FRM Pep2 080118 3 PDF
FRM Pep2 080118 3 PDF
FRM
PRACTICE EXAM PART II
®
Table of Contents
Introduction
The FRM Exam is a practice-oriented examination. Its questions are derived from a combination of
theory, as set forth in the core readings, and “real-world” work experience. Candidates are expected
to understand risk management concepts and approaches and how they would apply to a risk
manager’s day-to-day activities.
The FRM Exam is also a comprehensive examination, testing a risk professional on a number of risk
management concepts and approaches. It is very rare that a risk manager will be faced with an issue that
can immediately be slotted into one category. In the real world, a risk manager must be able to identify
any number of risk-related issues and be able to deal with them effectively.
The 2018 FRM Part I and Part II Practice Exams have been developed to aid candidates in their
preparation for the FRM Exam in May and November 2018. These Practice Exams are based on a sample
of questions from prior FRM Exams and are suggestive of the questions that will be on the 2018 FRM
Exam.
The 2018 FRM Part I Practice Exam contains 100 multiple-choice questions and the 2018 FRM Part II
Practice Exam contains 80 multiple-choice questions, the same number of questions that the actual
2018 FRM Exam Part I and 2018 FRM Exam Part II will contain. As such, the Practice Exams were
designed to allow candidates to calibrate their preparedness both in terms of material and time.
The 2018 FRM Practice Exams do not necessarily cover all topics to be tested in the 2018 FRM Exam as
any test samples from the universe of testable possible knowledge points. However, the questions
selected for inclusion in the Practice Exams were chosen to be broadly reflective of the material
assigned for 2018 as well as to represent the style of question that the FRM Committee considers
appropriate based on assigned material.
For a complete list of current topics, core readings, and key learning objectives, candidates should
refer to the 2018 FRM Exam Study Guide and 2018 FRM Learning Objectives.
Core readings were selected by the FRM Committee to assist candidates in their review of the subjects
covered by the Exam. Questions for the FRM Exam are derived from the core readings. It is strongly
suggested that candidates study these readings in depth prior to sitting for the Exam.
To maximize the effectiveness of the practice exams, candidates are encouraged to follow these
recommendations:
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
2. Unless otherwise indicated, option contracts are assumed to be on one unit of the underlying asset.
8. CEO, CFO, CIO, and CRO are: chief executive, financial, investment, and risk officers, respectively
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1. An investment bank with an active position in commodity futures is using the peaks-over-threshold (POT)
methodology for estimating VaR and ES at the 99% confidence level. The bank’s risk managers have set a
threshold level to evaluate excess losses. The choice of the threshold, they argue, is suitable and consistent
with the finding that 5.00% of the observations are more than the threshold value. The risk managers have
concluded that the position’s VaR using the POT measure is 4.45%. The VaR estimate is computed from the
following parameters and the managers’ empirical analysis is based upon the generalized Pareto distribution
assumption for the excess losses.
Parameter Symbol Value
Loss threshold (%) u 3
Number of observations n 740
Number of observations that exceed threshold Nu 37
Scale β 0.75
Shape (tail index) ξ 0.22
Given the VaR value and the parameter assumptions, which of the following is correct?
A. Keeping all other parameters constant, increasing the value of the tail index decreases both the ES and
the VaR.
B. Keeping all other parameters constant, decreasing the scale parameter increases both the ES and the
VaR.
C. The value of ES is 4.57%
D. The value of ES is 5.82%
2. A risk manager is estimating the market risk of a portfolio using both the arithmetic returns with normal
distribution assumptions and the geometric returns with lognormal distribution assumptions. The manager
gathers the following data on the portfolio:
• Annualized average of arithmetic returns: 15%
• Annualized standard deviation of arithmetic returns: 35%
• Annualized average of geometric returns: 13%
• Annualized standard deviation of geometric returns: 44%
• Current portfolio value: EUR 4,800,000
• Trading days in a year: 252
Assuming both daily arithmetic returns and daily geometric returns are serially independent, which of the
following statements is correct?
A. 1-day normal 95% VaR = 3.57% and 1-day lognormal 95% VaR = 3.55%
B. 1-day normal 95% VaR = 3.57% and 1-day lognormal 95% VaR = 4.41%
C. 1-day normal 95% VaR = 4.46% and 1-day lognormal 95% VaR = 3.57%
D. 1-day normal 95% VaR = 4.46% and 1-day lognormal 95% VaR = 4.49%
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
3. A credit manager in the counterparty risk division of a large bank uses a simplified version of the Merton
model to monitor the relative vulnerability of its largest counterparties to changes in their valuation and
financial conditions. To assess the risk of default of three particular counterparties, the manager calculates the
distance to default assuming a 1-year horizon (t=1). The counterparties: Company P, Company Q, and
Company R, belong to the same industry, and are non-dividend-paying firms. Selected information on the
companies is provided in the table below:
Using the information above with the assumption that a zero-coupon bond maturing in 1 year is the only
liability for each company, and the approximation formula of the distance to default, what is the correct
ranking of the counterparties, from most likely to least likely to default?
A. P; R; Q
B. Q; P; R
C. Q; R; P
D. R; Q; P
4. Bank HJK has written puts on Bank PQR stock to a hedge fund and sold CDS protection on Bank PQR to a
manufacturer. Bank HJK and Bank PQR operate in several of the same businesses and geographies and their
performances are highly correlated. Many in the market are concerned that rising interest rates could
negatively impact the credit quality of Bank HJK’s numerous borrowers, which in turn would increase the
credit spread of Bank HJK. From the perspectives of the hedge fund and the manufacturer, which of the
following is correct with respect to their counterparty risk exposure to Bank HJK?
Hedge Fund Manufacturer
A. Right-way risk Wrong-way risk
B. Wrong-way risk Right-way risk
C. Right-way risk Right-way risk
D. Wrong-way risk Wrong-way risk
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5. Bank JJQ, a member of a CCP, sells credit protection on a GBP 100 million counterparty position using CDS. The
reference entity is a gold mining company. Which of the following trades by Bank JJQ on the same reference
entity would be a hedge to transfer credit risk with minimal increase in counterparty risk?
6. A risk analyst at a mid-size hedge fund is evaluating the credit risk of several trade positions. The hedge fund
specializes in corporate debt and runs a strategy that utilizes both relative value and long-only trades using
CDS and bonds. One of the new trades at the hedge fund is a B-rated long bond valued at JPY 10 billion. Some
of the hedge fund’s newest clients, including the B-rated bond holders, are restricted from withdrawing their
funds for four years. The analyst is currently evaluating the impact of various default scenarios to estimate
future asset liquidity. The analyst assumes that defaults, if they occur, take place only at the end of the year
and has estimated that the marginal probability of default of the B-rated bond is 7.7% in Year 1; 7.1% in Year
2; 6.6% in Year 3; and 6.1% in Year 4. Assuming the default events are independent, what is the probability
that the bond survives the first 3 years and then defaults at the end of Year 4?
A. 4.9%
B. 5.7%
C. 6.1%
D. 6.9%
7. MDM Bank is seeking to enhance its enterprise risk management function. To achieve that objective, the bank
introduces a new decision-making process based on economic capital that involves assessing sources of risk
across different business units and organizational levels. Which of the following statements regarding the
correlations between these risks is correct?
A. Correlations between business units are only relevant in deciding total firm-wide economic capital levels
and are not relevant for decisions at the individual business unit or project level.
B. Correlations between broad risk types such as credit, market, and operational risk are generally well
understood and are easy to estimate at the individual firm level.
C. The introduction of correlations into firm-wide risk evaluation will result in a total VaR that, in general, is
greater than or equal to the sum of individual business unit VaRs.
D. The introduction of correlations into the risk evaluation of a bank’s loan book will result in total credit VaR
that, in general, is less than or equal to the sum of individual loan credit VaRs.
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8. A US pension fund had assets and liabilities valued at USD 840 million and USD 450 million, respectively, at the
end of 2016. The fund’s assets were fully invested in equities and commodities while its liabilities consisted
entirely of fixed-income obligations. The fund reported that by the end of 2017 the value of assets decreased
by 14.0% and the value of liabilities increased by 3.5%. Assuming no changes were made to the composition of
the assets and liabilities during the year, what was the change in the pension fund’s surplus over the 1-year
period?
9. A wealth management firm has a portfolio consisting of USD 48 million invested in US equities and
USD 35 million invested in emerging markets equities. The US equities and emerging markets equities both
have a 1-day 95% VaR of USD 1.2 million. The correlation between the returns of the US equities and emerging
markets equities is 0.36. While rebalancing the portfolio, the manager in charge decides to sell USD 8 million
of the US equities to buy USD 8 million of the emerging markets equities. At the same time, the CRO of the
firm advises the portfolio manager to change the risk measure from 1-day 95% VaR to 10-day 99% VaR.
Assuming that returns are normally distributed and that the rebalancing does not affect the volatility of the
individual equity positions, by how much will the portfolio VaR increase due to the combined effect of
portfolio rebalancing and change in risk measure?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
10. An operational risk manager is asked to report a bank’s operational risk capital under the Standardized
Measurement Approach (SMA) proposed by the Basel Committee in March 2016. The treasury department
produces the following data for the bank, calculated according to the SMA guidelines:
• Business Indicator (BI): EUR 1,200 million
• Internal Loss Multiplier: 1
In addition, the manager uses the Business Indicator buckets in the Business Component presented in the
table below:
Bucket BI Range BI Component
1 EUR 0 to EUR 1 billion 0.11*BI
2 EUR 1 billion to EUR 3 billion EUR 110 million + 0.15(BI – EUR 1 billion)
3 EUR 3 billion to EUR 10 billion EUR 410 million + 0.19(BI – EUR 3 billion)
4 EUR 10 billion to EUR 30 billion EUR 1.74 billion + 0.23(BI – EUR 10 billion)
5 EUR 30 billion to infinity EUR 6.34 billion + 0.29(BI – EUR 30 billion)
What is the correct operational risk capital that the bank should report under the SMA?
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11. A credit manager who is well versed in lessons learned from the 2007–2009 subprime mortgage crisis in the US
is overseeing the structured credit book of a bank in order to identify potential problems of information flow
(frictions) between the parties involved in the securitization process. Which of the following is a correct
combination of a potential friction in the securitization process and an appropriate mechanism to mitigate that
friction?
A. Friction between the asset manager and the investor: Adverse selection problem. This problem can be
mitigated by the asset manager charging due diligence fees to the investor.
B. Friction between the arranger and the originator: Model error problem. This problem can be mitigated by
the arranger providing a credit enhancement to the securitized products with its own funding.
C. Friction between the investor and credit rating agencies: Principal-agent conflict. This problem can be
mitigated by requiring credit rating agencies to be paid by originators and not by investors for their rating
services.
D. Friction between the servicer and the mortgagor: Moral hazard problem. This problem can be mitigated
by requiring the mortgagor to escrow funds for insurance and tax payments.
12. A risk manager is backtesting a company’s 1-day 99.5% VaR model over a 10-year horizon at the 95%
confidence level. Assuming 250 days in a year and the daily returns are independently and identically
distributed, which of the following is closest to the maximum number of daily losses exceeding the 1-day
99.5% VaR in 10 years that is acceptable to conclude that the model is calibrated correctly?
A. 19
B. 25
C. 35
D. 39
13. A portfolio manager is mapping a fixed-income portfolio into exposures on selected risk factors. The manager
is analyzing the comparable mechanics and risk measurement outputs of principal mapping, duration
mapping, and cash-flow mapping that correspond to the average portfolio maturity. Which of the following is
correct?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
14. A CRO of a hedge fund is asking the risk team to develop a term-structure model that is appropriate for fitting
interest rates for use in the fund’s options pricing practice. The risk team is evaluating several interest rate
models with time-dependent drift and time-dependent volatility functions. Which of the following is a correct
description of the specified model?
A. In the Ho-Lee model, the drift of the interest rate process is presumed to be constant.
B. In the Ho-Lee model, when the short-term rate is above its long-run equilibrium value, the drift is
presumed to be negative.
C. In the Cox-Ingersoll-Ross model, the basis-point volatility of the short-term rate is presumed to be
proportional to the square root of the rate, and short-term rates cannot be negative.
D. In the Cox-Ingersoll-Ross model, the volatility of the short-term rate is presumed to decline exponentially
to a constant long-run level.
15. Six months ago, Textile Manufacturing Inc. (TMI) entered into a 9-month forward contract with Spin Mills
Company (SMC) to purchase 36,000 tons of yarn from SMC. At the time the forward was entered into, 36,000
tons of yarn was priced at EUR 92.0 million but is currently priced at EUR 94.0 million. The continuously
compounded risk-free rate has remained stable at 3.0% per year and is not expected to change during the
remainder of the contract period. Assuming the forward is fairly priced, what is the current potential credit risk
exposure on the forward contract and who bears the risk?
16. A mid-sized investment bank conducts several trades. As part of its risk control, it has entered into netting
agreements on 8 equity trade positions with an average correlation of 0.28. The firm believes that it can
improve upon the diversification benefit of netting by revising the current agreement. Assuming values of
future trade positions are normally distributed, which of the following trade combinations would increase the
firm’s expected netting benefit the most from the current level?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
17. A portfolio manager is interested in liquidating Stock ASX from an existing portfolio. However, the manager is
concerned about the level of liquidity risk and proceeds to estimate liquidity-adjusted VaR for the stock. The
manager observes a quote for Stock ASX and reports that the midpoint of its current best bid and best ask
prices is AUD 54. Stock ASX has an estimated daily return volatility of 0.25% and an average bid-ask spread of
AUD 0.15. Using the constant spread approach on a position of 20,000 shares of Stock ASX, and assuming the
returns of the stock are normally distributed, which is closest to the correct estimate for the stock’s liquidity-
adjusted 1-day 99% VaR?
A. AUD 2,700
B. AUD 7,780
C. AUD 12,400
D. AUD 15,100
18. A manager is evaluating the risks of a portfolio of stocks. Currently, the portfolio is valued at CNY 124 million
and contains CNY 14 million in stock Y. The annualized standard deviations of returns of stock Y and of the
overall portfolio are 12% and 16%, respectively. The correlation of returns between stock Y and the portfolio is
0.52. Assuming the risk analyst uses a 1-year 95% VaR and that returns are normally distributed, what is the
component VaR of stock Y?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
19. The use of a central clearinghouse to handle the transactions executed between XYZ's main funding source,
ABC and ABC's client, Repo Co., would likely have resulted in a reduction in:
20. By using a clearinghouse to handle the repo transactions between ABC and Repo Co., obligations owed
between the two could have been netted once the fraudulent documentation was discovered. Which of the
following is the most appropriate type of netting to use in this situation and what would be a likely additional
impact from using this netting?
A. Payment netting would be used, which would reduce ABC's counterparty risk, but this risk would be
transferred to other creditors outside the clearinghouse.
B. Payment netting would be used, which would reduce Repo Co.'s counterparty risk, but ABC's counterparty
risk would be increased.
C. Closeout netting would be used, which would reduce ABC's counterparty risk, but this risk would be
transferred to other creditors outside the clearinghouse.
D. Closeout netting would be used, which would reduce Repo Co.'s counterparty risk, but ABC's counterparty
risk would be increased.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
21. A risk analyst at a fund management company is discussing with the risk team the gaps in the company’s risk
measurement system. Among the areas suggested for improvement is a better ability to anticipate the
company’s cash flow needs. Addressing such a problem requires that a good liquidity-at-risk (LaR)
measurement system be an essential part of the bank's risk management framework. Which of the following
statements concerning LaR is correct?
