reference:Hull,Chapter23.
13. BankAmakesa10millionUSDfiveyearloanandwantstooffsetthecreditexposuretotheobligor. Afiveyearcreditdefaultswapwiththeloanasthereferenceassettradesonthemarketataswap premiumof50basispointspaidquarterly.InordertohedgeitscreditexposureBankA:
a. b. c. d.
Sellsthe5yearCDSandreceivesaquarterlypaymentofUSD50,000. Buysthe5yearCDSandmakesaquarterlypaymentofUSD12,500. Buysthe5yearCDSandreceivesaquarterlypaymentofUSD12,500. Sellsthe5yearCDSandmakesaquarterlypaymentofUSD50,000.
CORRECT:B Tooffsetthecreditriskintheloan,thebankneedstobuycreditprotectionusingtheCDSwithsame maturity.Sincethebankisbuyingprotection,itpaystheinsurancepremiumquarterly.Theannual insurancepremiumswappaymentonthistransactionwouldbenotionalamountxswappremium or10,000,000*0.005=50,000.ThequarterlypremiumisUSD12,500. INCORRECT:ABankAneedstohedgeitscreditexposureandthereforehastobuythe5YearCDS (BankAbuyscreditprotection) INCORRECT:CThequarterlypaymentisUSD12,500=notionalxswappremiumx90/360=10USD millionx0.005x90/360 INCORRECT:DBankAneedstohedgeitscreditexposureandthereforehastobuythe5YearCDS (BankAbuyscreditprotection) Reference:HullChapter23.

14. Abankisconsideringbuying(i.e.sellingprotectionon)aAAAratedsuperseniortranche[10% 11%]ofasyntheticCDOreferencinganinvestmentgradeportfolio.Thepricingofthetranche assumesafixedrecoveryof40%forallnames.Allelsebeingequal,whichoneofthefollowingfour changeswillmaketheprincipalinvestedmorerisky?
a. b. c. d.
Anincreaseinsubordinationof1%,i.e.investinginthe[11%12%]tranche Anincreaseinthetranchethicknessfrom1%to3%,i.e.investinginthe[10%13%]tranche Usingarecoveryrateassumptionof50% Anincreaseindefaultcorrelationbetweennamesintheportfolio
CORRECT:D Theprobabilityofaseniortranchebeinghitdecreasesifthesubordinationincreasesorifthefixed recoveryrateincreases.Theexpectedlossofatranchedecreasesifthetranchethicknessincreases. Theseallleadtothetranchebeinglessrisky.Asportfoliocorrelationincreases,thelossdistribution
exhibitsfattertailandtheprobabilityofaseniortranchebeinghitincreases,leadingtoamorerisky tranche. Reference:Culp,Chapters16,17,18.

15. Twobanksenterintoafiveyearfirsttodefaultbasketcreditdefaultswaptransaction.Thebasket containsthreeuncorrelatedcredits,W,XandY,eachwithaUSUSD25millionnotionalamount.The protectionsellerhastosettleonthecreditthatdefaultsfirstduringthetransaction.Afterthat,the protectionsellerhasnoobligationandthetransactionterminates.Supposethecreditshavethe following5yearcumulativeprobabilityofdefaults. 5YearProbabilitiesof Credit Default W 9.68% X 8.97% Y 8.02% Whichofthefollowingistheprobabilityofatleastonedefaultinthebasketduringthe5years? a. 8.02% b. 9.68% c. 24.38% d. 26.67%
CORRECT:C. Duringthe5years,theprobabilityofnodefaultis(19.68%)x(18.97%)x(18.02%)=75.62%. Theprobabilityofatleastonedefaultis(175.62%)=24.38%. Theanswerisneitherthemaximum(B)norminimum(A)northesum(D)ofthedefaultprobabilities. Reference:HullChapter23.

16. BankAhasexposureto100millionUSDofdebtissuedbyCompanyR.BankAentersintoacredit defaultswaptransactionwithBankBtohedgeitsdebtexposuretoCompanyR.BankBwouldfully compensateBankAifCompanyRdefaultsinexchangeforapremium.Assumethatthedefaultsof BankA,BankBandCompanyRareindependentandthattheirdefaultprobabilitiesare0.3%,0.5% and3.6%,respectively.WhatistheprobabilitythatBankAwillsufferacreditlossinitsexposureto CompanyR?
a. b. c. d.
3.6% 4.1% 0.0180% 0.0108%
CORRECT:C BankAwillonlysufferalosswhenCompanyRandBankBjointlydefault.Withzerocorrelation,this probabilityisequalto0.5%x3.6%=0.018%. 3.6%isthemaximum,4.1%isthesum,and0.0108%=0.3%*3.6% Reference:Hull,Chapters22,23