22. Pillar 1 of the Basel II framework allows banks to use various approaches to calculate the capital requirements
for credit risk, operational risk, and market risk. Which of the following Basel II approaches allows a bank to
explicitly recognize diversification benefits?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
23. The risk audit committee of an equity mutual fund is reviewing a portfolio construction technique proposed
by a new portfolio manager who has recently been allocated capital to manage. The fund typically grants its
portfolio managers flexibility in selecting and implementing appropriate portfolio construction procedures but
requires that any methodology adopted fulfills key risk control objectives set by the firm. Which of the
following portfolio construction techniques and its capability for risk control in portfolio construction is
correct?
A. Quadratic programming allows for risk control through parameter estimation but generally requires many
more inputs estimated from market data than other portfolio construction techniques require.
B. The screening technique provides superior risk control by concentrating stocks in selected sectors based
on expected alpha.
C. When using the stratification technique, risk control is implemented by overweighting the categories with
lower risks and underweighting the categories with higher risks.
D. When using the linear programming technique, risk is controlled by selecting the portfolio with the lowest
level of active risk.
24. An analyst reports the following fund information to the advisor of a pension fund that currently invests in
government and corporate bonds and carries a surplus of USD 40 million:
Pension Assets Liabilities
Amount (USD million) 180 140
Expected annual growth rate 6% 10%
Annual volatility of growth rates 25% 12%
To evaluate the sufficiency of the fund's surplus, the advisor estimates the possible surplus values at the end
of 1 year. The advisor assumes that annual returns on assets and the annual growth of the liabilities are jointly
normally distributed and their correlation coefficient is 0.68. Assume that the volatility of surplus in dollar is
USD 35.76 million, what is the lower bound of the 95% confidence interval for the expected end-of-year
surplus that the advisor can report?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
25. A due diligence specialist at a company is evaluating the risk management process of a hedge fund in which
the company is considering making an investment. Which of the following statements best describes
appropriate criteria the specialist should use for such an evaluation?
A. Because of the overwhelming importance of tail risk, the company should not invest in the fund unless it
fully accounts for fat tails using extreme value theory at the 99.99% level when estimating VaR.
B. Today's best practices in risk management require that a fund employ independent risk service providers
and that these service providers play important roles in risk-related decisions.
C. When considering a leveraged fund, the specialist should assess how the fund estimates risks related to
leverage, including funding liquidity risks during periods of market stress.
D. It is crucial to assess the fund's valuation policy, and in general if more than 10% of asset prices are based
on model prices or broker quotes, the specialist should recommend against investment in the fund
regardless of other information available about the fund.
26. A packaging materials manufacturer is considering a project that has an estimated risk-adjusted return on
capital (RAROC) of 15%. Suppose that the risk-free rate is 3% per year, the expected market rate of return is
11% per year, and the company's equity beta is 1.8. Using the criterion of adjusted risk-adjusted return on
capital (ARAROC), the company should:
A. Reject the project because the ARAROC is higher than the market expected excess return.
B. Accept the project because the ARAROC is higher than the market expected excess return.
C. Reject the project because the ARAROC is lower than the risk-free rate.
D. Accept the project because the ARAROC is lower than the risk-free rate.
27. A derivative trading firm only trades derivatives on rare commodities. The company and a handful of other
firms, all of whom have large notional outstanding contracts with the company, dominate the market for such
derivatives. The company’s management would like to mitigate its overall counterparty exposure, with the
goal of reducing it to almost zero. Which of the following methods, if implemented, could best achieve this
goal?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
28. HIP Bank (HIP) often enters into interest rate swaps with ADB Banking Corporation (ADB) on terms that reflect
appropriate counterparty risk. Earlier in the year, HIP and ADB entered into a 3-year swap in which ADB
agreed to pay HIP a fixed rate of 5% in return for 6-month LIBOR plus a spread. Since the swap was entered
into, both banks were downgraded. As a result of the ratings changes, the credit spread for HIP has increased
from 36 bps to 144 bps, while the credit spread for ADB has increased from 114 bps to 156 bps. Assuming no
change in the LIBOR curve, if an identical 3-year swap was entered into today, which of the following is the
most likely to be correct?
A. Since HIP’s spread increased more than ADB’s spread, HIP’s DVA will increase and ADB’s DVA will
decrease.
B. Since HIP’s spread increased more than ADB’s spread, HIP’s CVA will increase and ADB’s CVA will
decrease.
C. Since both banks’ spreads increased, the CVA on both sides of the contract will be higher.
D. Since both banks’ spreads increased, the DVA on both sides of the contract will be lower.
29. A risk analyst estimates that the hazard rate for a company is 0.12 per year. Assuming a constant hazard rate
model, what is the probability that the company will survive in the first year and then default before the end
of the second year?
A. 8.9%
B. 10.0%
C. 11.3%
D. 21.3%
30. Computing VaR on a portfolio containing a very large number of positions can be simplified by mapping these
positions to a smaller number of elementary risk factors. Which of the following mapping technique for the
given positions is the most appropriate?
A. USD/EUR forward contracts are mapped to the USD/EUR spot exchange rate.
B. Each position in a corporate bond portfolio is mapped to the bond with the closest maturity among a set
of government bonds.
C. Zero-coupon government bonds are mapped to government bonds paying regular coupons.
D. A position in the stock market index is mapped to a position in a stock within that index.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
31. A market risk manager seeks to calculate the price of a 2-year zero-coupon bond. The 1-year interest rate
today is 10.0%. There is a 50% probability that the 1-year interest rate will be 12.0% and a 50% probability
that it will be 8.0% in 1 year. Assuming that the risk premium of duration risk is 50 bps each year, and that the
bond’s face value is EUR 1,000, which of the following should be the price of the zero-coupon bond?
A. EUR 822.98
B. EUR 826.74
C. EUR 905.30
D. EUR 921.66
32. A financial analyst is pricing a 5-year call option on a 5-year Treasury note using a successfully validated
pricing model. Current interest rate volatility is high and the analyst is concerned about the effect this may
have on short-term rates when pricing the option. Which of the following actions would best address the
potential for negative short-term interest rates to arise in the model?
A. When short-term rates are negative, the financial analyst adjusts the risk-neutral probabilities.
B. When short-term rates are negative, the financial analyst increases the volatility.
C. When short-term rates are negative, the financial analyst sets the rate to zero.
D. When short-term rates are negative, the financial analyst sets the mean-reverting parameter to 1.
33. An investment bank has been using VaR as its main risk measurement tool. ES is suggested as a better
alternative to use during market turmoil. What should be understood regarding VaR and ES before modifying
current practices?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
34. A derivative trading desk at a bank decides that its existing VaR model, which has been used broadly across
the firm for several years, is too conservative. The existing VaR model uses a historical simulation over a 3-
year look-back period, weighting each day equally. A quantitative analyst in the group quickly develops a new
VaR model, which uses the delta normal approach. The new model uses volatilities and correlations estimated
over the past 4 years using the RiskMetrics EWMA method.
For testing purposes, the new model is used in parallel with the existing model for 6 weeks to estimate the 1-
day 99% VaR. After 6 weeks, the new VaR model has no exceedances despite consistently estimating VaR to
be considerably lower than the existing model's estimates. The analyst argues that the lack of exceedances
shows that the new model is unbiased and pressures the bank’s model evaluation team to agree. Following an
overnight examination of the new model by one junior analyst, instead of the customary evaluation that takes
several weeks and involves a senior member of the team, the model evaluation team agrees to accept the
new model for use by the desk.
Which of the following statements is a correct conclusion for this replacement?
A. Delta-normal VaR is more appropriate than historical simulation VaR for assets with non-linear payoffs.
B. Changing the look back period and weighting scheme from 3 years, equally weighted, to 4 years,
exponentially weighted, will understate the risk in the portfolio.
C. Overnight examination by the junior analyst increased the desk’s exposure to model risk due to the
potential for incorrect calibration and programming errors.
D. A 99% VaR model that generates no exceedances in 6 weeks is necessarily conservative.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
35. The senior management team of a small regional bank has established a committee to review procedures and
implement best practices related to entering into significant contracts with third-party vendors. The
committee is reviewing one proposed relationship with a third-party vendor who would have a significant
responsibility for marketing the bank’s financial products to potential customers. In establishing policies to
reduce the operational risk associated with this potential vendor contract, which of the following
recommendations would be most appropriate?
A. The bank should review all third-party audit reports of the vendor that are publicly available.
B. The bank should ensure that the vendor's sales representatives are compensated mainly with
commissions from the sale of the bank’s products.
C. The bank should prevent the third-party vendor from having access to any of its critical processes.
D. The bank should be responsible for developing the vendor's contingency planning process to mitigate risk
exposure to the vendor.
36. The Basel Committee recommends that banks use a set of early warning indicators in order to identify
emerging risks and potential vulnerabilities in their liquidity position. Which of the following is an early
warning indicator of a potential liquidity problem?
37. Large dealer banks have often financed significant fractions of their assets using short-term (overnight)
repurchase agreements in which creditors hold bank securities as collateral against default losses. The table
below shows the quarter-end financing of four A-rated broker-dealer banks. All values are in USD billion.
In the event that repo creditors become equally nervous about each bank’s solvency, which bank is most
vulnerable to a liquidity crisis?
A. Bank P
B. Bank Q
C. Bank R
D. Bank S
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
38. During a training seminar, a supervisor at Firm W discusses different types of operational risk that the firm
may face, which could be in the short-term or over a longer-term period. Which of the following is an example
of loss caused by an operational risk of firm W?
A. After a surprise announcement by the central bank that interest rates would increase, bond prices fall and
Firm W incurs a significant loss on its bond portfolio.
B. The data capture system of Firm W fails to capture the correct market rates causing derivative trades to
be done at incorrect prices, leading to significant losses.
C. As a result of an increase in commodity prices, the share price of a company that Firm W invested in falls
significantly, causing major investment losses.
D. A counterparty of Firm W fails to settle its debt to Firm W, and in doing this, it is in breach of a legal
agreement to pay for services rendered.
39. An information technology analyst at a large global bank is preparing a plan to aggregate the bank's risk data
and increase the quality of the firm's data governance practices. The bank has several business divisions that
represent product lines that are offered across multiple regions. To effectively aggregate the risk data and
ensure a strong data governance process, which of the following conditions would the analyst point out as
posing the greatest information technology challenge to the bank?
A. Most of the risk data are located on spreadsheets at the individual business units.
B. The bank rapidly integrates the information technology systems of each company that it acquires into its
own technology platform.
C. The product lines are divided into legal entities by geographic region, but data from each entity is
aggregated in a centralized data warehouse.
D. The bank installs technology platforms before investing in approved strategic initiatives that require those
platforms.
40. A risk analyst is building a bank’s enterprise risk management system. During the process, the analyst takes an
inventory of firm risks and categorizes these risks as market, credit, or operational. Which of the following
observations of the bank’s data should be considered unexpected if compared to similar industry data?
A. The operational risk loss distribution has many small losses, and therefore a relatively low mode.
B. The operational risk loss distribution is symmetric and fat-tailed.
C. The credit risk distribution is asymmetric and fat-tailed.
D. The market risk distribution is symmetric.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
41. A regional commercial bank is considering a loan to be fully funded by deposits, with the following
parameters:
• Loan amount: JPY 4.2 billion
• Average annual interest rate paid on deposits: 0.4%
• Annual interest rate received on loan: 3.2%
• Expected loss: 2.0% of face value of loan
• Annual operating costs: 0.5% of face value of loan
• Economic capital required to support the loan: 10.0%
• Average pre-tax return on economic capital: 1.4%
• Effective tax rate: 38%
• Other transfer costs: JPY 0
What is the after-tax RAROC for this loan?
A. 0.27%
B. 2.73%
C. 4.40%
D. 10.73%
42. A bank is using the VaR and stressed VaR market risk framework in line with the Basel 2.5 guidelines. The
bank’s internal models for market risk have generated the following risk measures (in USD million) for the
current trading book positions:
Latest Available Average 10-day Average 10-day
Confidence Latest Available 10-day Stressed VaR of Previous 60 Stressed VaR of
Level 10-day VaR VaR Days Previous 60 Days
95.0% 238 484 252 546
99.0% 451 995 413 1,106
99.9% 578 1,281 528 1,372
Assuming the supervisory authority has set the multiplication factors for both the VaR and the stressed VaR
values to 3, what is the correct capital requirement for general market risk for the bank under Basel 2.5?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
43. Company OBD has an outstanding zero-coupon bond with 1 year remaining to maturity. The bond has a face
value of USD 1,000,000 and a recovery rate of 0% in the event of default. The bond is currently trading at 85%
of face value. Assuming the excess spread only captures credit risk and that the risk-free rate is 2% per year,
and using risk-neutral binomial pricing tree methodology, what is the approximate risk-neutral 1-year
probability of default of Company OBD?
A. 13.3%
B. 14.5%
C. 17.2%
D. 19.4%
44. A portfolio manager at an insurance company has observed the price of one of the corporate bonds that the
company currently holds and wants to estimate the premium the company needs to accept the default risk of
the bond. The manager has determined that the bond’s real-world default probability is 2.0%, its liquidity risk
premium is 1.8%, and its risk-neutral default probability is 6.1%. Ignoring any other risk premiums that might
affect the bond’s pricing, what is the bond’s default risk premium?
A. 2.0%
B. 2.3%
C. 3.8%
D. 4.1%
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
45. A financial institution has four open derivative positions with an investment company. A description of the
positions and their current market values are displayed in the table below:
If the investment company defaults, what would be the loss to the financial institution if netting is used
compared to the loss if netting is not used?
A. Loss of USD 20 million if netting is used; loss of USD 24 million if netting is not used
B. Loss of USD 20 million if netting is used; loss of USD 44 million if netting is not used
C. Loss of USD 24 million if netting is used; loss of USD 32 million if netting is not used
D. Loss of USD 24 million if netting is used; loss of USD 44 million if netting is not used
46. A derivative trading firm sells a European-style call option on stock JKJ with a time to expiration of 9 months, a
strike price of EUR 45, an underlying asset price of EUR 67, and implied annual volatility of 27%. The annual
risk-free interest rate is 2.5%. What is the firm’s counterparty credit exposure from this transaction?
A. EUR 0.00
B. EUR 9.45
C. EUR 19.63
D. EUR 22.00
47. A financial firm has sold default protection on the most senior tranche of a CDO. If the default correlation
between assets held in the CDO decreases sharply from the correlation used in pricing the CDO tranches,
assuming everything else is unchanged, how will the position of the financial firm be impacted?
A. It will either increase or decrease, depending on the pricing model used and the market conditions.
B. It will gain significant value, since the probability of exercising the protection falls.
C. It will lose significant value, since the protection will gain value.
D. It will neither gain nor lose value, since only expected default losses matter and correlation does not
affect expected default losses.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
48. A risk analyst constructs a binomial interest rate tree by using the Ho-Lee model. The time step is monthly and
the annualized drift is 80 bps in the first month and 120 bps in the second month. Assuming the current
annualized short-term rate is 3.2% and the annual basis point-volatility is 2.1%, what is the interest rate in the
lowest node after 2 months?
A. 1.82%
B. 2.15%
C. 2.76%
D. 3.03%
49. Four derivative counterparties have entered into bilateral netting arrangements. The exhibit below presents a
summary of their bilateral mark-to-market (MtM) trades.
If netting agreements exist between all pairs of counterparties shown, what is the correct order of net
exposure per counterparty, from highest to lowest?
A. P, Q, S, R
B. Q, R, S, P
C. R, Q, P, S
D. S, P, Q, R
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
50. Interest rate and currency swaps display differing profiles of expected exposure (EE) over time. Assuming each
instrument matures in 5 years, which of the following graphs is an accurate representation of a typical EE
profile for the corresponding instrument?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
51. A risk analyst is examining a firm’s foreign currency option price assumptions. The implied volatility is
relatively low for an at the at-the-money option and it becomes progressively higher as the option moves
either into the money or out of the money. Compared to the lognormal distribution with the same mean and
standard deviation, the distribution of option prices on this foreign currency implied by the Black-Scholes-
Merton model would have:
52. A wealth management firm has JPY 72 billion in assets under management. The portfolio manager computes
the daily VaR at various confidence levels as follows:
What is the closest estimate of the daily ES at the 97.5% confidence level?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
53. A newly hired risk analyst is backtesting a firm’s VaR model. Previously, the firm calculated a 1-day VaR at the
95% confidence level. Following the Basel framework, the risk analyst is recommending that the firm switch to
a 99% VaR confidence level. Which of the following statements concerning this switch is correct?