17. A3yearcreditlinkednotewithunderlyingcompanyZhasaLIBOR+60bpssemiannualcoupon. ThefacevalueoftheCLNisUSD100.LIBORis5%forallmaturities.Current3yearcreditdefault swap(CDS)spreadforcompanyZis90bps.ThefairvalueoftheCLNisclosestto:
a. b. c. d.
USD99.19 USD100.00 USD101.65 USD111.05
CORRECT:A Thisquestionrequiresnocalculation.Becausethediscountfactor(0.5*(0.05+0.009)=0.0295)is greaterthanthecouponrate,thepresentvaluehastobelessthanthefacevaluethecorrect answerisA. Thisquestioncanbeworkedoutbyusingcalculator,whereN=6,I/Y=2.95,PMT=2.8,FV=100> PV=99.19. INCORRECT:BIsthefacevalue. INCORRECT:CIswhereonlyLiborrateisusedfordiscounting.N=6,I/Y=2.5,PMT=2.8,FV=100> PV=101.65. INCORRECT:DIswhereonlyCDSspreadisusedfordiscounting.N=6,I/Y=0.9,PMT=2.8,FV=100> PV=101.65. Reference:Hull,Culp
18. Ariskmanagerestimatesthedailyvariance(ht)usingaGARCHmodelondailyreturns(rt): ht=0+1r2t1+ht1 Assumethemodelparametervaluesare0 =0.005, =0.04,=0.94.Thelongrunannualized volatilityisapproximately: a. 25.00% b. 13.54% c. 72.72% d. 7.94% CORRECT:D Thelongrunvarianceis0.005/(10.040.94)=0.005/0.02=0.25.Thedailyvolisthusthesquare root,or0.5%andannualvol7.935%. INCORRECT:AThedailyvarianceisindeed0.25%,andthedailyvolatility0.5%butthisneedstobe annualized. INCORRECT:BMiscalculatesvarianceassqrt(0.04/(10.940.005))*15.87=13.54% INCORRECT:CMiscalculatesvarianceas0.04/(10.940.005)=72.72% Reference:Hull
19. AbankassignscapitaltoitstradersusingcomponentVaR,whichisbasedonthetradingportfolios VaRestimatedatthe99%confidencelevel.ThemarketvalueofthebankstradingportfolioisHKD1 billionwithadailyvolatilityof2%.Ofthisportfolio,1%isinvestedinatradingbookwithabetaof 0.6relativetothetradingportfolio.Theclosestestimateofthecapitalassignedtothistradingbook is:
a. b. c. d.
HKD167,760 HKD279,600 HKD197,400 HKD1,977,070
CORRECT:B ThisquestionassessescandidatesabilitiestocarryoutCVaRcalculationscorrectly.
Using,e.g.,equation7.29fromJorion2ndedition,wehave CVaR = VaRwi i ,where wi isthe shareoftheithassetintheportfolioand i isitsbeta.Usingtheinformationgiven,VaR=2.33* 0.02*1,000,000,000=46,600,000,soCVaR=46,600,000*0.01*0.6=279,600. INCORRECT:AIncorrectlymultipliesthevolatilitybybetaintheVaRcalculation. INCORRECT:CIncorrectlyuses1.645intheVaRcalculation. INCORRECT:DIncorrectlyusesthesquarerootofthevolatilityintheVaRcalculation. Reference:Jorion,VaR,2ndedition,p.160,chapter7(Portfoliorisk:analyticalmethods).

20. Considerthefollowingpotentialoperationalrisks.Duetoaroguetrader,weestimatethatovera1 yearperiodthereisa10%chancewecouldloseanywherebetween0and100MM(equal probabilityforallpointswithinthatrangeand0probabilityofanylossesoutsidethatrange).Due tomodelrisk,weestimatethatovera1yearperiodthereisa20%chancethatwewilllose25MM normallydistributedwithastandarddeviationof5MM.Whichofthefollowingstatementsis true?
a. Theexpectedlossfromaroguetraderislessthantheexpectedlossfrommodelrisk. b. Theexpectedlossfromaroguetraderisgreaterthantheexpectedlossfrommodelrisk. c. Themaximumunexpectedlossfromaroguetraderatthe95%confidencelevelislessthanthe maximumunexpectedlossatthe95%confidencelevelfrommodelrisk. d. Themaximumunexpectedlossatthe95%levelfromaroguetraderisgreaterthanthe maximumunexpectedlossatthe95%levelfrommodelrisk.
CORRECT:D Thisquestiontestsunderstandingofexpectedvs.unexpectedloss.Theroguetraderhasanexpected loss(severitymultipliedbyprobability)of5MMwhilethemodelriskhasanexpectedlossof5MM. ThereforebothAandBareincorrect.Wethereforemustexamineunexpectedlosses.Therogue traderhasamuchwiderdistribution(Uniform)andalowerprobabilityofoccurrencethanthemodel risk(normaldistribution).Thereforetheroguetraderhasagreaterriskofunexpectedlosses. Unexpectedlossforroguetraderat95%confidencelevel:50MM5MM=45MM Thelossfrommodelriskatthe95thpercentilecorrespondstothe75thpercentileforthenormal distributionwithmean25andstandarddeviation5,sounexpectedlossformodelriskat95% confidencelevel:<(25MM+1.645*5MM)5MM<30MM Reference:Dowd,Chapter16.
21. Whichofthefollowingstatementsaboutliquidityriskelasticity(LRE)isincorrect?
a. Incalculatingthesensitivityofafirmsnetassetstoachangeinitsfundingliquiditypremium, LREassumesaparallelshiftinfundingcostsacrossallmaturities. b. LREisprimarilyusefulforexaminingmarginalchangesinfundingcostsonanetasset/liability position. c. TheLREisacashflowliquidityriskmeasure,notapresentvalueliquidityriskmeasure. d. TheLREisonlyreliableforsmallchangesininterestcosts.
CORRECT:C LREmeasuresliquidityriskforpresentvalues.Itisnotusefulifafirmisconcernedaboutperperiod cashflows. Reference:Dowd,Chapter14;Saunders,Chapter17.

22. Theriskoftheoccurrenceofasignificantdifferencebetweenthemarktomodelvalueofacomplex and/orilliquidinstrument,andthepriceatwhichthesameinstrumentisrevealedtohavetradedin themarketisreferredtoas:
a. b. c. d.
DynamicRisk LiquidityRisk MarktoMarketRisk ModelRisk
CORRECT:D Thisishowmodelriskisdefinedinthereading. INCORRECT:AUndefinedterm INCORRECT:BTheriskofnotbeingabletosellanassetquickly INCORRECT:CUndefinedterm Reference:Dowd,Chapter16.

23. Whichofthefollowingstatementsregardingeconomiccapitalaretrue?
I. Economiccapitalisdesignedtoprovideacushionagainstunexpectedlossesataspecified confidenceleveloverasettimehorizon. II. Sinceregulatorycapitalmodelsandeconomiccapitalmodelshavedifferentobjectives, economiccapitalmodelscannothelpregulatorsinsettingregulatorycapital requirements. III. Firmswhosecapitalexceedstheirrequiredregulatorycapitalarefirmsthatemploytheir capitalinefficientlyandtheirshareholderswouldbenefitiftheyusedsomeoftheircapital torepurchasesharesorincreasedividends. IV. Economiccapitalcanbeusedtovalidateafirmsregulatorycapitalrequirementagainst itsownassessmentoftherisksitisrunning.
a. b. c. d.
IIIandIVonly I,IIandIIIonly I,IIIandIVonly IandIVonly
CORRECT:C Economiccapitalisdefinedasacapitalbufferthatisrequiredtoabsorbtheimpactofunexpected lossesduringatimehorizonataportfoliomanagerslevelofconfidence.Afirmmayemploythe economiccapitalasitsowninternalassessmenttochecktheefficiencyofoverallamountofcapitalit holds.Therefore,IandIIIarecorrect. RecentregulatorychangessuchastheinternalratingsbasedapproachinBaselIIprovides encouragementforfirmstodeveloptheirinternalriskmanagementmodels.Therefore,economic capitalwillbecomeakeyregulatorytoolwithaconvergingtrendbetweeneconomiccapitaland regulatorycapitalmodels.IIisincorrectandIViscorrect Reference:Crouhy,Galai,andMark,RiskManagement.Chapter14CapitalAllocationand PerformanceMeasurement

24. YouareananalystatBankAlpha.YouweregiventhetasktodeterminewhetherunderBaselIIyour bankcanusethesimplifiedapproachtoreportoptionsexposureinsteadoftheintermediate approach.Whichofthefollowingcriteriawouldyourbankhavetosatisfyinorderforittousethe simplifiedapproach?
a. Thebankpurchasesandwritesoptionsandhassignificantoptiontrading. b. Thebankwritesoptionsbutitsoptionstradingisinsignificantinrelationtoitsoverallbusiness activities. c. Thebankpurchasesandwritesoptionsbutitsoptiontradingisinsignificant. d. Thebanksolelypurchasesoptionsanditsoptionstradingisinsignificantinrelationtoitsoverall businessactivities.
CORRECT:D Thebankonlypurchasesoptionsanditsoptionstradingisnotsignificant. INCORRECT:AIfabankwritesoptions,theintermediateapproachmustbeused. INCORRECT:BIfbankwritesoptions,theintermediateapproachmustbeused. INCORRECT:CIfoptiontradingissignificant,theintermediateapproachmustbeused. Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion

25. Yourbankisusingtheinternalmodelsapproachtoestimateitsgeneralmarketriskcharge.The multiplicationfactork,setbytheregulator,is3andbanksareallowedtousethesquarerootrule toscaledailyVaR.Thepreviousdays1dayVaRestimateisEUR3million,andtheaverageofthe dailyVaRoverthelast60daysisEUR2million.Giventheaboveinformation,whatwillbethe marketriskchargeforyourbank? a. EUR18.97million b. EUR9.49million c. EUR6.32million d. EUR28.46million
CORRECT:A Therequiredmarketriskchargewouldbesquarerootof10timesthemaximumofpreviousdayVaR andtheaveragedaily60daysVaR,timesk. 10*Max(3,3*2)=18.97 INCORRECT:B10*3=9.49 INCORRECT:C10*2=6.32

INCORRECT:D10*Max(3*3,3*2)=28.46 Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006). 26. UndertheBaselIICapitalAccord,banksthathaveobtainedpriorregulatoryapprovalcanusethe internalmodelsapproachtoestimatetheirmarketriskcapitalrequirement.Whatapproachor methodologyisusedundertheinternalmodelsapproachtocomputecapitalrequirements?
a. b. c. d.
Stresstestingandbacktesting. Internalratingandvendormodels. VaRmethodology Expectedtailloss,asVaRisnotacoherentmeasureofrisk.
CORRECT:C BaselIIprescribesa10dayVaRat99%confidencelevelforcapitalchargecomputation.However, banksarefreetochoosethemethodtocomputeVaR. INCORRECT:AStresstestingandbacktestingareusedtosupplementandvalidatetheresultsof capitalcomputation,andarenotthemethodpersetobeadoptedforcapitalcomputation INCORRECT:BInternalratingapproachandvendormodelsaresomethingassociatedwithcredit riskratherthanmarketrisk INCORRECT:DRegulationprescribesVaRandnotETLorCVaR,evenwhenitisknownthatVaRis notsubadditiveatalltimes. Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006).