A. The decision to accept or reject a VaR model based on backtesting results at the two-tailed 95%
confidence level is less reliable with a 99% VaR model than with a 95% VaR model.
B. The 95% VaR model is less likely to be rejected using backtesting than the 99% VaR model.
C. When backtesting using a two-tailed 90% confidence level test, there is a smaller probability of incorrectly
rejecting a 95% VaR model than a 99% VaR model.
D. Using a 99% VaR model will lower the probability of committing both type 1 and type 2 errors.
54. A hedge fund risk manager is looking at various models that are flexible enough to incorporate mean
reversion and risk premium into term structure modeling. Which of the following is correct about the Vasicek
model?
A. It incorporates the mean reversion feature and its drift is always zero.
B. It incorporates the mean reversion feature and models the risk premium as a component of a constant or
changing drift.
C. It cannot incorporate risk premium and its drift is always zero.
D. It cannot capture the mean reversion feature but can be used to model the time-varying risk premium.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
55. A hedge fund that runs a distressed securities strategy is evaluating the solvency conditions of two potential
investment targets. Currently firm RST is rated BB and firm WYZ is rated B. The hedge fund is interested in
determining the joint default probability of the two firms over the next 2 years using the Gaussian default
time copula under the assumption that a 1-year Gaussian default correlation is 0.36. The fund reports that xBB
and xB are abscise values of the bivariate normal distribution presented in the table below where
xBB= N-1(QBB(tBB)) and xB= N-1(QB(tB)) with tBB and tB being the time-to-default of BB-rated and B-rated
companies respectively; and QBB and QB being the cumulative distribution functions of tBB and tB, respectively;
and N denotes the standard normal distribution:
Firm RST Firm WYZ
Firm RST Cumulative Firm WYZ Cumulative
Cumulative Standard Cumulative Standard
Default Firm RST Default Normal Firm WYZ Default Normal
Time in Default Probability Percentiles Default Probability Percentiles
Year Probability QBB(t) N-1(QBB(t)) Probability QB(t) N-1(QB(t))
1 5.21% 5.21% -1.625 19.06% 19.06% -0.876
2 6.12% 11.33% -1.209 10.63% 29.69% -0.533
3 5.50% 16.83% -0.961 8.24% 37.93% -0.307
4 4.81% 21.64% -0.784 6.10% 44.03% -0.150
5 4.22% 25.86% -0.648 4.03% 48.06% -0.049
Applying the Gaussian copula, which of the following corresponds to the joint probability that firm RST and
firm WYZ will both default before the end of year 2?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
56. A risk committee of the board of company ABC is discussing the difference between pricing deep out-of-the-
money call options on ABC stock and pricing deep out-of-the-money call options on the USD/GBP foreign
exchange (FX) rate using the Black-Scholes-Merton model. The committee considers pricing each of these two
options based on two distinct probability distributions of underlying asset prices at the option expiration date:
a lognormal probability distribution, and an implied risk-neutral probability distribution obtained from the
volatility smile for each aforementioned option of the same maturity and the same moneyness. If the implied
risk-neutral probability distribution is used instead of the lognormal distribution, which of the following is
correct?
A. The price of the option on ABC stock would be relatively high and the price of the option on USD/GBP FX
rate would be relatively low compared to those computed from the lognormal counterparts.
B. The price of the option on ABC stock would be relatively low and the price of the option on USD/GBD FX
rate would be relatively high compared to those computed from the lognormal counterparts.
C. The price of the option on ABC stock would be relatively low and the price of the option on USD/GBD FX
rate would be relatively low compared to those computed from the lognormal counterparts.
D. The price of the option on ABC stock would be relatively high and the price of the option on USD/GBD FX
rate would be relatively high compared to those computed from the lognormal counterparts.
57. A CRO is concerned that a firm’s existing internal risk models are not adequate in addressing potential random
extreme losses of the firm. The CRO then recommends the use of extreme value theory (EVT). When applying
EVT and examining distributions of losses exceeding a threshold value, which of the following is correct?
A. As the threshold value is increased, the distribution of losses over a fixed threshold value converges to a
generalized Pareto distribution.
B. If the tail parameter value of the generalized extreme-value (GEV) distribution goes to infinity, then the
GEV essentially becomes a normal distribution.
C. To apply EVT, the underlying loss distribution must be either normal or lognormal.
D. The number of exceedances decreases as the threshold value decreases, which causes the reliability of
the parameter estimates to increase.
58. In the Basel framework, a penalty is given to banks that have more than four exceptions to their 1-day 99%
VaR over the course of the last 250 trading days. Which of the following causes of exceptions is most likely to
lead to a penalty?
A. A large move in interest rates occurs in conjunction with a small move in correlations.
B. The bank’s model calculates interest rate risk based on the median duration of the bonds in the portfolio.
C. A sudden market crisis in an emerging market, which leads to losses in the equity positions in that
country.
D. A sudden devastating earthquake that causes major losses in the bank’s key area of operation.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
59. A fund manager owns a portfolio of options on TUV, a non-dividend-paying stock. The portfolio is made up of
5,000 deep in-the-money call options on TUV and 20,000 deep out-of-the-money call options on TUV. The
portfolio also contains 10,000 forward contracts on TUV. Currently, TUV is trading at USD 52. Assuming 252
trading days in a year, the volatility of TUV is 12% per year, and that each of the option and forward contracts
is on one share of TUV, which of the following amounts would be closest to the 1-day 99% VaR of the
portfolio?
A. USD 11,557
B. USD 12,627
C. USD 13,715
D. USD 32,000
60. When measuring risk in hedge funds that hold illiquid assets using monthly data, certain biases can create a
misleading picture. For example, these hedge funds might have the appearance of low systematic risk. Which
of the following represents an appropriate means of correction?
A. Account for negative serial correlation of returns by first differencing the data when extrapolating risk to
longer time horizons.
B. Account for positive serial correlation of returns by aggregating the data.
C. Use regressions with fewer lags of the market factors and sum the coefficients across lags.
D. Use regressions with additional lags of the market factors and sum the coefficients across lags.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
61. If the energy asset is dropped from the portfolio and the proceeds from liquidating the asset are not reinvested
in the portfolio, what will be the reduction in portfolio VaR?
A. CNY 2,252,250
B. CNY 3,494,700
C. CNY 5,746,950
D. CNY 6,999,300
62. What is the closest to the correct estimate for the component VaR of the financial asset?
A. CNY 3,240,000
B. CNY 3,495,000
C. CNY 6,930,000
D. CNY 7,000,000
63. An analyst regresses the returns of 400 stocks against the returns of a major market index. The resulting pool of
alphas has a residual risk of 13.78% and an information coefficient of 0.12. If the alphas are normally
distributed with a mean of 0%, roughly how many stocks have an alpha greater than 3.24% or less than -3.24%?
A. 5
B. 15
C. 20
D. 45
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
64. A risk analyst at an investment bank is conducting performance analyses of hedge funds and real estate funds.
Each year, whenever a hedge fund stops reporting its performance, the hedge fund is removed from the
database of hedge funds. Assets owned by the real estate funds are valued only once a year due to the
infrequent trading. Which of the following best describes the impacts on the hedge fund and real estate fund
analyses performed using these databases?
A. The average Sharpe ratio of hedge funds is understated and the average Sharpe ratio of real estate funds
is overstated.
B. The average Sharpe ratio of hedge funds is overstated and the average Sharpe ratio of real estate funds is
also overstated.
C. The average volatility of hedge funds is overstated and the average volatility of real estate funds is
overstated.
D. The average volatility of hedge funds is overstated and the average volatility of real estate funds is
understated.
65. A money manager wants to invest a small amount of new capital that has recently come into a fund. The fund
is benchmarked to an index and, rather than adding a new holding, the manager is considering increasing the
holdings of one of the four assets whose performances, during the most recent evaluation period, are
described in the following table:
The portfolio manager wants to select the asset that has the lowest marginal VaR as long as its Jensen’s alpha
is greater than or equal to the market risk premium. Assuming the risk-free rate is 3% and the market return is
8%, which asset should the portfolio manager select?
A. Asset BDE
B. Asset JKL
C. Asset MNO
D. Asset STU
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
66. A risk analyst at an insurance company has determined that a counterparty to the company has a constant
default probability of 5% per year. What is the probability that this counterparty survives the first 2 years and
defaults in year 3?
A. 4.51%
B. 5.00%
C. 9.50%
D. 15.00%
67. The board of directors of a manufacturing company is considering the funding risk of the defined benefit plan
of the company’s pension fund. Which of the following statements about the pension fund’s funding risk is
correct?
68. A portfolio manager is evaluating the risk profile for a portfolio of stocks. Currently, the portfolio is valued at
CAD 20 million and contains CAD 5 million in stock XYZ. The standard deviation of returns of stock XYZ is 15%
annually and that of the overall portfolio is 12% annually. The correlation of returns between stock XYZ and
the portfolio is 0.3. Assuming the portfolio manager uses a 1-year 99% VaR and that returns are normally
distributed, what is the estimated component VaR of stock XYZ?
A. CAD 162,972
B. CAD 234,906
C. CAD 523,350
D. CAD 632,152
69. A newly established risk division of a regional financial institution is setting up a Monte Carlo simulation
methodology to estimate the firm’s aggregate operational loss distribution. Which of the following loss
frequency and loss severity distribution pairs is the most appropriate to use?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
The CRO also reports the minimum regulatory capital requirements under the revised capital framework as
presented in the table below. The capital ratios also include the capital conservation buffer of 2.5% (phased-in at an
annual increment of 0.75%, starting January 2016) and a G-SIB surcharge of 3.0% (phased-in at an annual increment
of 0.625%, starting January 2016) of risk-weighted assets to be reached by January 2019:
70. Given the regulatory benchmarks and the bank’s performance, which of the capital requirements does Bank
LGX satisfy as of January 2017?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
71. In viewing the results of this capital analysis report and other considerations for Bank LGX’s capital planning,
which of the following conclusions is correct?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
72. CMM’s CRO was concerned about the bank’s liquidity position and decided to review the impact of the
devaluation and other capital market events on its net stable funding ratio (NSFR). Ignoring any changes in the
market value of CMM’s sovereign debt holdings, which of the following is correct?
A. The NSFR will not be impacted by the sovereign credit rating changes because the overall sovereign debt
portfolio remains investment grade.
B. The NSFR will be reduced by the sovereign credit rating changes but this effect can be offset by selling A-
rated sovereign debt and investing the proceeds in gold.
C. The NSFR will not be impacted by the change in demand deposits because the bank’s overall deposit level
is unchanged.
D. The NSFR will be reduced by the change in demand deposits but this effect can be offset by issuing
common stock.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
73. Before the devaluation of CNY, CMM’s trading desk had established a short call options position on the USD-
CNY (CNY per USD) exchange rate that was made delta-neutral through a spot USD transaction. The position
was no longer delta-neutral after the devaluation came into effect and the desk wanted to take steps to make
it delta-neutral again. The bank was concerned about whether this would involve buying or selling USD and
what impact this might have on liquidity. The trader who initiated the position suggested that, once it was
made delta-neutral, the short call options position would be an effective way to hedge the bank’s long CNY
exposure against further devaluations and that the bank should consider increasing the size of the position
accordingly. In considering this situation, what should the CRO conclude?
A. The bank will have to buy USD to make the position delta neutral, but the delta-neutral short call options
position is not an effective way to hedge an underlying long CNY exposure against further devaluations.
B. The bank will have to sell USD to make the position delta neutral, but the delta-neutral short call options
position is not an effective way to hedge an underlying long CNY exposure against further devaluations.
C. The bank will have to buy USD to make the position delta neutral, and the delta-neutral short call options
position is an effective way to hedge an underlying long CNY exposure against further devaluations.
D. The bank will have to sell USD to make the position delta neutral, and the delta-neutral short call options
position is an effective way to hedge an underlying long CNY exposure against further devaluations.
74. CMM had CNY-denominated loans outstanding to TVR, a foreign manufacturing firm that generated its
revenue in CNY. To hedge some of its risk, CMM had bought CDS protection on TVR from a bank from the
same country as TVR, Bank EP. Assuming the default probability of TVR increases unexpectedly, and the
default correlation between TVR and Bank EP is positive and remains constant, which of the following is
correct?
A. The value of the CDS will increase and CMM has a wrong-way risk with Bank EP.
B. The value of the CDS will decrease and CMM has a wrong-way risk with Bank EP.
C. The value of the CDS will increase and CMM has a right-way risk with Bank EP.
D. The value of the CDS will decrease and CMM has a right-way risk with Bank EP.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
75. A large bank is reviewing its processes and procedures to manage operational risk in accordance with best
practices established by the Basel Committee. In implementing the three lines of defense model, which of the
following statements is correct?
A. The internal audit function should serve as the first line of defense and continually validate operational
procedures used by the business lines.
B. Business line managers, as part of the first line of defense, should provide a credible challenge to the
internal audit function.
C. The corporate operational risk function, as part of the second line of defense, should challenge risk inputs
from business line managers.
D. The corporate operational risk function should serve as the third line of defense and validate model
assumptions made by senior management.
76. A CRO at an investment bank has asked the risk department to evaluate the bank’s 3-year derivative exposure
position with a counterparty. The 1-year CDS on the counterparty is currently trading at a spread of 180 bps.
The table below presents trade and forecast data on the CDS spread, the expected exposure, and the recovery
rate on the counterparty:
Additionally, the CRO has presented the risk team with the following set of assumptions to use in conducting
the analysis:
• The investment bank and the counterparty have signed a credit support annex to cover this exposure, which
requires collateral posting of AUD 13 million throughout the life of the contract.
• The current risk-free rate of interest is 2% and the term structure of interest rates remains flat over the 3-
year horizon.
• Collateral and exposure values remain stable as projected over the life of the contract.
Given the information and the assumptions above, what is the correct estimate for the credit valuation
adjustment for this position?
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
77. The CEO of a large bank has reported that the bank’s framework for managing operational risk is consistent
with Basel II and Basel III model for operational risk governance. Which of the following actions and
principles of the bank is correct?
A. The bank considers identification and management of risk as the second line of defense.
B. The bank considers independent review and audit of the risk processes and systems as the third line of
defense.
C. The bank includes damaged reputation due to a failed merger in its measurement of operational risk.
D. The bank excludes destruction by fire or other external catastrophes from its measurement of
operational risk.
78. A risk manager has asked a junior analyst to estimate the implied default probability for a BBB-rated
discount corporate bond. The continuously compounded annual yields of other fixed-income securities are
given below:
• 3-year Treasury note (a risk-free bond): 3%
• 1-year BBB-rated discount bond: 5%
• 2-year BBB-rated discount bond: 8%
• 3-year BBB-rated discount bond: 9%
If the recovery rate on that BBB-rated bond is expected to be 0% in the event of default, which of the
following is the best estimate of the risk-neutral probability that the BBB-rated discount bond defaults
within the next 3 years?
A. 12.29%
B. 13.76%
C. 14.61%
D. 16.47%
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
79. Pension fund managers must deal with a range of policy, risk, and return requirements. Which of the following
statements about risk management in the pension fund industry is correct?