27. BankZ,amediumsizebank,usesonlyoperationallossdatafrominternalrecordstomodelitsloss distributionfromoperationalriskevents.Thebankrevieweditsrecordsand,afterconfirmingthat theywerecompleterecordsofitshistoricallossesandthatitslossescouldbeapproximatedbya uniformdistribution,itdecidedagainstusingexternallossdatatoestimateitslossdistribution. Basedonthatdecision,whichofthefollowingstatementsiscorrect?
a. TheestimatedlossdistributionlikelyoverstatesBankZsrealriskbecausemanyincidencesin thepastwerelikelyoneoff. b. TheestimatedlossdistributionlikelyaccuratelyrepresentsBankZsrealriskbecausethe recordsareaccurateandcomplete. c. TheestimatedlossdistributionlikelyunderstatesBankZsrealriskbecausethebankhasnot experiencedahugeloss. d. TheestimatedlossdistributionlikelyisthebestestimateofBankZsrealriskbecausethereisno betterlossdataforthebankthanitsown.
CORRECT:C OneofthebiggestissuesofOperationalRiskmodelingisthatthereislikelynotenoughinternaldata torepresentlargeenoughlossassuchlossisextremelyrare.Usingexternallossdatabasecanhelp tomitigatethisproblem. Reference:Allenetal.,Chapter5.
28. Alargeinternationalbankhasatradingbookwhosesizedependsontheopportunitiesperceivedby itstraders.ThemarketriskmanagerestimatestheonedayVaR,atthe95%confidencelevel,tobe USD50million.Youareaskedtoevaluatehowgoodofajobthemanagerisdoinginestimatingthe onedayVaR.Whichofthefollowingwouldbethemostconvincingevidencethatthemanageris doingapoorjob,assumingthatlossesareidenticallyindependentlydistributed?
a. b. c. d.
Overthelast250days,themeanlossisUSD60million. Overthelast250days,thereisnoexceedence. Overthelast250days,thereare8exceedences. Overthelast250days,thelargestlossisUSD500million.
CORRECT:B UsingtheKupiectest,thereisanextremelylowprobabilityofnoexceedenceover250days. INCORRECT:AVaRtellsusnothingaboutthemeanlossovertimesincethesizeofthetradingbook variesovertimeasopportunitieschange. INCORRECT:CWiththesametest,theprobabilityof8exceedencesishigherthantheprobabilityof noexceedence. INCORRECT:DTheVaRdoesnottellusthedistributionofthemaximumloss. Reference:Jorion,Chapter6.

29. Tohandlethefinancingofalargecomplexproject,yourbankisestablishingaspecialpurposeentity (SPE)forwhichyourbankwillactastrustee.Whichofthefollowingcouldresultinliabilitytoyour bankthroughitsroleastrustee?
a. TheSPEwasformedtotakeadvantageofapreferablelegaljurisdiction. b. TheSPEprimarypurposewastoallowforthedeferralofincometaxes. c. TheSPEcontrolswereunabletodeterminewhetheritsinvestorsusedfundsderivedfrom legitimatebusinessopportunities. d. TheSPEstructureprovidedforfewercreditorsandareducedlikelihoodthattheprojectwould beforcedintobankruptcy.
CORRECT:C Reference:Culp

30. YourbankisimplementingtheadvancedIRBapproachofBaselIIforcreditriskandtheAMA approachforoperationalrisk.Thebankusesthemodelapproachformarketrisk.TheChiefRisk Officer(CRO)wantstoestimatethebankstotalriskbyaddinguptheregulatorycapitalformarket risk,creditrisk,andoperationalrisk.TheCROasksyoutoidentifytheproblemswithusingthis approachtoestimatethebankstotalrisk.Whichofthefollowingstatementsaboutthisapproachis incorrect?
a. b. c. d.
Itignorestheinterestriskassociatedwiththebanksloans. Itassumesmarket,credit,andoperationalriskshavezerocorrelation. Itignoresstrategicrisks. Itusesatendayhorizonformarketrisk.
CORRECT:B Theapproachassumesacorrelationofone.Thereisnocapitalchargeforstructuralinterestraterisk underBaselII.Operationalriskincludeslegalrisk.Itusesatendayhorizonformarketrisk. Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006).

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

loanshavethesameProbabilityofDefault,PD,of2%withaLossGivenDefault,LGD,of50%. OperatingcostsareUSD10million.ThefundingcostofthebusinessisUSD30million.RAROCis estimatedusingacreditVaRforloanbusinesses.Inthiscase,theappropriatecreditVaRforthe loansis7.5%.Theeconomiccapitalisinvestedandearns6%.TheRAROCis:
a. b. c. d.
32.67% 13.33% 19.33% 46.00%
CORRECT:C (0.1*50051030+0.06*37.5)/37.5=19.33% INCORRECT:A(0.1*5001030+0.06*37.5)/37.5=32.67% INCORRECT:B(0.1*50051030)/37.5=13.33% INCORRECT:D(0.1*500530+0.06*37.5)/37.5=46.00% Reference:Crouhy,Galai,Mark,Chapter14.
32. WhichofthefollowingstatementsregardingBaselIInonadvancedapproachesisincorrect?
a. Thestandardizedapproachusesdatafromthelastthreeyearsofgrossincometoobtaina banksoperationalriskcapitalcharge. b. Thestandardizedapproachmakesitadvantageousforabanktobooklossesearlyifdoingso reducesthisyearsgrossincomesufficientlytomakeitnegative. c. Thestandardizedapproachdividesthebankintobusinesslinesandusesdatafromthelast threeyearsofabusinesslinesgrossincomeandabetafactortoobtaintheregulatorycapital forthatbusinessline. d. Corporatefinance,tradingandsales,andpaymentandsettlementarethebusinesslineswith thehighestregulatorycapitalrequirements.
CORRECT:B Onlypositivegrossincomeisincludedintheformula.Everythingelseiscorrect. Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006).
33. WhichoneofthefollowingstatementsdoesnotapplytotheBaselIIAdvancedMeasurement Approach(AMA)foroperationalrisk?
a. Incontrasttocreditriskregulatorycapitalforcorporateloans,banksusingtheAMAapproach mayhavetosetasidecapitalforbothexpectedandunexpectedoperationalrisklosses. b. IncontrasttothecreditriskIRBapproaches,banksusingtheAMAapproachmayestimatethe correlationbetweendifferenttypesofoperationalrisksiftheirmodelssatisfyregulatory requirements. c. Toevaluateexposuretohighseverityoperationalriskevents,banksusingtheAMAapproach mayuseeitherscenarioanalysisofexpertopinion,orVaRmodelestimatesbasedoninternal datausingextremevaluetheory. d. Reportingofoperationalriskexposuretoseniormanagementisanecessaryconditionfora banksabilitytousetheAMAapproach.
CORRECT:C Everythingiscorrectusingthe2006BaselIIdocumentexceptforc.TheBaselIIdocumentrequires theuseofscenariosobtainedwithexpertadviceforhighseverityeventswhenthebankusesonly internaldata. Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006).

34. Whichofthefollowingapproachesforcalculatingoperationalriskcapitalchargesleadstoahigher capitalchargeforagivenaccountingincomeasriskincreases?
a. b. c. d.
Thebasicindicatorapproach Thestandardizedapproach Theadvancedmeasurementapproach(AMA) Alloftheabove
CORRECT:C UnderAMA,thecapitalchargeisbasedonthebanksinternalmeasurementsystem.Underthe2 otherapproachesthecapitalchargeisbasedupontheGrossIncome,whichhasnothingtodowith riskexposure. Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006).

35. Whichofthefollowingisnotincludedasanelementincalculatingoperationalriskcapitalunderthe AdvancedMeasurementApproach?
a. b. c. d.
Externaldata Keyriskindicators Factorsreflectingthebusinessenvironment Scenarioanalysis
CORRECT:B KRIisnotincludedintheBaseldocumentatall Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006).

36. YourfirmsfixedincomeportfoliohasinterestonlyCMOs(IO),callablecorporatebonds,inverse floaters,noncallablecorporatebonds.Yourbosswantstoknowwhichofthefollowingsecuritiescan losevalueasyieldsdecline.
a. b. c. d.
callablecorporateonly inversefloateronly IOandcallablecorporatebond IOandnoncallablecorporatebond
CORRECT:C TheIOdecreasesinvaluebecauseadeclineinratesimpliesanincreaseinmortgageprepayments, whichdecreasesthenotionalprincipaluponwhichtheIOpaysitsinterest INCORRECT:AWhilethepriceofacallablecorporatemaydeclineasthecallgoesinthemoney,the IOalsodecreasesinvalue INCORRECT:BTheIOdecreasesinvalue,butsocanthecallablecorporate INCORRECT:DThenoncallablecorporatebondincreasesinvalueasyieldsdecline Reference:Tuckman,Chapter21

37. Abankwouldliketoestimatethenumberofoperationalriskeventsduetoproblemswithtellers (largemistakes,fraud,andsoon).Thebankdecidestomodeltelleroperationalriskeventsasa PoissonProcesswithrate (numberofeventsperyear).Withthismodel,telleroperationalrisk eventsareassumedtooccurindependentlyofoneanotherandthenumberoftelleroperationalrisk eventsinayearisPoissondistributedwithmean . OtherpropertiesofaPoissondistributionwith mean include: Variance: Skewness: Excesskurtosis -0.5 1/
Basedonhistoricaldataregardingthenumberoftelleroperationalriskeventsthatoccurredin previousyears,thebankdeterminesthattheaveragenumberofeventshasbeen5peryearand decidestosetto5.Whichofthefollowingistrueregardingthatmodel?
a. Thevarianceofthenumberoftelleroperationaleventsinayearis25. b. Thecorrespondingexponentialdistributionthatdescribesthetimebetweentwoteller operationalriskeventshasameanvalueof0.25years. c. Themodelisnotappropriateifatellerismorelikelytohaveanoperationalriskeventbecause hisfriendwhoisalsoatellerhasbeencaughtstealing. d. Thenumberoftelleroperationalriskeventsinayearcannotexceed25.
CORRECT:C ThePoissonmodelimpliesthattellereventsareindependentofoneanother. INCORRECT:AThetelleroperationalriskeventhasavarianceof5. INCORRECT:BTheexponentialprobabilitydistributiondescribesthedistributionoftheperiod betweentwotellerevents.IfthePoissonProcesshasarateof5,thentheassociatedexponential distributionmodelhasameanvalueofM=1/5=0.2years. INCORRECT:DThereisnoboundonthenumberofeventsthatcanoccur. Reference:Rachev,Menn,Fabozzi;Chapter3.