A. A pension plan’s total VaR is equal to the sum of its policy-mix VaR and active management VaR.
B. Pension fund risk analysis does not consider performance relative to a benchmark.
C. In most defined-benefit pension plans, if liabilities exceed assets, the shortfall does not create a risk for
the plan sponsor.
D. From the plan sponsor’s perspective, nominal pension obligations are similar to a short position in a long-
term bond.
80. A financial institution has a two-way credit support annex (CSA) with a counterparty covering a portfolio
valued at JPY 400 million. The margining terms of the collateralized portfolio include a threshold of
JPY 180 million, a minimum transfer amount of JPY 30 million, and a margin period of risk of 10 days. Which of
the following is correct?
A. A lower threshold value implies that a larger portion of exposure is protected by collateral.
B. A shorter margin period of risk implies that a smaller portion of exposure is protected by collateral.
C. A lower independent amount implies that a larger portion of exposure is protected by collateral.
D. The protection from collateral specified in the CSA is uniform throughout the life of the exposure profile.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
1. An investment bank with an active position in commodity futures is using the peaks-over-threshold (POT)
methodology for estimating VaR and ES at the 99% confidence level. The bank’s risk managers have set a
threshold level to evaluate excess losses. The choice of the threshold, they argue, is suitable and consistent
with the finding that 5.00% of the observations are more than the threshold value. The risk managers have
concluded that the position’s VaR using the POT measure is 4.45%. The VaR estimate is computed from the
following parameters and the managers’ empirical analysis is based upon the generalized Pareto distribution
assumption for the excess losses.
Parameter Symbol Value
Loss threshold (%) u 3
Number of observations n 740
Number of observations that exceed threshold Nu 37
Scale β 0.75
Shape (tail index) ξ 0.22
Given the VaR value and the parameter assumptions, which of the following is correct?
A. Keeping all other parameters constant, increasing the value of the tail index decreases both the ES and the
VaR.
B. Keeping all other parameters constant, decreasing the scale parameter increases both the ES and the VaR.
C. The value of ES is 4.57%
D. The value of ES is 5.82%
Correct Answer: D
Explanation: D is correct.
𝛽𝛽 𝑛𝑛 −𝜉𝜉 0.75 740 −0.22
𝑉𝑉𝑉𝑉𝑉𝑉(%) = 𝑢𝑢 + � � �� (1 − 𝛼𝛼)� − 1� = 3 + � � �� (1 − 0.99)� − 1� = 4.45
𝜉𝜉 𝑁𝑁𝑢𝑢 0.22 37
Reference: Kevin Dowd, Measuring Market Risk, Second Edition (West Sussex, England: John Wiley &
Sons, 2005). Chapter 7, Parametric Approaches (II): Extreme Value
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
2. A risk manager is estimating the market risk of a portfolio using both the arithmetic returns with normal
distribution assumptions and the geometric returns with lognormal distribution assumptions. The manager
gathers the following data on the portfolio:
• Annualized average of arithmetic returns: 15%
• Annualized standard deviation of arithmetic returns: 35%
• Annualized average of geometric returns: 13%
• Annualized standard deviation of geometric returns: 44%
• Current portfolio value: EUR 4,800,000
• Trading days in a year: 252
Assuming both daily arithmetic returns and daily geometric returns are serially independent, which of the
following statements is correct?
A. 1-day normal 95% VaR = 3.57% and 1-day lognormal 95% VaR = 3.55%
B. 1-day normal 95% VaR = 3.57% and 1-day lognormal 95% VaR = 4.41%
C. 1-day normal 95% VaR = 4.46% and 1-day lognormal 95% VaR = 3.57%
D. 1-day normal 95% VaR = 4.46% and 1-day lognormal 95% VaR = 4.49%
Correct Answer: B
Reference: Kevin Dowd, Measuring Market Risk, 2nd Edition (West Sussex, England: John Wiley &
Sons, 2005). Chapter 3, Estimating Market Risk Measures: An Introduction and Overview
Learning Objective: Estimate VaR using a parametric approach for both normal and lognormal return
distributions.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
3. A credit manager in the counterparty risk division of a large bank uses a simplified version of the Merton
model to monitor the relative vulnerability of its largest counterparties to changes in their valuation and
financial conditions. To assess the risk of default of three particular counterparties, the manager calculates the
distance to default assuming a 1-year horizon (t=1). The counterparties: Company P, Company Q, and
Company R, belong to the same industry, and are non-dividend-paying firms. Selected information on the
companies is provided in the table below:
Using the information above with the assumption that a zero-coupon bond maturing in 1 year is the only
liability for each company, and the approximation formula of the distance to default, what is the correct
ranking of the counterparties, from most likely to least likely to default?
A. P; R; Q
B. Q; P; R
C. Q; R; P
D. R; Q; P
Correct Answer: A
Explanation: A is correct.
Distance to Default (DtD) approximates the number of standard deviations to reach the
default threshold; thus, the higher the DtD, the least likely to default.
𝜎𝜎𝑎𝑎2
ln 𝑉𝑉𝑎𝑎 − ln 𝐹𝐹 + �𝜇𝜇 − � (𝑡𝑡)
2
𝐷𝐷𝐷𝐷𝐷𝐷 =
𝜎𝜎𝑎𝑎 √𝑡𝑡
DtD can be simplified by reducing the forward time periods to 1 (t=1) and minimizing the
drift factors (µ - σ2/2) that tend to be small (assumed to equal 0) over one period to yield:
ln 𝑉𝑉𝑎𝑎 − ln 𝐹𝐹
𝐷𝐷𝐷𝐷𝐷𝐷 =
�
𝜎𝜎𝑎𝑎
[ln(market value of assets/face value of debt)/annual volatility of asset value)]. Using this
formula results in:
DtD for Company P = ln(100/60)/0.10 = 5.11
DtD for Company Q = ln(150/100)/0.07 = 5.79
DtD for Company R = ln(250/160)/0.08 = 5.58
Q is least likely to default; R is in the middle; P is most likely to default.
Reference: Giacomo De Laurentis, Renato Maino,and Luca Molteni, Developing, Validating and Using
Internal Ratings (West Sussex, United Kingdom: John Wiley & Sons, 2010). Chapter 3 -
Rating Assignment Methodologies.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
Learning Objective: Apply the Merton model to calculate default probability and the distance to default and
describe the limitations of using the Merton model.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
4. Bank HJK has written puts on Bank PQR stock to a hedge fund and sold CDS protection on Bank PQR to a
manufacturer. Bank HJK and Bank PQR operate in several of the same businesses and geographies and their
performances are highly correlated. Many in the market are concerned that rising interest rates could
negatively impact the credit quality of Bank HJK’s numerous borrowers, which in turn would increase the
credit spread of Bank HJK. From the perspectives of the hedge fund and the manufacturer, which of the
following is correct with respect to their counterparty risk exposure to Bank HJK?
Hedge Fund Manufacturer
A. Right-way risk Wrong-way risk
B. Wrong-way risk Right-way risk
C. Right-way risk Right-way risk
D. Wrong-way risk Wrong-way risk
Correct Answer: D
Explanation: The hedge fund has wrong-way risk. As interest rates rise, both Bank HJK’s and Bank
PQR’s equity value would decline since the performances of the two banks are highly
correlated. Therefore, the value of the long put option on PQR would increase, resulting
in a higher exposure to bank HJK for the hedge fund. This is a wrong-way risk since the
hedge fund’s exposure to HJK would be increasing as the credit quality of HJK is declining.
The manufacturer also has wrong-way risk. Since the credit spread of Bank HJK is
increasing and credit spreads of different banks in the same market tend to be positively
correlated, the credit spread of Bank PQR should also increase. Therefore, the value of
the manufacturer’s long CDS position on Bank PQR is increasing at the same time the
credit quality of Bank HJK is decreasing; thus, that is wrong-way risk.
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, Third Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 17. Wrong-
way Risk [CR-16].
Learning Objective: Identify examples of wrong-way risk and examples of right-way risk.
Describe wrong-way risk and contrast it with right-way risk.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
5. Bank JJQ, a member of a CCP, sells credit protection on a GBP 100 million counterparty position using CDS. The
reference entity is a gold mining company. Which of the following trades by Bank JJQ on the same reference
entity would be a hedge to transfer credit risk with minimal increase in counterparty risk?
Correct Answer: C
Explanation: C is correct. Selling/issuing a credit-linked note (CLN) transfers credit risk to the investors
while there is no counterparty risk for the CLN issuer because CLNs are funded. Since CLN
is essentially a funded version of CDS, it can be used to hedge the short position of CDS
with minimal increase in counterparty risk. To explain further, a CLN trade means the
buyer pays the seller the principal of the note and receives a regular coupon throughout
the lifetime of that CLN. If there is no credit event happening to the reference entity, the
principal will be paid back to the investor. Otherwise, the CLN buyer will receive the
collateral (i.e., the defaulted referenced bond) and the coupon payment will stop. Thus,
the CLN buyer is the protection seller and the issuer is the protection buyer. If the CDS
and CLN are fairly priced, the seller of CDS can hedge his position by issuing CLN. Also,
since the principal is kept by Bank JJQ in the beginning of the CLN trade, the increment in
counterparty risk created by such hedge should be minimal.
A is incorrect. The CLN buyer, like a bond buyer, bears counterparty risk as the issuer can
default on principal and interests.
B and D are incorrect. The total return swap (TRS) has counterparty risk. In general, TRS is
not funded.
Reference: Michel Crouhy, Dan Galai and Robert Mark, The Essentials of Risk Management, 2nd
Edition (New York: McGraw-Hill, 2014). Chapter 12, The Credit Transfer markets and Their
Implications.
Learning Objective: Describe the different types and structures of credit derivatives including credit default
swap (CDS), first-to-default put, total return swaps (TRS), asset-backed credit-linked note
(CLN), and their application.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
6. A risk analyst at a mid-size hedge fund is evaluating the credit risk of several trade positions. The hedge fund
specializes in corporate debt and runs a strategy that utilizes both relative value and long-only trades using
CDS and bonds. One of the new trades at the hedge fund is a B-rated long bond valued at JPY 10 billion. Some
of the hedge fund’s newest clients, including the B-rated bond holders, are restricted from withdrawing their
funds for four years. The analyst is currently evaluating the impact of various default scenarios to estimate
future asset liquidity. The analyst assumes that defaults, if they occur, take place only at the end of the year
and has estimated that the marginal probability of default of the B-rated bond is 7.7% in Year 1; 7.1% in Year
2; 6.6% in Year 3; and 6.1% in Year 4. Assuming the default events are independent, what is the probability
that the bond survives the first 3 years and then defaults at the end of Year 4?
A. 4.9%
B. 5.7%
C. 6.1%
D. 6.9%
Correct Answer: A
Explanation: A is correct. The probability that the bond survives for 3 years and then defaults at the
end of Year 4 can be modeled as a Bernoulli trial given by the following equation, where
MP stands for marginal probability:
P (Default at end of Year 4) = (1 – MP Year 1 default)*(1 – MP Year 2 default)* =(1 – MP
Year 3 default)*(MP Year 4 default) = (1 – 0.077)*(1 – 0.071)*(1 – 0.066)*(0.061) = 0.0489
= 4.9%.
B is incorrect. It is the probability that the bond defaults in Year 3.
C is incorrect. 6.1% is the marginal default probability in Year 4.
D is incorrect. The probability is incorrectly derived:
6.9% = [(1+0.077)(1+0.071)(1+0.066)(1+0.061)]1/4 – 1.
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 12 - Default
Probabilities, Credit Spreads and Funding Costs
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
7. MDM Bank is seeking to enhance its enterprise risk management function. To achieve that objective, the bank
introduces a new decision-making process based on economic capital that involves assessing sources of risk
across different business units and organizational levels. Which of the following statements regarding the
correlations between these risks is correct?
A. Correlations between business units are only relevant in deciding total firm-wide economic capital levels
and are not relevant for decisions at the individual business unit or project level.
B. Correlations between broad risk types such as credit, market, and operational risk are generally well
understood and are easy to estimate at the individual firm level.
C. The introduction of correlations into firm-wide risk evaluation will result in a total VaR that, in general, is
greater than or equal to the sum of individual business unit VaRs.
D. The introduction of correlations into the risk evaluation of a bank’s loan book will result in total credit VaR
that, in general, is less than or equal to the sum of individual loan credit VaRs.
Correct Answer: D
Explanation: D is correct. Credit VaR (CVaR)= VaR – EL. Lower (or negative) correlations among loan
assets lead to lower overall VaR due to the diversification effect, which effectively lowers
CVaR since EL is not affected by correlations. When correlations are perfectly positive
(and equal to one), there is no diversification and loan portfolio VaR will equal the sum of
the individual loan VaRs.
A is incorrect. An effective ERM practice business requires that unit managers proposing
new projects should evaluate all major risks in the context of the marginal impact of the
project on the firm’s total risk. Therefore, correlations between business units are
relevant in determining total firm risk, and in making decisions on firm-wide economic
capital levels.
B is incorrect. Market, credit, and operational risks have different distributions, which
makes it difficult to understand and estimate the correlations between them. While
market risk has a “normal” distribution, credit and operational risks tend to have
asymmetric distributions with fat tails. Aggregating risks, which is more difficult at the
individual firm level, requires understanding the correlations between the broad risk
types.
C is incorrect. Factoring correlations into firm-wide risk evaluation will result in a total
VaR that, in general, is less than or equal to the sum of individual business unit VaRs due
to the effect of diversification.
Reference: Brian Nocco and René Stulz, “Enterprise Risk Management: Theory and Practice,” Journal
of Applied Corporate Finance 18, No. 4 (2006): pp. 8-20.
Giacomo De Laurentis, Renato Maino, and Luca Molteni, Developing, Validating and Using
Internal Ratings (West Sussex, United Kingdom: John Wiley & Sons, 2010). Chapter 2 –
Classifications and Key Concepts of Credit Risk.
Learning Objective: Describe the role of and issues with correlation in risk aggregation, and describe typical
properties of a firm’s market risk, credit risk, and operational risk distributions.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
Explain expected loss, unexpected loss, VaR, and concentration risk, and describe the
differences among them.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
8. A US pension fund had assets and liabilities valued at USD 840 million and USD 450 million, respectively, at the
end of 2016. The fund’s assets were fully invested in equities and commodities while its liabilities consisted
entirely of fixed-income obligations. The fund reported that by the end of 2017 the value of assets decreased
by 14.0% and the value of liabilities increased by 3.5%. Assuming no changes were made to the composition of
the assets and liabilities during the year, what was the change in the pension fund’s surplus over the 1-year
period?
Correct Answer: A
Explanation: A is correct. The change in the pension fund’s surplus (∆S) for the year 2017 is equal to
the ending surplus (S1) at the end of 2017 less the initial surplus (S0) at the end of 2016.
That is, ∆S = S1 – S0.
The initial surplus is calculated as S0 = A0 – L0 = 840 – 450 = USD 390 million, where A0 =
the firm’s initial assets and L0 = the firm’s initial liabilities.
Next, we must calculate S1, the surplus at the end of 2017:
Given the 14.0% decline in asset value, the new level of assets A1 at the end of 2017 is
equal to:
A1 = (1 – 0.14) * 840 = USD 722.40 million.
Given the 3.5% increase in the value of liabilities, the new level of liabilities L1 at the end
of 2017 is equal to:
L1 = (1 + 0.035) * 450 = USD 465.75 million.
Thus, the ending surplus for 2017 = S1 = A1 – L1 = 722.40 – 465.75 = USD 256.65 million
Therefore, the change in surplus for 2017 = ∆S = S1 – S0 = 256.65 – 390 = USD –133.35
million.
B is incorrect. USD -117.6 million is the change in asset values (722.4 - 840 = USD 117.6
million)
C is incorrect. USD 256.7 million is the year-end 2017 surplus.
D is incorrect. USD 390.0 million is the year-end 2016 surplus.