38. Allthefollowingareoperationalrisklossevents,except:
a. Aloanofficerinaccuratelyentersclientfinancialinformationintothebanksproprietarycredit riskmodel b. Anindividualshowsupatabranchpresentingacheckwrittenbyacustomerforanamount substantiallyexceedingthecustomerslowcheckingaccountbalance.Whenthebankcallsthe customertoaskhimforthefunds,thephoneisdisconnectedandthebankcannotrecoverthe funds. c. Duringanadversemarketmovement,thecomputernetworksystembecomesoverwhelmed andonlyintermittentpricinginformationisavailabletothebankstradingdesk,leadingtolarge lossesastradersbecomeunabletoaltertheirhedgesinresponsetofallingprices d. Abank,actingasatrusteeforaloanpool,receiveslessthantheprojectedfundsduetodelayed repaymentofcertainloans.
CORRECT:D AbroadinterpretationoftheFDICandBaselIIrulesdefiningoperationalriskswouldconsiderall,but alternatived,asoperationalriskeventsandoperationalrisklosses.Aloanofficerentering inaccurateclientfinancialinformationintothebanksproprietarycreditriskmodelisaprocessrisk andanylossesattributabletothisemployeeerrorshouldbeconsideredasanoperationalriskevent. Customerswritingchecksexceedingthebalanceofacheckingaccountanddepositingthefundsina savingsaccountisanexampleofcheckkiting.Ifduringtimesofadversemarketmovement,the computernetworkbecomesoverwhelmedandonlydelayedpricinginformationreachesthebanks tradingdeskandtradesarebasedontheavailableinformation,thebankissubjecttobusiness disruptionandsystemfailures.Whenabank,actingasatrusteeforaloanpool,receiveslessthan theprojectedfundsduetodelayedrepaymentofcertainloansinthepoolisnotanoperationalrisk lossevent. Reference:BaselII:InternationalConvergenceofCapitalMeasurementandCapitalStandards:A RevisedFrameworkComprehensiveVersion(BaselCommitteeonBankingSupervisionPublication, June2006).

39. Supposeyouareholding100WheelbarrowCompanyshareswithacurrentpriceofUSD50.The dailyhistoricalmeanandvolatilityofthereturnofthestockis1%and2%,respectively.Thebidask spreadofthestockvariesovertime.Thedailyhistoricalmeanandvolatilityofthespreadis0.5% and1%,respectively.CalculatethedailyliquidityadjustedVaR(LVaR)at99%confidencelevel:(Both thereturnandspreadofthestockarenormallydistributed):
a. b. c. d.
USD325 USD275 USD254 USD229
CORRECT:C VaR=USD50*100*(2.33*0.020.01)=USD183 Liquidityadjusted=USD50*100*0.5*(2.33*0.01+0.005)=USD71 LVaR=VaR+Liquidityadjusted=USD254 Reference:Dowd:Chapter14.

40. Supposeyouaregiventhefollowinginformationabouttheoperationalrisklossesatyourbank.

Frequencydistribution Probability Frequency 0.5 0 0.3 1 0.2 2
SeverityDistribution Probability Severity 0.6 USD1,000 0.3 USD10,000 0.1 USD100,000
WhatistheestimateoftheVaRatthe95%confidencelevel,assumingthatthefrequencyand severitydistributionsareindependent?
a. b. c. d.
USD200,000 USD110,000 USD100,000 USD101,000
CORRECT:C Thelossdistributionis: Totalloss 0 1,000 2,000 10,000 11,000 20,000 100,000 101,000 110,000 200,000 Probability 0.5 0.18 0.072 0.09 0.072 0.018 0.03 0.024 0.012 0.002
The95%VaRis100,000.Theotheranswersarefromthisdistribution,butnotcorrespondingtothe 95%VaR.
Reference:Allenetal.,chapter5.

41. Tocontrolrisktakingbytraders,yourbanklinkstradercompensationwiththeircompliancewith imposedVaRlimitsontheirtradingbook.Whyshouldyourbankbecarefulintyingcompensation totheVaRofeachtrader?
a. Itencouragestraderstoselectpositionswithlowestimatedrisks,whichleadstoan underestimationoftheVaRlimits. b. Itencouragestraderstoselectpositionswithlowestimatedrisks,whichleadstoan overestimationoftheVaRlimits. c. Itencouragestraderstoselectpositionswithhighestimatedrisks,whichleadstoan underestimationoftheVaRlimits. d. Itencouragestraderstoselectpositionswithhighestimatedrisks,whichleadstoan overestimationoftheVaRlimits.

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

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

43. Amutualfundinvestingincommonstockshasadoptedaliquidityriskmeasurelimitingeachofits holdingstoamaximumof30%ofitsthirtydayaveragevaluetraded.IfthefundsizeisUSD3billion, whatisthemaximumweightthatthefundcanholdinastockwithathirtydayaveragevaluetraded ofUSD2.4million?
a. b. c. d.
24.00% 0.08% 0.024% 80.0%
CORRECT:C Thirtydayaveragevaluetraded=USD2.4million 30%ofthirtydayaveragevaluetraded=30%xUSD2.4=USD0.72million %ofPortfolio=USD0.72million/USD3billion=0.024% Reference:Grinold,Kahn,Chapters,14,17.