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition (New York: McGraw-Hill, 2007). Chapter 17, VaR and Risk Budgeting in Investment
Management.
Learning Objective: Describe the investment process of large investors such as pension funds.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
9. A wealth management firm has a portfolio consisting of USD 48 million invested in US equities and
USD 35 million invested in emerging markets equities. The US equities and emerging markets equities both
have a 1-day 95% VaR of USD 1.2 million. The correlation between the returns of the US equities and emerging
markets equities is 0.36. While rebalancing the portfolio, the manager in charge decides to sell USD 8 million
of the US equities to buy USD 8 million of the emerging markets equities. At the same time, the CRO of the
firm advises the portfolio manager to change the risk measure from 1-day 95% VaR to 10-day 99% VaR.
Assuming that returns are normally distributed and that the rebalancing does not affect the volatility of the
individual equity positions, by how much will the portfolio VaR increase due to the combined effect of
portfolio rebalancing and change in risk measure?
Correct Answer: D
Explanation: D is correct. The first step is to calculate the VaR of the original portfolio of two equities,
US (u) and emerging markets (e). This can be derived by using the following equation:
(v) Next, convert the 1-day 95% VaR to 10-day 95% VaR:
10-day 95% VaR = (1-day 95% VaR) * sqrt(10)/1 = 2.0554 x 3.1623 = USD 6.4998 million.
(vi) Finally, convert the 10-day 95% VaR to 10-day 99% VaR:
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
10-day 99% VaR = (10-day 95% VaR) * (2.326/1.645) = 6.4998 x 1.4140 = USD 9.1906
million.
The question is to compare the original 1-day 95% VaR (USD 1.979m) to the new
rebalanced 10-day 99% VaR (USD 9.191m). Thus, VaR will increase by (9.191 – 1.979)
million, or USD 7.212 million. Thus, D is correct.
A is incorrect. USD 4.521 million is the difference between the 10-day 95% VaR for the
rebalanced portfolio and the 1-day 95% VaR for the original portfolio: 6.4998 million –
1.979 million = 4.521 million.
B is incorrect. USD 6.258 million is the portfolio VaR if the 1-day 95% original portfolio
VaR is converted to a 10-day 95% VaR: 10-day 95% VaR = (1-day 95% VaR) * sqrt(10)/1 =
1.979 x 3.1623 = USD 6.258 million.
C is incorrect. USD 7.136 million is the difference between the 10-day 99% VaR for the
rebalanced portfolio and the 1-day 95% VaR for the rebalanced portfolio: 9.191 million –
2.0554 million = 7.136 million
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition (New York: McGraw-Hill, 2007). Chapter 7: Portfolio Risk — Analytical Methods.
Learning Objective: Define, calculate, and distinguish between the following portfolio VaR measures:
individual VaR, incremental VaR, marginal VaR, component VaR, undiversified portfolio
VaR, and diversified portfolio VaR.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
10. An operational risk manager is asked to report a bank’s operational risk capital under the Standardized
Measurement Approach (SMA) proposed by the Basel Committee in March 2016. The treasury
department produces the following data for the bank, calculated according to the SMA guidelines:
• Business Indicator (BI): EUR 1,200 million
• Internal Loss Multiplier: 1
In addition, the manager uses the Business Indicator buckets in the Business Component presented in
the table below:
Bucket BI Range BI Component
1 EUR 0 to EUR 1 billion 0.11*BI
2 EUR 1 billion to EUR 3 billion EUR 110 million + 0.15(BI – EUR 1 billion)
3 EUR 3 billion to EUR 10 billion EUR 410 million + 0.19(BI – EUR 3 billion)
4 EUR 10 billion to EUR 30 billion EUR 1.74 billion + 0.23(BI – EUR 10 billion)
5 EUR 30 billion to infinity EUR 6.34 billion + 0.29(BI – EUR 30 billion)
What is the correct operational risk capital that the bank should report under the SMA?
Correct B
Answer:
Explanation: B is correct. Under the proposed Standardized Measurement Approach, operational risk
capital is equal to the Business Indicator Component multiplied by the Internal Loss
Multiplier.
The Business Indicator Component is determined by the Business Indicator (BI), which is
made up of almost the same P&L items that are found in the composition of Gross
Income (GI). The main difference relates to how the items are combined. The BI uses
positive values of its components, thereby avoiding counterintuitive negative
contributions from some of the bank’s businesses to the capital charge (e.g. negative P&L
on the trading book), which is possible under the GI. In addition, the BI includes income
statement items related to activities that produce operational risk that are omitted (e.g.
P&L on the banking book) or netted (e.g. fee expenses, other operating expenses) in the
GI.
In this case, the BI is already given as EUR 1,200 million.
Therefore, with a BI of EUR 1,200 million falling into the BI range of Bucket 2, and given
that the Internal Loss Multiplier is equal to 1, the calculation of the operational risk
capital for the bank in Bucket 2 is calculated as follows:
SMA operational risk capital (Bucket 2) = BIC*1 = EUR 110 million + 0.15(BI – EUR 1
billion) = EUR 110 million + 0.15(EUR 1,200 million – EUR 1,000 million) = EUR 140 million.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
Learning Explain the elements of the proposed Standardized Measurement Approach (SMA),
Objective: including the business indicator, internal loss multiplier and loss component, and
calculate the operational risk capital requirement for a bank using the SMA.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
11. A credit manager who is well versed in lessons learned from the 2007–2009 subprime mortgage crisis in the US
is overseeing the structured credit book of a bank in order to identify potential problems of information flow
(frictions) between the parties involved in the securitization process. Which of the following is a correct
combination of a potential friction in the securitization process and an appropriate mechanism to mitigate that
friction?
A. Friction between the asset manager and the investor: Adverse selection problem. This problem can be
mitigated by the asset manager charging due diligence fees to the investor.
B. Friction between the arranger and the originator: Model error problem. This problem can be mitigated by
the arranger providing a credit enhancement to the securitized products with its own funding.
C. Friction between the investor and credit rating agencies: Principal-agent conflict. This problem can be
mitigated by requiring credit rating agencies to be paid by originators and not by investors for their rating
services.
D. Friction between the servicer and the mortgagor: Moral hazard problem. This problem can be mitigated
by requiring the mortgagor to escrow funds for insurance and tax payments.
Correct Answer: D
Explanation: D is correct. The friction between the servicer and the mortgagor is a moral hazard
problem. The servicer and the mortgagor do not share the full consequence of bad
outcomes (e.g., loan foreclosure, delinquencies). The mortgagor typically has limited
liability, and has little incentive to expend effort or resources to maintain a property close
to foreclosure. On the other hand, the servicer strives to work in investors’ best interest
by keeping up with payment of property taxes and insurance, and generally maintaining
the property. A way to mitigate this friction is to require the mortgagor to regularly
escrow funds for insurance and tax payments in order to forestall the risk of foreclosure.
A is incorrect. Friction between the asset manager and the investor is a principal-agent
problem. The investor is less sophisticated than the asset manager, does not fully
understand the investment strategy of the asset manager, has uncertainty about the
manager’s ability, and does not observe any effort that the manager makes to conduct
due diligence. Some of the ways to mitigate this friction is through the use of investment
mandate, and the evaluation of manager performance relative to its peers or a peer
benchmark.
B is incorrect. Friction between the arranger and originator is a predatory borrowing and
lending problem. It is one of the key frictions in the process of securitization involving an
information problem between the originator and arranger. In particular, the originator
has an information advantage over the arranger with regard to the quality of the
borrower. Without adequate safeguards in place, an originator can have the incentive to
collaborate with a borrower in order to make significant misrepresentations on the loan
application. Depending on the situation, this could be either construed as predatory
lending (where the lender convinces the borrower to borrow too large of a sum given the
borrower’s financial situation) or predatory borrowing (the borrower convinces the
lender to lend too large a sum). To mitigate the problem, the arranger should have
safeguards in place, including carrying out a thorough due diligence on the originator and
requiring the originator to have adequate capital to buy back problem loans.
C is incorrect. Friction between the investor and credit rating agencies is a model error
problem. Investors are not able to assess the efficacy of rating agency models and, so, are
susceptible to both honest and dishonest errors. Worse still, rating agencies are paid by
the arranger and not by the investors for their opinion, which creates a potential conflict
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
of interest. This friction can be mitigated by requiring public disclosure of the criteria for
ratings and downgrades, and for holding rating agencies accountable for their reputation.
Reference: Adam Ashcroft and Til Schuermann, “Understanding the Securitization of Subprime
Mortgage Credit,” Federal Bank of New York Staff Reports, No. 318 (March 2008).
Learning Objective: Identify and describe key frictions in subprime mortgage securitization, and assess the
relative contribution of each factor to the subprime mortgage problems.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
12. A risk manager is backtesting a company’s 1-day 99.5% VaR model over a 10-year horizon at the 95%
confidence level. Assuming 250 days in a year and the daily returns are independently and identically
distributed, which of the following is closest to the maximum number of daily losses exceeding the 1-day
99.5% VaR in 10 years that is acceptable to conclude that the model is calibrated correctly?
A. 19
B. 25
C. 35
D. 39
Correct Answer: A
Explanation: A is correct. The risk manager will reject the hypothesis that the model is correctly
calibrated if the number x of losses exceeding the VaR is such that:
𝑥𝑥 − 𝑝𝑝𝑝𝑝
> 𝑧𝑧 = 1.96
�𝑝𝑝(1 − 𝑃𝑃)𝑇𝑇
where p represents the failure rate and is equal to 1-0.995, or 0.5%; and T is the number
of observations = 250*10=2500. And z = 1.96 is the two-tail confidence level quantile,
given a confidence level of 95%.
𝑥𝑥−0.005∗2500
If = 1.96 then, x = 19.4
�0.005∗(1−0.005)∗2500
So, the maximum number of exceedances would be 19 to conclude that the model is
calibrated correctly.
Alternatively, we can use the Kupiec test by calculating the log-likelihood ratio:
𝑁𝑁 𝑇𝑇−𝑁𝑁 𝑁𝑁 𝑁𝑁
𝐿𝐿𝐿𝐿𝑈𝑈𝑈𝑈 = −2 ln[(1 − 𝑝𝑝)𝑇𝑇−𝑁𝑁 𝑝𝑝𝑁𝑁 ] + 2ln ��1 − � � � �
𝑇𝑇 𝑇𝑇
We reject the null hypothesis if LR > 3.841.
If we have 20 exceedances, LRUC = 3.823, which is less than 3.841 so we can’t reject the
null hypothesis.
If we have 21 exceedances, LRUC = 4.818. which is greater than 3.841 so we can reject the
null hypothesis.
Based on the Kupiec test, the maximum number of acceptable daily losses exceeding the
1-day 99.5% VaR in 10 years is 20.
Answer A is still the closest to the maximum number of exceedances.
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition. (New York: McGraw-Hill, 2007). Chapter 6, Backtesting VaR.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
13. A portfolio manager is mapping a fixed-income portfolio into exposures on selected risk factors. The manager
is analyzing the comparable mechanics and risk measurement outputs of principal mapping, duration
mapping, and cash-flow mapping that correspond to the average portfolio maturity. Which of the following is
correct?
Correct Answer: B
Explanation: B is correct. With duration mapping, a portfolio is replaced by a zero-coupon bond with
maturity equal to the duration of the portfolio.
A is incorrect. Principal mapping considers the timing of redemption payments only and
does not consider coupon payments.
C is incorrect. Cash-flow mapping considers the present values of the cash flows placed to
correspond to the maturities for which volatilities are provided. The statement provided
relates to the Principal mapping instead.
D is incorrect. Cash-flow mapping considers the present values of the cash flows
throughout the lives of assets in the portfolio. Consideration of the average maturity of
the entire portfolio is done under the Principal mapping and not the Cash-flow mapping.
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition. (New York: McGraw-Hill, 2007). Chapter 11, VaR Mapping.
Learning Objective: Differentiate among the three methods of mapping portfolios of fixed income securities.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
14. A CRO of a hedge fund is asking the risk team to develop a term-structure model that is appropriate for fitting
interest rates for use in the fund’s options pricing practice. The risk team is evaluating several interest rate
models with time-dependent drift and time-dependent volatility functions. Which of the following is a correct
description of the specified model?
A. In the Ho-Lee model, the drift of the interest rate process is presumed to be constant.
B. In the Ho-Lee model, when the short-term rate is above its long-run equilibrium value, the drift is
presumed to be negative.
C. In the Cox-Ingersoll-Ross model, the basis-point volatility of the short-term rate is presumed to be
proportional to the square root of the rate, and short-term rates cannot be negative.
D. In the Cox-Ingersoll-Ross model, the volatility of the short-term rate is presumed to decline exponentially
to a constant long-run level.
Correct Answer: C
Explanation: C is correct. In the CIR model, the basis-point volatility of the short rate is not
independent of the short rate as other simpler models assume. The annualized basis-
point volatility equals 𝜎𝜎*sqrt(r) and therefore increases as a function of the square root
of the rate. Short-term rate in the CIR model cannot be negative because of the
combined property that (i) basis-point volatility equals zero when short-term rate is zero,
and (ii) the drift is positive when the short-term rate is zero.
A is incorrect. In the Ho-Lee model, the drift of the interest rate process is presumed to
be time-varying.
B is incorrect. No long-run equilibrium value is defined in the Ho-Lee model.
D is incorrect. The volatility of the short-term rate is assumed to be proportional to the
square root of the short-rate in CIR model.
Reference: Bruce Tuckman and Angel Serrat, Fixed Income Securities, 3rd Edition (Hoboken, NJ: John
Wiley & Sons, 2011). Chapter 9: The Art of Term Structure Models: Drift.
Bruce Tuckman and Angel Serrat, Fixed Income Securities, 3rd Edition (Hoboken, NJ: John
Wiley & Sons, 2011). Chapter 10: The Art of Term Structure Models: Volatility and
Distribution.
Learning Objective: Describe methods of addressing the possibility of negative short-term rates in term
structure models; Construct a short-term rate tree under the Ho-Lee Model with time-
dependent drift.
Describe the short-term rate process under the Cox-Ingersoll-Ross (CIR) and lognormal
models.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
15. Six months ago, Textile Manufacturing Inc. (TMI) entered into a 9-month forward contract with Spin Mills
Company (SMC) to purchase 36,000 tons of yarn from SMC. At the time the forward was entered into, 36,000
tons of yarn was priced at EUR 92.0 million but is currently priced at EUR 94.0 million. The continuously
compounded risk-free rate has remained stable at 3.0% per year and is not expected to change during the
remainder of the contract period. Assuming the forward is fairly priced, what is the current potential credit risk
exposure on the forward contract and who bears the risk?
Correct Answer: A
Explanation: A is correct. Given the risk-free rate of 3.0%, we can estimate the forward price (at
maturity, in nine months) of the contract as:
Forward price = Spot*exp(r*t) = 92.0*exp(0.03*0.75) = EUR 94.0935 million.
Today, after 6 months (3 months to maturity), the forward contract price estimate
= 94.0935/exp(0.03*0.25)
= EUR 93.3904 million.
Note that, Forward Contract Value = Credit Risk Exposure;
Therefore, given that the current (with 3 months remaining to maturity) underlying asset
price of EUR 94 million, the long forward contract’s exposure value is given by:
Current Potential Exposure Value of Forward Contract = (Market Price – Contract Price)
= 94.0 – 93.3904 = EUR 0.6096 = EUR 0.610 million.
Because the contract value of EUR 0.610 million is positive, the long counterparty (TMI)
bears the credit risk exposure.
Positive exposure = Max(value, 0), Negative exposure = Min(value, 0)
And for long forward contracts: Contract Value = (Market Price – Contract Price).
For forwards, while there is no current credit risk (loss), because payment is only made at
expiration, there is always positive potential exposure so long as market price > contract
price, and negative potential exposure if market price < contract price. At origination
(time 0), there is neither current credit risk nor potential credit exposure (since market
price = contract price).
B is incorrect (see explanation above).
C and D are incorrect. They compute the contract price incorrectly by discounting the
forward value over 6 months and not 3 months:
The forward contract price = 94.093*exp(-0.03*0.5) = EUR 92.692 million. Therefore,
Current Value of Forward Contract = (Market Price – Contract Price) = 94.0 – 92.692 =
EUR 1.308 million.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 7 - Credit
Exposure and Funding
Learning Objective: Describe and calculate the following metrics for credit exposure: expected mark-to-
market, expected exposure, potential future exposure, expected positive exposure and
negative exposure, effective exposure, and maximum exposure.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
16. A mid-sized investment bank conducts several trades. As part of its risk control, it has entered into netting
agreements on 8 equity trade positions with an average correlation of 0.28. The firm believes that it can
improve upon the diversification benefit of netting by revising the current agreement. Assuming values of
future trade positions are normally distributed, which of the following trade combinations would increase the
firm’s expected netting benefit the most from the current level?
Correct Answer: C
n + n(n − 1)ρ
Netting Factor =
n
where n represents the number of exposures and ρ represents the average correlation.
For the current position, when n = 8 and ρ = 0.28:
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 7 - Credit
Exposure and Funding
Learning Objective: Explain the impact of netting on exposure, the benefit of correlation, and calculate the
netting factor.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
17. A portfolio manager is interested in liquidating Stock ASX from an existing portfolio. However, the manager is
concerned about the level of liquidity risk and proceeds to estimate liquidity-adjusted VaR for the stock. The
manager observes a quote for Stock ASX and reports that the midpoint of its current best bid and best ask
prices is AUD 54. Stock ASX has an estimated daily return volatility of 0.25% and an average bid-ask spread of
AUD 0.15. Using the constant spread approach on a position of 20,000 shares of Stock ASX, and assuming the
returns of the stock are normally distributed, which is closest to the correct estimate for the stock’s liquidity-
adjusted 1-day 99% VaR?
A. AUD 2,700
B. AUD 7,780
C. AUD 12,400
D. AUD 15,100
Correct Answer: B
Reference: Kevin Dowd, Measuring Market Risk, 2nd Edition (West Sussex, England: John Wiley &
Sons, 2005). Chapter 14, Estimating Liquidity Risks.
Learning Objective: Describe and calculate LVaR using the constant spread approach and the exogenous
spread approach
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
18. A manager is evaluating the risks of a portfolio of stocks. Currently, the portfolio is valued at CNY 124 million
and contains CNY 14 million in stock Y. The annualized standard deviations of returns of stock Y and of the
overall portfolio are 12% and 16%, respectively. The correlation of returns between stock Y and the portfolio is
0.52. Assuming the risk analyst uses a 1-year 95% VaR and that returns are normally distributed, what is the
component VaR of stock Y?
Correct Answer: B
Explanation: B is correct. The component VaR for stock Y (CVaRY) can be presented as:
CVaRY = ρy,p*VaRY
where VaRY = VaR of stock Y; and ρy,p= correlation coefficient between stock Y and the
portfolio.
Let wY represent the value of stock Y; σY represent the standard deviation of stock Y
returns; α(95%) represent the 95% confidence factor for the VaR estimate, which is
1.645. Hence,
VaRY = wY*σY*α(95%) = CNY 14 million x 0.12 x 1.645 = CNY 2.7636 million.
Therefore,
CVaRY = ρy,p*VaRY = 0.52 x 2.7636 = CNY 1.4371 million.
A is incorrect. CNY 0.103 million is the marginal VaR of stock Y.
C is incorrect. CNY 2.032 million is the component VaR of stock Y if the manager
incorrectly uses the 99% VaR.
D is incorrect. CNY 3.685 million is the incremental VaR of stock Y (assuming that the
volatility of the portfolio without stock Y remains 16% and the correlation of returns
between stock Y and the portfolio without stock Y is 0.52). Alternatively, CNY 3.685
million is simply the weight of stock Y in the portfolio multiplied by the portfolio VaR.
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition. (New York: McGraw-Hill, 2007). Chapter 7, Portfolio Risk: Analytical Methods.
Learning Objective: Define, calculate, and distinguish between the following portfolio VaR measures:
individual VaR, incremental VaR, marginal VaR, component VaR, undiversified portfolio
VaR, and diversified portfolio VaR.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
19. The use of a central clearinghouse to handle the transactions executed between XYZ's main funding source,
ABC and ABC's client, Repo Co., would likely have resulted in a reduction in:
Correct Answer: D
Explanation: D is correct. If it uses a clearinghouse and the clearinghouse makes a mistake (operational
risk) like that made by ABC, ABC will have recourse to the clearinghouse and it would
have, therefore, reduced its operational risk exposure.
A is incorrect. ABC is not funding from Repo Co.
B is incorrect. The use of a clearinghouse does not change Repo Co.’s default risk – just
ABC’s exposure to Repo Co. defaults.
C is incorrect. The use of a clearinghouse in this situation does not reduce XYZ’s lending
risk.
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital,
3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 4 – Counterparty Risk
Learning Objective: Describe counterparty risk and differentiate it from lending risk.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
20. By using a clearinghouse to handle the repo transactions between ABC and Repo Co., obligations owed
between the two could have been netted once the fraudulent documentation was discovered. Which of the
following is the most appropriate type of netting to use in this situation and what would be a likely additional
impact from using this netting?
A. Payment netting would be used, which would reduce ABC's counterparty risk, but this risk would be
transferred to other creditors outside the clearinghouse.
B. Payment netting would be used, which would reduce Repo Co.'s counterparty risk, but ABC's counterparty
risk would be increased.
C. Closeout netting would be used, which would reduce ABC's counterparty risk, but this risk would be
transferred to other creditors outside the clearinghouse.
D. Closeout netting would be used, which would reduce Repo Co.'s counterparty risk, but ABC's counterparty
risk would be increased.
Correct Answer: C
Explanation: C is correct. Close-out netting occurs if there is an event of default, which would include
an incidence of fraud. One of the shortcomings of clearinghouses, and close-out netting as
well, is that the other party, in this case ABC, jumps to the head of the queue with its
claim on Repo Co. to the possible detriment of others, particularly those outside the
clearinghouse in general.
A is incorrect. Payment netting is the simple netting of cash flows due on the same day. It
relates to settlement risk and not to counterparty risk.
B is incorrect, as explained in A and C.
D is incorrect. While close-out netting is the most appropriate type of netting to use in this
case, it is ABC’s counterparty risk that would be reduced (and not Repo Co.’s).
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and Capital,
3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 5 – Netting, Close-out,
and Related Aspects
Learning Objective: Summarize netting and close-out procedures (including multilateral netting), explain their
advantages and disadvantages, and describe how they fit into the framework of the ISDA
master agreement.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
21. A risk analyst at a fund management company is discussing with the risk team the gaps in the company’s risk
measurement system. Among the areas suggested for improvement is a better ability to anticipate the
company’s cash flow needs. Addressing such a problem demands that a good liquidity-at-risk (LaR)
measurement system be an essential part of the bank's risk management framework. Which of the following
statements concerning LaR is correct?
Correct Answer: B
Explanation: B is correct. The LaR can differ substantially from the VaR in a hedged portfolio, and in
different situations can be larger or smaller than the VaR. For example, consider a
portfolio where futures contracts are used to hedge. While the hedge can reduce the VaR
of the portfolio, the LaR can be larger than the VaR as the futures contracts create an
exposure to margin calls and the potential for cash outflows. Alternatively, in situations
where the hedging instruments do not result in potential cash outflows over the
measurement period (e.g. a portfolio of European options which do not expire during the
period), the LaR can be smaller than the VaR. Thus, B is correct and both C and D are
incorrect. In fact, A is also incorrect because LaR surely increases when its credit quality
declines.
Reference: Kevin Dowd, Measuring Market Risk, 2nd Edition (West Sussex, England: John Wiley &
Sons, 2005). Chapter 14, Estimating Liquidity Risks.
Learning Objective: Describe liquidity at risk (LaR) and compare it to LVaR and VaR, describe the factors that
affect future cash flows, and explain challenges in estimating and modeling LaR.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
22. Pillar 1 of the Basel II framework allows banks to use various approaches to calculate the capital requirements
for credit risk, operational risk, and market risk. Which of the following Basel II approaches allows a bank to
explicitly recognize diversification benefits?
Correct Answer: C
Explanation: C is correct. The internal models approach allows banks to use risk measures derived
from their own internal risk management models, subject to a set of qualitative
conditions and quantitative standards. In terms of risk aggregation within market risk
using the internal models approach, banks are explicitly allowed to recognize empirical
correlations across broad market risk categories. The standardized approach for market
risk, on the other hand, assigns capital separately to each of debt securities, equity
securities, foreign exchange risk, commodity risk, and options without consideration for
correlations between different types of instruments. Thus, C is correct, and B is incorrect.
Also, A and D are incorrect because these approaches do not recognize diversification.
Reference: John Hull, Risk Management and Financial Institutions, 4th Edition, (Hoboken, NJ: John
Wiley & Sons, 2015). Chapter 15, Basel I, Basel II, and Solvency II.
Learning Objective: Describe and contrast the major elements—including a description of the risks covered—
of the two options available for the calculation of market risk: Standardized
Measurement Method and Internal Models Approach.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
23. The risk audit committee of an equity mutual fund is reviewing a portfolio construction technique proposed by
a new portfolio manager who has recently been allocated capital to manage. The fund typically grants its
portfolio managers flexibility in selecting and implementing appropriate portfolio construction procedures but
requires that any methodology adopted fulfills key risk control objectives set by the firm. Which of the
following portfolio construction techniques and its capability for risk control in portfolio construction is
correct?
A. Quadratic programming allows for risk control through parameter estimation but generally requires many
more inputs estimated from market data than other portfolio construction techniques require.
B. The screening technique provides superior risk control by concentrating stocks in selected sectors based
on expected alpha.
C. When using the stratification technique, risk control is implemented by overweighting the categories with
lower risks and underweighting the categories with higher risks.
D. When using the linear programming technique, risk is controlled by selecting the portfolio with the lowest
level of active risk.
Correct Answer: A
Explanation: A is correct. Quadratic programming requires many more inputs than other portfolio
construction techniques because it entails estimating volatilities and pair-wise
correlations between all assets in a portfolio. Quadratic programming is a powerful
process, but given the large number of inputs and the less than perfect nature of most
data, it introduces the potential for noise and poor calibration.
The screening technique strives for risk control by including a sufficient number of stocks
that meet the screening parameters and by weighting them to avoid concentrations in
any particular stock.
However, screening does not necessarily select stocks evenly across sectors and can
ignore entire sectors or classes of stocks if they do not pass the screen. Therefore, risk
control in a screening process is fragmentary at best.
Stratification separates stocks into categories (for example, economic sectors) and
implements risk control by ensuring that the weighting in each sector matches the
benchmark weighting. Therefore, it does not allow for overweighting or underweighting
specific categories.
Linear programming does not necessarily select the portfolio with the lowest level of
active risk. Rather, it attempts to improve on stratification by introducing many more
dimensions of risk control and ensuring that the portfolio approximates the benchmark
for all these dimensions.
Reference: Richard Grinold and Ronald Kahn, Active Portfolio Management: A Quantitative Approach
for Producing Superior Returns and Controlling Risk, 2nd Edition (New York: McGraw-Hill,
2000). Chapter 14, Portfolio Construction.
Learning Objective: Evaluate the strengths and weaknesses of the following portfolio construction
techniques: screens, stratification, linear programming, and quadratic programming.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
24. An analyst reports the following fund information to the advisor of a pension fund that currently invests in
government and corporate bonds and carries a surplus of USD 40 million:
Pension Assets Liabilities
Amount (USD million) 180 140
Expected annual growth rate 6% 10%
Annual volatility of growth rates 25% 12%
To evaluate the sufficiency of the fund's surplus, the advisor estimates the possible surplus values at the end
of 1 year. The advisor assumes that annual returns on assets and the annual growth of the liabilities are jointly
normally distributed and their correlation coefficient is 0.68. Assume that the volatility of surplus in dollar is
USD 35.76 million, what is the lower bound of the 95% confidence interval for the expected end-of-year
surplus that the advisor can report?
Correct Answer: C
Explanation: C is correct. The lower bound of the 95% confidence interval is equal to: Expected Surplus
– (95% confidence factor * Volatility of Surplus).
Expected surplus:
VA*[1 + E(RA)] – VL*[1 + E(RL)] = 180*1.06 – 140*1.10 = USD 36.80 million.
For a 95% confidence interval, the appropriate z-value is 1.96. Therefore, the lower
bound of the surplus at the 95% confidence level = 36.80 – 1.96*35.76 = USD -33.2896
million.
Section: Risk Management and Investment Management
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition. (New York: McGraw-Hill, 2007). Chapter 17, VaR and Risk Budgeting in
Investment Management.
Learning Objective: Distinguish among the following types of risk: absolute risk, relative risk, policy-mix risk,
active management risk, funding risk, and sponsor risk.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
25. A due diligence specialist at a company is evaluating the risk management process of a hedge fund in which
the company is considering making an investment. Which of the following statements best describes
appropriate criteria the specialist should use for such an evaluation?
A. Because of the overwhelming importance of tail risk, the company should not invest in the fund unless it
fully accounts for fat tails using extreme value theory at the 99.99% level when estimating VaR.
B. Today's best practices in risk management require that a fund employ independent risk service providers
and that these service providers play important roles in risk-related decisions.
C. When considering a leveraged fund, the specialist should assess how the fund estimates risks related to
leverage, including funding liquidity risks during periods of market stress.
D. It is crucial to assess the fund's valuation policy, and in general if more than 10% of asset prices are based
on model prices or broker quotes, the specialist should recommend against investment in the fund
regardless of other information available about the fund.
Correct Answer: C
Explanation: C is correct. Generally speaking, with a leveraged fund, an investor will need to evaluate
historical and current changes in leverage, as well as the level of liquidity of the portfolio,
particularly during times of market stress. Certain strategies may in fact expose an
investor to tail risk, so while an investor should inquire whether the manager believes
that tail risk exists, and whether or not it is hedged, it is then up to the investor to decide
whether to accept the risk unhedged or hedge it on their own. Many funds employ
independent risk service providers to report risks to investors, but these firms do not get
involved in risk related decision making. And finally, while it is important to know what
percentage of the assets is exchange-traded and marked to market, what might be
acceptable may differ depending on the strategy of the fund.
Reference: Kevin R. Mirabile, Hedge Fund Investing: A Practical Approach to Understanding Investor
Motivation, Manager Profits, and Fund Performance, 2nd Edition (Hoboken, NJ: Wiley
Finance, 2016).
Learning Objective: Describe criteria that can be evaluated in assessing a fund’s risk management process.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
26. A packaging materials manufacturer is considering a project that has an estimated risk-adjusted return on
capital (RAROC) of 15%. Suppose that the risk-free rate is 3% per year, the expected market rate of return is
11% per year, and the company's equity beta is 1.8. Using the criterion of adjusted risk-adjusted return on
capital (ARAROC), the company should:
A. Reject the project because the ARAROC is higher than the market expected excess return.
B. Accept the project because the ARAROC is higher than the market expected excess return.
C. Reject the project because the ARAROC is lower than the risk-free rate.
D. Accept the project because the ARAROC is lower than the risk-free rate.
Correct Answer: C
Explanation: C is correct. Consider the basic adjusted RAROC (ARAROC) formula for a project:
ARAROC = RAROC - βE*(Rm – Rf)
Where:
βE = Beta of the equity of the firm
Rm.= Expected market rate of return
Rf = Risk-free rate of interest
βE*(Rm – Rf) = Risk premium of the project.