44. Aninvestorisinvestigatingthreehedgefundsaspotentialinvestments.HedgefundAisanequity marketneutralfund,Bisaglobalmacrofundwithemphasisonequitymarkets,andCisa convertiblearbitragefund.Whichanswercorrectlyspecifiesthefundswiththehighestexposureto aworldwidevalueweightedequityindexandtoacreditdefaultswapsindex? Highestequityindexexposure Highestcreditdefaultswapindexexposure a. A B b. A C c. B A d. B C
CORRECT:D HedgefundB,globalmacro,hashighestequityexposure.HedgefundA(equitymarketneutral)has nonetequityexposureaslongpositionsareoffsetbyshortpositionswithregardstoequity exposure.Similarly,littleoutrightmarketriskforconvertiblearbitragefundCasitinvolvesarbitrage toalargeextent. Withregardstocreditrisk,convertiblearbitragefundChashighestcreditrisk,sinceitinvestsin interestratesensitiveinstrumentshighlyaffectedbychangesincreditratings. Reference:LarsJaeger,ThroughtheAlphaSmokeScreens:AGuidetoHedgeFundReturnSources, Chapter5
45. Whichofthefollowingisnotanapproachfordetectingstyledriftofhedgefunds? a. Performanceattribution b. Peergroupcomparison c. Cashflowanalysis d. Communicationwithfundmanager
CORRECT:C CashFlowanalysisforthefundcannotdetectstyledrift INCORRECT:APerformanceattributioncandetermineifeachperformancecomponentisconsistent withtheperdeterminedstyleoffund. INCORRECCT:BPeergroupcanbeusedtodeterminetheconsistencyofthefundsriskandreturn profile INCORRECT:DDiscussionwithfundmanagercanrevealchangeinstyleandstrategyofthefund. Reference:LarsJaeger,ed.,TheNewGenerationofRiskManagementforHedgeFundsandPrivate EquityInvestments,Chapter27

46. Allofthefollowingstrategiesareexamplesofcapitalstructurearbitrage,except:
a. Longpositioninthebondsissuedbythecompany,andshortpositioninthecompanysstock. b. Shortpositioninthebondsissuedbythecompany,andlongpositioninthecompanysstock. c. Longpositioninacreditdefaultswaponthecompanyandwritingputoptionsonthecompanys stock. d. Shortpositioninthepreferredstockissuedbythecompanyandwritingcalloptionsonthe companysstock.
CORRECT:D Alongpositioninthebondsissuedbythecompanyandshortpositioninthecompanysstock,anda shortpositioninthebondsissuedbythecompanyandalongpositioninthecompanysstockare bothcapitalizingonthedifferentspeedofadjustmenttoinformationinthebondandequities markets.Alongpositioninacreditdefaultswaponthecompanyandwritingputoptionsonthe companysstockcapitalizesonthedifferencesinthevolatilitysurfacebetweenbondsandequity. Shortpositioninthepreferredstockissuedbythecompanyandwritingcalloptionsonthe companysstockinfactisanetshortpositionwhichshouldnotbesensitivetorelativechangesinthe differencebetweenthetwoinstruments. Reference:Jaeger,ThroughtheAlphaSmokescreens,Chapter5
47. Youhavebeenaskedtoevaluatetheperformanceoftwohedgefunds:GlobalAssetManagementI andInternationalMomentumII.BotharebenchmarkedtoMSCIEAFE.Whichofthetwofundshad ahigherrelativeRiskAdjustedPerformance(RAP)lastyear,andwhatistheRAP?
ThevolatilityofEAFEis17.5%andtheannualizedperformanceis10.6%.Theriskfreerateis3.5%. Fund Volatility AnnualizedPerformance GlobalAssetManagementI 24.5% 12.5% InternationalMomentumII 27.3% 13.6%
a. b. c. d.

GlobalAssetManagement,4.85% GlobalAssetManagement,6.16% InternationalMomentum,5.42% InternationalMomentum,1.18%
CORRECT:C Theannualizedriskadjustedperformanceism/p(RpRm)+Rf= mbenchmarkvolatility pportfoliovolatility Rpportfolioreturn Rmbenchmarkreturn Rfriskfreereturn TheriskadjustedperformanceforGlobalisthenm/p(RpRm)+Rf=17.5/24.5x(12.510.6)+3.5 =4.85% TheriskadjustedperformanceforInternationalisthenm/p(RpRm)+Rf=17.5/27.3x(13.610.6) +3.5=5.42%.InternationalhasagreaterRAP. Reference:Grinold,Kahn,Chapters14,17.

48. OnJanuary1,2006,apensionfundhasassetsofEUR100billionandisfullyinvestedintheequity market.IthasEUR85billioninliabilities.During2006,theequitymarketdeclinedby15%andyields increasedby1.2%.Ifthemodifieddurationoftheliabilitiesis12.5,whatisthepensionfunds surplusonDecember31,2006?
a. b. c. d.
EUR15.00billion EUR12.93billion EUR12.75billion EUR12.57billion
CORRECT:C Thesurplusatthebeginningoftheyearwas10085or15billionEUR.Duringtheyear,theequity portfoliodeclines15%,or15billionEUR,to85billionEUR.Duetotheincreaseinyields,thedollar valueoftheliabilitiesdecreasesby12.5*1.2%*85billionEUR,or12.75.Thusattheendofthe year,theassetsareworth(10015)=85billionEURandtheliabilities(8512.75)=72.25billion. Thesurplusisthen12.75,adecreaseof2.25billionEUR. INCORRECT:A15istheequitylossin2006 INCORRECT:B12.93=15*(1(.15.012)) INCORRECT:D12.57=15*(1(.15+.012)) Reference:Jorion,VaR,3rded,Chapter17.