ARAROC is simply “RAROC adjusted for the systematic riskiness of the returns”. ARAROC
can be used in evaluating the project in the following way: If the project’s “RAROC less
the project’s risk premium” is greater than the risk-free rate, then the firm’s shareholders
are compensated for the non-diversifiable systematic risk they bear when investing in the
activity, assuming the investors hold a well-diversified portfolio (i.e., the project adds
value). That is, if the project’s ARAROC exceeds the risk-free rate, it should be accepted
by the firm. Otherwise, if it is less than the risk-free rate, the project should be rejected.
Given RAROC = 15%, βE = 1.8, Rm = 11% and Rf = 3%, one can compute ARAROC = 0.15-
1.8*(0.11- 0.03) = 0.006 = 0.6% and is less that Rf = 3%. Thus, the project is rejected.
Reference: Michel Crouhy, Dan Galai and Robert Mark, The Essentials of Risk Management, 2nd
edition (New York: McGraw-Hill, 2014). Chapter 17, Risk Capital Attribution and Risk-
Adjusted Performance Measurement.
Learning Objective: Compute the adjusted RAROC for a project to determine its viability
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
27. A derivative trading firm only trades derivatives on rare commodities. The company and a handful of other
firms, all of whom have large notional outstanding contracts with the company, dominate the market for such
derivatives. The company’s management would like to mitigate its overall counterparty exposure, with the
goal of reducing it to almost zero. Which of the following methods, if implemented, could best achieve this
goal?
Correct Answer: A
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 4 –
Counterparty Risk
Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 6 – Collateral
Learning Objective: Identify and describe the different ways institutions can quantify, manage and mitigate
counterparty risk.
Describe the rationale for collateral management.
Describe the terms of a collateral and features of a credit support annex (CSA) within the
ISDA Master Agreement including threshold, initial margin, minimum transfer amount
and rounding, haircuts, credit quality, and credit support amount.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
28. HIP Bank (HIP) often enters into interest rate swaps with ADB Banking Corporation (ADB) on terms that reflect
appropriate counterparty risk. Earlier in the year, HIP and ADB entered into a 3-year swap in which ADB agreed
to pay HIP a fixed rate of 5% in return for 6-month LIBOR plus a spread. Since the swap was entered into, both
banks were downgraded. As a result of the ratings changes, the credit spread for HIP has increased from
36 bps to 144 bps, while the credit spread for ADB has increased from 114 bps to 156 bps. Assuming no
change in the LIBOR curve, if an identical 3-year swap was entered into today, which of the following is the
most likely to be correct?
A. Since HIP’s spread increased more than ADB’s spread, HIP’s DVA will increase and ADB’s DVA will
decrease.
B. Since HIP’s spread increased more than ADB’s spread, HIP’s CVA will increase and ADB’s CVA will
decrease.
C. Since both banks’ spreads increased, the CVA on both sides of the contract will be higher.
D. Since both banks’ spreads increased, the DVA on both sides of the contract will be lower.
Correct Answer: C
Explanation: C is correct. The lower credit qualities and increased credit spreads should result in higher
DVA and CVA for both ADB and HIP. Therefore, only C is correct, and A, B and D are all
incorrect.
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 14 – Credit and
Debt Value Adjustments
Stress Testing: Approaches, Methods, and Applications, Edited by Akhtar Siddique and
Iftekhar Hasan (London: Risk Books, 2013). Chapter 4 - The Evolution of Stress Testing
Counterparty Exposures
Learning Objective: Explain the motivation for and the challenges of pricing counterparty risk
Calculate the debt value adjustment (DVA) and explain how stressing DVA enters into
aggregating stress tests of CCR.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
29. A risk analyst estimates that the hazard rate for a company is 0.12 per year. Assuming a constant hazard rate
model, what is the probability that the company will survive in the first year and then default before the end
of the second year?
A. 8.9%
B. 10.0%
C. 11.3%
D. 21.3%
Correct Answer: B
Explanation: B is correct.
The joint probability of survival up to time t and default over (t, t+ τ) is:
The joint probability of survival the first year and default over the first year and the
second year is:
Reference: Allan Malz, Financial Risk Management: Models, History, and Institutions (Hoboken, NJ:
John Wiley & Sons, 2011). Chapter 7, Spread Risk and Default Intensity Models.
Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 12 - Default
Probabilities, Credit Spreads, and Funding Costs
Learning Objective: Define the hazard rate and use it to define probability functions for default time and
conditional default probabilities.
Distinguish between cumulative and marginal default probabilities.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
30. Computing VaR on a portfolio containing a very large number of positions can be simplified by mapping these
positions to a smaller number of elementary risk factors. Which of the following mapping technique for the
given positions is the most appropriate?
A. USD/EUR forward contracts are mapped to the USD/EUR spot exchange rate.
B. Each position in a corporate bond portfolio is mapped to the bond with the closest maturity among a set
of government bonds.
C. Zero-coupon government bonds are mapped to government bonds paying regular coupons.
D. A position in the stock market index is mapped to a position in a stock within that index.
Correct Answer: A
Explanation: A is correct. Mapping several USD/EUR forward contracts to USD/EUR spot exchange rate
is an adequate process, because all the forward positions are exposed to a single major
risk factor, which is the USD/EUR spot exchange rate. However, this is not a perfect
mapping (for instance, the sensitivity of both the forward and the spot exchange rates to
a specific risk factor such as changes in interest rates, may differ).
While the single aggregation of exposure of this risk factor is acceptable for risk
measurement, it is not adequate for pricing of the portfolio.
B is incorrect because any bond must be mapped on yields that best represent its current
profile and the yield differences between the corporate bonds and the government
bonds disqualify this as the best mapping.
C is incorrect because such procedure maps a simple single source of uncertainty (the
payoff at the maturity) to multiple sources of uncertainty (coupon payments and the
payoff at the maturity) which violates the first principle of mapping, simplify the source of
uncertainty.
D is also incorrect as the stock market index is a more diversified factor than a single
stock. In fact, it is usually the reverse, i.e., a position of stock within an index is mapped to
a position in that index. (See p.62 of FRM book on Market Risk)
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition (New York: McGraw-Hill, 2007). Chapter 11, VaR Mapping.
Learning Objective: Explain the principles underlying VaR mapping, and describe the mapping process.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
31. A market risk manager seeks to calculate the price of a 2-year zero-coupon bond. The 1-year interest rate
today is 10.0%. There is a 50% probability that the 1-year interest rate will be 12.0% and a 50% probability that
it will be 8.0% in 1 year. Assuming that the risk premium of duration risk is 50 bps each year, and that the
bond’s face value is EUR 1,000, which of the following should be the price of the zero-coupon bond?
A. EUR 822.98
B. EUR 826.74
C. EUR 905.30
D. EUR 921.66
Correct Answer: A
Reference: Bruce Tuckman and Angel Serrat, Fixed Income Securities, 3rd Edition (Hoboken, NJ: John
Wiley & Sons, 2011), Chapter 8 - The Evolution of Short Rates and the Shape of the Term
Structure
Learning Objective: Calculate the price and return of a zero-coupon bond incorporating a risk premium.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
32. A financial analyst is pricing a 5-year call option on a 5-year Treasury note using a successfully validated pricing
model. Current interest rate volatility is high and the analyst is concerned about the effect this may have on
short-term rates when pricing the option. Which of the following actions would best address the potential for
negative short-term interest rates to arise in the model?
A. When short-term rates are negative, the financial analyst adjusts the risk-neutral probabilities.
B. When short-term rates are negative, the financial analyst increases the volatility.
C. When short-term rates are negative, the financial analyst sets the rate to zero.
D. When short-term rates are negative, the financial analyst sets the mean-reverting parameter to 1.
Correct Answer: C
Explanation: C is correct. Negative short-term interest rates can arise in models for which the terminal
distribution of interest rates follow a normal distribution. The existence of negative
interest rates (although possible) does not make much economic sense since market
participants would generally not lend cash at negative interest rates when they can hold
cash and earn a zero return. One method that can be used to address the potential for
negative interest rates when constructing interest rate trees is to set all negative interest
rates to zero. This localizes the change in assumptions to points in the distribution
corresponding to negative interest rates and preserves the original rate tree for all other
observations. In comparison, adjusting the risk neutral probabilities would alter the
dynamics across the entire range of interest rates and therefore not be an optimal
approach.
When a model displays the potential for negative short-term interest rates, it can still be
a desirable model to use in certain situations, especially in cases where the valuation
depends more on the average path of the interest rate, such as in valuing coupon bonds.
Therefore, the potential for negative rates does not automatically rule out the use of the
model.
Reference: Bruce Tuckman, Fixed Income Securities, 3rd Edition (Hoboken, NJ: John Wiley & Sons,
2011). Chapter 9, The Art of Term Structure Models: Drift.
Learning Objective: Describe methods for addressing the possibility of negative short-term rates in term
structure models.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
33. An investment bank has been using VaR as its main risk measurement tool. ES is suggested as a better
alternative to use during market turmoil. What should be understood regarding VaR and ES before modifying
current practices?
Correct Answer: A
Explanation: A is correct. Expected shortfall is always greater than or equal to VaR for a given
confidence level α, since α measures the minimum loss in case the worst α probability
event happens and ES accounts for the severity of expected losses beyond VaR.
Reference: "Messages from the Academic Literature on Risk Measurement for the Trading Book",
Basel Committee on Banking Supervision, Working Paper No. 19, January 2011.
Learning Objective: Compare VaR, expected shortfall, and other relevant risk measures.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
34. A derivative trading desk at a bank decides that its existing VaR model, which has been used broadly across
the firm for several years, is too conservative. The existing VaR model uses a historical simulation over a 3-
year look-back period, weighting each day equally. A quantitative analyst in the group quickly develops a new
VaR model, which uses the delta normal approach. The new model uses volatilities and correlations estimated
over the past 4 years using the RiskMetrics EWMA method.
For testing purposes, the new model is used in parallel with the existing model for 6 weeks to estimate the 1-
day 99% VaR. After 6 weeks, the new VaR model has no exceedances despite consistently estimating VaR to
be considerably lower than the existing model's estimates. The analyst argues that the lack of exceedances
shows that the new model is unbiased and pressures the bank’s model evaluation team to agree. Following an
overnight examination of the new model by one junior analyst, instead of the customary evaluation that takes
several weeks and involves a senior member of the team, the model evaluation team agrees to accept the
new model for use by the desk.
Which of the following statements is a correct conclusion for this replacement?
A. Delta-normal VaR is more appropriate than historical simulation VaR for assets with non-linear payoffs.
B. Changing the look back period and weighting scheme from 3 years, equally weighted, to 4 years,
exponentially weighted, will understate the risk in the portfolio.
C. Overnight examination by the junior analyst increased the desk’s exposure to model risk due to the
potential for incorrect calibration and programming errors.
D. A 99% VaR model that generates no exceedances in 6 weeks is necessarily conservative.
Correct Answer: C
Explanation: C is correct. Given the quick implementation of the new VaR model and the insufficient
amount of testing that was done, the desk’s exposure to model risk has increased due to
the increased potential for incorrect calibration and programming errors. This situation is
similar to the JP Morgan London Whale case in 2012, where a new VaR model was very
quickly introduced for its Synthetic Credit portfolio without appropriate time to test the
model in response to increasing losses and multiple exceedances of the earlier VaR
model limit in the portfolio.
Reference: Allan Malz, Financial Risk Management: Models, History, and Institutions (Hoboken, NJ:
John Wiley & Sons, 2011). Chapter 11, Assessing the Quality of Risk Measures.
Learning Objective: Describe ways that errors can be introduced into models.
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35. The senior management team of a small regional bank has established a committee to review procedures and
implement best practices related to entering into significant contracts with third-party vendors. The
committee is reviewing one proposed relationship with a third-party vendor who would have a significant
responsibility for marketing the bank’s financial products to potential customers. In establishing policies to
reduce the operational risk associated with this potential vendor contract, which of the following
recommendations would be most appropriate?
A. The bank should review all third-party audit reports of the vendor that are publicly available.
B. The bank should ensure that the vendor's sales representatives are compensated mainly with
commissions from the sale of the bank’s products.
C. The bank should prevent the third-party vendor from having access to any of its critical processes.
D. The bank should be responsible for developing the vendor's contingency planning process to mitigate risk
exposure to the vendor.
Correct Answer: A
Explanation: A is correct. Internal Controls: “For significant service provider relationships, financial
institutions should assess the adequacy of the provider's control environment.
Assessments should include reviewing available audits or reports such as the American
Institute of Certified Public Accountants' Service Organization Control 2 report.”
B is incorrect. The bank should review the vendor’s incentive compensation structure
and ensure that the structure does not encourage vendor sales representatives to direct
customers towards higher margin products without regard for the risk incurred.
Compensating sales reps mostly with commissions would not be an appropriate
structure.
C is incorrect. Outsourcing critical processes is not ruled out as a guideline, for example:
“A community banking organization may have critical business activities being
outsourced, but the number may be few and to highly reputable service providers.”
“(Larger) financial institutions may use hundreds or thousands of service providers for
numerous business activities that have material risk…”
D is incorrect. The bank should monitor the vendor’s contingency planning process and
“assess the adequacy and effectiveness of a service provider’s disaster recovery and
business continuity plan and its alignment with its own plan”.
Reference: “Guidance on Managing Outsourcing Risk,” Board of Governors of the Federal Reserve
System, December 2013.
Learning Objective: Describe topics and provisions that should be addressed in a contract with a third-party
service provider.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
36. The Basel Committee recommends that banks use a set of early warning indicators to identify emerging risks
and potential vulnerabilities in their liquidity position. Which of the following is an early warning indicator of a
potential liquidity problem?
Correct Answer: C
Explanation: C is correct. Rapid asset growth is an early warning of a potential liquidity problem.
Positive publicity, credit rating upgrade, and increased asset diversification are all not
early warnings of a potential liquidity problem.
Reference: Darrell Duffie, The Failure Mechanics of Dealer Banks, Journal of Economic Perspectives
(2010, Volume 24, Number 1) pp. 51-72.
Learning Objective: Identify situations that can cause a liquidity crisis at a dealer bank and explain responses
that can mitigate these risks.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
37. Large dealer banks have often financed significant fractions of their assets using short-term (overnight)
repurchase agreements in which creditors hold bank securities as collateral against default losses. The table
below shows the quarter-end financing of four A-rated broker-dealer banks. All values are in USD billion.
In the event that repo creditors become equally nervous about each bank’s solvency, which bank is most
vulnerable to a liquidity crisis?
A. Bank P
B. Bank Q
C. Bank R
D. Bank S
Correct Answer: B
Explanation:
B is correct. A liquidity crisis could materialize if repo creditors become nervous about a
bank’s solvency and choose not to renew their positions. If enough creditors choose not
to renew, the bank could likely be unable to raise sufficient cash by other means on such
short notice, thereby precipitating a crisis. The bank may therefore be forced to sell its
assets in a hurry to buyers that know it needs to sell quickly. This leads to the potential
for a fire sale, and supports using the proportion of assets covered by repos as a signal of
liquidity risk. Also, low prices recorded in a fire sale could lower the market valuation of
securities not sold, and thus reduce the amount of cash that could be raised through
repurchase agreements collateralized by those securities. Overall, this vulnerability is
directly related to the proportion of assets a bank has pledged as collateral.
Bank Q is most vulnerable since it has the largest dependence on short-term repo
financing (i.e. the highest percentage of its assets out of the four banks is pledged as
collateral (see additional discussions in the 2018 FRM Reading [OR-19], pages 353-358).
Reference: Darrell Duffie, The Failure Mechanics of Dealer Banks, Journal of Economic Perspectives
(2010, Volume 24, Number 1) pp. 51-72.