49. WhichofthefollowingstatementsregardingExtremeValueTheory(EVT)isincorrect?
a. ConventionalapproachesforestimatingVaRthatassumethatthedistributionofreturnsfollow auniquedistributionfortheentirerangeofvaluesmayfailtoproperlyaccountforthefattails ofthedistributionofreturns. b. IncontrasttoconventionalapproachesforestimatingVaR,EVTonlyconsidersthetailbehavior ofthedistribution. c. Bysmoothingthetailofthedistribution,EVTeffectivelyignoresextremeeventsandlosses whichcangenerallybelabeledoutliers. d. EVTattemptstofindtheoptimalpointbeyondwhichallvaluesbelongtothetailandthen modelsthedistributionofthetailseparately.
CORRECT:C Statementsa,b,anddarevalidstatements.Statementcisincorrectoutliersareabigconcernin riskanalysisandcannotbeignored. Reference:Dowd,Chapter7.
50. Consideraportfoliowith40%investedinassetXand60%investedinassetY.Themeanand varianceofreturnonXare0and25respectively.ThemeanandvarianceofreturnonYare1and 121respectively.ThecorrelationcoefficientbetweenXandYis0.3.Whatisthenearestvaluefor portfoliovolatility? a. b. c. d. 9.51% 8.60% 13.38% 7.45%
CORRECT:D Theportfoliovolatilityiscalculatedasfollows:
2 2 2 2 portfolio variance = w x x + w y y + 2w x w y xy x y
= 0.4 2 * 25 + 0.62 * 121 + 2 * 0.4 * 0.6 * 0.3 * 5 * 11 = 55.48
portfoliovolatility=(portfoliovariance)0.5=(55.48)0.5=7.45 INCORRECT:AThissolutionincorrectlycalculatestheportfoliovarianceusingwxandwyinsteadof wx2andwy2. INCORRECT:BThissolutionincorrectlyomitsthecorrelationbetweenXandYintheportfolio variancecalculation. INCORRECT:CThissolutionincorrectlyomitstheweightingtermsintheportfoliovariance calculation. Reference:PhilippeJorion,ValueatRisk,3rdedition.Chapter7.
ENDOF2009FRMFULLEXAMPRACTICEEXAMII Questions&Explanations

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Fixedforfloatingswap Interestratecollar Interestratefloor Callswaption

2.9% 2% 1.1% 4.7%

wheredriftandvolareknownparametersandtisthestepsize. Thegenerationofeachpathrequiresanumberofsteps.Whichofthefollowingdescribesthe correctprocedure?

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

25.00% 13.54% 72.72% 7.94%

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

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

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

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

Contango Backwardation Inversion Needmoreinformationtodetermine

11. Thepriceofa3yearzerocoupongovernmentbondis85.16.Thepriceofasimilar4yearbondis 79.81.Whatistheoneyearimpliedforwardratefromyear3toyear4?

5.4% 5.5% 5.8% 6.7%

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

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

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

0.5554 0.9333 1.2099 0.8198

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

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

15.10 14.47 9.20 17.20

Ifthedriftisnegative,thepriceoneyearfromnowwillbebelowtodaysprice. Theinstantaneousrateofreturnonthestockfollowsauniformdistribution. ThestockpriceSfollowsalognormaldistribution. Thismodelimposesmeanreversion.

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

1/9 1/4 1/36 Cannotbedetermined

20. Ifstockreturnsareindependentlyidenticallynormallydistributedandtheannualvolatilityis30%, thenthedailyVaRatthe99%confidencelevelofastockmarketportfolioisapproximately:

2.41% 3.11% 4.40% 1.89%

618contracts 288contracts 574contracts 906contracts

23. WhatistheannualizedrateofreturnearnedonacashandcarrytradeenteredintoinMarchand closedoutinJune?

8.9% 9.8% 35.7% 39.1%

25. WhichofthefollowingproblemsareNOTinherentdisadvantagesofthehistoricalsimulation approachtoestimatingVaR?

IandIIonly IIonly I,IIIandIVonly IIIandIVonly

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

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

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

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

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

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

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

Theyshouldbeexactlythesame Theforwardrateisnormallyhigherthanthefuturesrate Theforwardrateisnormallylowerthanthefuturesrate Theyhavenofixedrelationship

3.5% 7% 11% 14%

0.274 1.727 0.653 0.378

38. Whichofthefollowingstatementsaboutthelinearregressionofthereturnofaportfoliooverthe returnofitsbenchmarkpresentedbelowarecorrect?

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

IIandIV IIIandIV I,IIandIII II,IIIandIV

Ionly IandIVonly IandIIIonly IVonly

40. Whichofthefollowingriskmanagementstrategiesofafirmwhichhasprincipalpaymentstomake onitsdebtinoneyearthatsubstantiallyexceedthemarketvalueofitsassetsismostlikelytobein theinterestoftheshareholders?

Reductionoftheoverallrisklevelofthefirm Increaseoftheoverallrisklevelofthefirm Keepthesamerisklevel Itisimpossibletosaywhichriskmanagementstrategytheshareholdersprefer

Fixedforfloatingswap Interestratecollar Interestratefloor Callswaption

5.44% 3.62% 2.96% 1.31%

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

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

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

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

CORRECT:B ThisquestionassessescandidatesabilitiestoapplythedurationVaRformulatotwobonds simultaneouslyandtorecallthatthedurationofazerocouponbondisequaltothebondmaturity. UsinganobviousextensionofJorionsequation9.5

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

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

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

Contango Backwardation Inversion Needmoreinformationtodetermine

5.4% 5.5% 5.8% 6.7%

Forward rate = 0.067034 or 6.7%

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

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

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

0.5554 0.9333 1.2099 0.8198

CORRECT:D Sinceeachvariableisstandardized,itsvarianceis1.ThereforeV(3A+2B)=9V(A)+4V(B)+2x3x2 xCov(A,B)=9+4+4.2=17.2 INCORRECT:A9+4+60.35=15.1 INCORRECT:B9+4+120.35^2= INCORRECT:C3+2+12*0.35=9.2 Reference:DamodarGujarati