Learning Objective: Identify situations that can cause a liquidity crisis at a dealer bank and explain responses
that can mitigate these risks.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
38. During a training seminar, a supervisor at Firm W discusses different types of operational risk that the firm
may face, which could be in the short-term or over a longer-term period. Which of the following is an example
of loss caused by an operational risk of firm W?
A. After a surprise announcement by the central bank that interest rates would increase, bond prices fall and
Firm W incurs a significant loss on its bond portfolio.
B. The data capture system of Firm W fails to capture the correct market rates causing derivative trades to
be done at incorrect prices, leading to significant losses.
C. As a result of an increase in commodity prices, the share price of a company that Firm W invested in falls
significantly, causing major investment losses.
D. A counterparty of Firm W fails to settle its debt to Firm W, and in doing this, it is in breach of a legal
agreement to pay for services rendered.
Correct Answer: B
Explanation: B is correct. In B, systems failure or incorrect systems caused the problem. The losses are
directly due to an operational risk exposure. In A and C, an increase in interest rates and
the fall in the value of an investment, respectively, are both examples of market risk
exposure. In D, failure to repay debt is an example of credit risk exposure.
Reference: “Principles for the Sound Management of Operational Risk,” (Basel Committee on
Banking Supervision Publication, June 2011).
Learning Objective: Describe tools and processes that can be used to identify and assess operational risk.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
39. An information technology analyst at a large global bank is preparing a plan to aggregate the bank's risk data
and increase the quality of the firm's data governance practices. The bank has several business divisions that
represent product lines that are offered across multiple regions. To effectively aggregate the risk data and
ensure a strong data governance process, which of the following conditions would the analyst point out as
posing the greatest information technology challenge to the bank?
A. Most of the risk data are located on spreadsheets at the individual business units.
B. The bank rapidly integrates the information technology systems of each company that it acquires into its
own technology platform.
C. The product lines are divided into legal entities by geographic region, but data from each entity is
aggregated in a centralized data warehouse.
D. The bank installs technology platforms before investing in approved strategic initiatives that require
those platforms.
Correct Answer: A
Explanation: A is correct. As per the Senior Supervisors Group paper: “Many firms still rely heavily on
spreadsheet environments, which significantly delay report processing while raising
concerns about accuracy.” Spreadsheets involve a high level of manual intervention and
are therefore prone to error. Also, as per the Federal Capital Planning paper, “Using
standalone tools or spreadsheets in the aggregation process is a weak process.”
B is incorrect. Banks are encouraged to integrate technology systems of acquired
companies as quickly as possible after a merger or acquisition in order to reduce
fragmentation.
C is incorrect. Aggregating risk data from different divisions into a centralized data
warehouse is a recommended practice.
D is incorrect. It is also a recommended practice for the bank to envision the technology
system requirements
Learning Objective: Explain the challenges and best practices related to data aggregation at an organization.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
40. A risk analyst is building a bank’s enterprise risk management system. During the process, the analyst takes an
inventory of firm risks and categorizes these risks as market, credit, or operational. Which of the following
observations of the bank’s data should be considered unexpected if compared to similar industry data?
A. The operational risk loss distribution has many small losses, and therefore a relatively low mode.
B. The operational risk loss distribution is symmetric and fat-tailed.
C. The credit risk distribution is asymmetric and fat-tailed.
D. The market risk distribution is symmetric.
Correct Answer: B
Explanation: B is correct. Statements A, C, and D are consistent with industry data. However, with
operational risk, there tends to be large numbers of small losses and a small number of
large losses, so the distribution is asymmetric (and fat-tailed).
Reference: Brian Nocco and René Stulz, Enterprise Risk Management: Theory and Practice, Journal
of Applied Corporate Finance (Volume 18, Number 4, 2006), pp. 8 – 20.
Learning Objective: Describe the development and implementation of an ERM system, as well as challenges
to the implementation of an ERM system.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
41. A regional commercial bank is considering a loan to be fully funded by deposits, with the following
parameters:
• Loan amount: JPY 4.2 billion
• Average annual interest rate paid on deposits: 0.4%
• Annual interest rate received on loan: 3.2%
• Expected loss: 2.0% of face value of loan
• Annual operating costs: 0.5% of face value of loan
• Economic capital required to support the loan: 10.0%
• Average pre-tax return on economic capital: 1.4%
• Effective tax rate: 38%
• Other transfer costs: JPY 0
What is the after-tax RAROC for this loan?
A. 0.27%
B. 2.73%
C. 4.40%
D. 10.73%
Correct Answer: B
Explanation: B is correct. The risk-adjusted after-tax return on capital (RAROC) is computed by:
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 − 𝑡𝑡𝑡𝑡𝑡𝑡 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 − 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑛𝑛𝑛𝑛𝑛𝑛 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
11,457,600
𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 = = 0.0273 = 2.73%
420,000,000
A is incorrect. 0.27% is the result obtained when the economic capital is incorrectly taken
to be JPY 4.2 billion instead of it being 10% of the loan amount.
C is incorrect. 4.40% is the result obtained when taxes are ignored.
D is incorrect. 10.73% is the result obtained when IC is added instead of subtracting in
the numerator.
Reference: Michel Crouhy, Dan Galai and Robert Mark, The Essentials of Risk Management, 2nd
Edition (New York: McGraw-Hill, 2014). Chapter 17, Risk Capital Attribution and Risk-
Adjusted Performance Measurement.
Learning Objective: Compute and interpret the RAROC for a project, loan, or loan portfolio, and use RAROC
to compare business unit performance.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
42. A bank is using the VaR and stressed VaR market risk framework in line with the Basel 2.5 guidelines. The
bank’s internal models for market risk have generated the following risk measures (in USD million) for the
current trading book positions:
Confidence Latest Available Latest Available Average 10-day Average 10-day
Level 10-day VaR 10-day Stressed VaR of Previous 60 Stressed VaR of
VaR Days Previous 60 Days
95.0% 238 484 252 546
99.0% 451 995 413 1,106
99.9% 578 1,281 528 1,372
Assuming the supervisory authority has set the multiplication factors for both the VaR and the stressed VaR
values to 3, what is the correct capital requirement for general market risk for the bank under Basel 2.5?
Correct Answer: C
Explanation: C is correct. The revised market risk capital requirement (at 99.0% level) is:
Market Risk Capital
= max(VaRt-1, mc*VaR60-day Avg) + max(sVaRt-1, ms*sVaR60-day Avg)
= max(451, 3*413) + max(995, 3*1,106)
= USD 1,239 million + USD 3,318 million
= USD 4,557 million
Reference: John Hull, Risk Management and Financial Institutions, 4th Edition (New York: John Wiley
& Sons, 2015). Chapter 16, Basel II.5, Basel III, and Other Post-Crisis Changes.
Learning Objective: Describe and calculate the stressed value-at-risk measure introduced in Basel 2.5, and
calculate the market risk capital charge.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
43. Company OBD has an outstanding zero-coupon bond with 1 year remaining to maturity. The bond has a face
value of USD 1,000,000 and a recovery rate of 0% in the event of default. The bond is currently trading at 85%
of face value. Assuming the excess spread only captures credit risk and that the risk-free rate is 2% per year,
and using risk-neutral binomial pricing tree methodology, what is the approximate risk-neutral 1-year
probability of default of Company OBD?
A. 13.3%
B. 14.5%
C. 17.2%
D. 19.4%
Correct Answer: A
A is correct.
Using risk-neutral binomial tree pricing methodology for a 1-year zero-coupon bond, let:
π = risk-neutral probability of default;
R = recovery rate;
r = risk-free rate = 2%;
F = 1,000,000 = face value of bond (time t=1);
V = 850,000 = current value of bond (time t=0).
Therefore, taking default as a Bernoulli variable, the recovery rate equals 100% in the
event of no default (upward movement) and the recovery rate is 0% in the event of
default (downward movement):
Time t = 1 (upward node, no default): Expected value of the bond = 1,000,000*(1 - π)*R
= 1,000,000*(1 -π)*1 = 1,000,000*(1- π)
Time t = 1 (downward node): Expected value of bond 1,000,000*π*R = 1,000,000*π*0 =
0
Time t = 1 (overall): Expected value of bond = 1,000,000*(1 - π) + 0 = 1,000,000*(1 - π)
Therefore, Equations (1) and (2) must be equal. Equating the two Equations and solving
for the risk-neutral default probability π, we get:
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
Reference: Bruce Tuckman and Angel Serrat, Fixed Income Securities, 3rd Edition (Hoboken, NJ: John
Wiley & Sons, 2011), Chapter 8 - The Evolution of Short Rates and the Shape of the Term
Structure
Learning Objective: Calculate the price and return of a zero-coupon bond incorporating a risk premium.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
44. A portfolio manager at an insurance company has observed the price of one of the corporate bonds that the
company currently holds and wants to estimate the premium the company needs to accept the default risk of
the bond. The manager has determined that the bond’s real-world default probability is 2.0%, its liquidity risk
premium is 1.8%, and its risk-neutral default probability is 6.1%. Ignoring any other risk premiums that might
affect the bond’s pricing, what is the bond’s default risk premium?
A. 2.0%
B. 2.3%
C. 3.8%
D. 4.1%
Correct Answer: B
Explanation: B is correct. Risk-neutral default probability = Real-world default prob. + Default risk
premium + Liquidity risk premium
Therefore,
Default risk premium = Risk-neutral default probability - Real-world default prob. -
Liquidity risk premium
= 6.1% - 2.0% - 1.8% = 2.3%
A is incorrect. 2.0% is the given real-world default probability.
C is incorrect. 3.8% is the sum of the real-world default probability and the liquidity risk
premium.
D is incorrect. 4.1% is the difference between the risk-neutral default probability and the
real-world default probability.
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 12 - Default
Probabilities, Credit Spreads, and Funding Costs
Learning Objective: Calculate risk-neutral default probabilities, and compare the use of risk-neutral and real-
world default probabilities in pricing derivative contracts.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
45. A financial institution has four open derivative positions with an investment company. A description of the
positions and their current market values are displayed in the table below:
If the investment company defaults, what would be the loss to the financial institution if netting is used
compared to the loss if netting is not used?
A. Loss of USD 20 million if netting is used; loss of USD 24 million if netting is not used
B. Loss of USD 20 million if netting is used; loss of USD 44 million if netting is not used
C. Loss of USD 24 million if netting is used; loss of USD 32 million if netting is not used
D. Loss of USD 24 million if netting is used; loss of USD 44 million if netting is not used
Correct Answer: B
Explanation: B is correct. Netting means that the payments between the two counterparties are
netted out, so that only a net payment has to be made. With netting, the investment
firm is not required to make every payout, hence the loss will be reduced to: USD 32
million + USD 12 million – USD 16 million – USD 8 million = USD 20 million. Without
netting, the loss is the outstanding long position: USD 32 million + USD 12 million =
USD 44 million.
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 5, Netting,
Close-out, and Related Aspects.
Learning Objective: Describe the effectiveness of netting in reducing credit exposure under various scenarios.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
46. A derivative trading firm sells a European-style call option on stock JKJ with a time to expiration of 9 months, a
strike price of EUR 45, an underlying asset price of EUR 67, and implied annual volatility of 27%. The annual
risk-free interest rate is 2.5%. What is the firm’s counterparty credit exposure from this transaction?
A. EUR 0.00
B. EUR 9.45
C. EUR 19.63
D. EUR 22.00
Correct Answer: A
Explanation: A is correct. Selling an option exposes the firm to zero counterparty credit risk as the
premium is paid up front. However, buying an option would expose the firm to a
counterparty credit risk. All the pieces of information necessary to price the option are
provided but they are not necessary for answering the question.
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 4 –
Counterparty Risk
Learning Objective: Describe transactions that carry counterparty risk and explain how counterparty risk can
arise in each transaction.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
47. A financial firm has sold default protection on the most senior tranche of a CDO. If the default correlation
between assets held in the CDO decreases sharply from the correlation used in pricing the CDO tranches,
assuming everything else is unchanged, how will the position of the financial firm be impacted?
A. It will either increase or decrease, depending on the pricing model used and the market conditions.
B. It will gain significant value, since the probability of exercising the protection falls.
C. It will lose significant value, since the protection will gain value.
D. It will neither gain nor lose value, since only expected default losses matter and correlation does not
affect expected default losses.
Correct Answer: B
Explanation: B is correct. The senior tranche will gain value if the default correlation decreases. High
correlation implies that if one name defaults, a large number of other names in the CDO
will also default. Low correlation implies that if one name defaults, there would be little
impact on the default probability of the other names. Therefore, as the correlation
decreases, the cumulative probability of enough defaults occurring to exceed the credit
enhancement on the senior tranche will also decrease. Hence the investor who has sold
protection on the senior tranche will see a gain.
Reference: Allan Malz, Financial Risk Management: Models, History, and Institutions (Hoboken, NJ:
John Wiley & Sons, 2011). Chapter 9, Structured Credit Risk.
Learning Objective: Explain how the default probabilities and default correlations affect the credit risk in a
securitization.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
48. A risk analyst constructs a binomial interest rate tree by using the Ho-Lee model. The time step is monthly and
the annualized drift is 80 bps in the first month and 120 bps in the second month. Assuming the current
annualized short-term rate is 3.2% and the annual basis point-volatility is 2.1%, what is the interest rate in the
lowest node after 2 months?
A. 1.82%
B. 2.15%
C. 2.76%
D. 3.03%
Correct Answer: B
Explanation: B is correct. The interest rate in the lowest node based on the Ho-Lee model is:
(0.8% + 1.25) 1
= 3.2% + − 2 ∗ 2.1% ∗ �
12 12
= 0.021542 = 2.15%
A is incorrect. This uses the incorrect formula r0 - (λ1 + λ2)dt - 2σ√𝑑𝑑𝑑𝑑 dt to calculate the
interest rate, subtracting instead of adding the second term in the formula.
C Is incorrect. This uses the incorrect formula r0 + (λ1 + λ2)dt - σ√𝑑𝑑𝑑𝑑 to calculate the
interest rate, forgetting to multiply by 2 in the third term.
D Is incorrect. This uses the incorrect formula r0 - (λ1 + λ2)dt to calculate the interest rate,
omitting the third term entirely.
Reference: Bruce Tuckman and Angel Serrat, Fixed Income Securities, 3rd Edition (Hoboken, NJ: John
Wiley & Sons, 2011). Chapter 9 – The Art of Term Structure Models: Drift
Learning Objective: 5.6.13.4 Construct a short-term rate tree under the Ho-Lee Model with time-dependent
drift.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
49. Four derivative counterparties have entered into bilateral netting arrangements. The exhibit below presents a
summary of their bilateral mark-to-market (MtM) trades.
If netting agreements exist between all pairs of counterparties shown, what is the correct order of net exposure
per counterparty, from highest to lowest?
A. P, Q, S, R
B. Q, R, S, P
C. R, Q, P, S
D. S, P, Q, R
Correct Answer: A
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 5 - Netting,
Close-out, and Related Aspects
Learning Objective: Describe the effectiveness of netting in reducing credit exposure under various scenarios.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
50. Interest rate and currency swaps display differing profiles of expected exposure (EE) over time. Assuming each
instrument matures in 5 years, which of the following graphs is an accurate representation of a typical EE
profile for the corresponding instrument?
Correct Answer: B
Explanation: B is correct. The risk of cross-currency swaps is driven by a large final payoff, and thus the
profile increases monotonically until the maturity of the trade. The FX risk of the notional
exchange dominates the small contribution due to interest rate exposure.
A is incorrect. For fixed rate bond, the EE is usually considered constant (notional value)
between t=0 and its maturity.
C is incorrect. The EE of an interest rate swap should be 0 at t=0 and also 0 when it
expires.
D is incorrect. The EE of a foreign exchange forward should be 0 at t=0 but should be the
notional amount at maturity.
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 7 - Credit
Exposure and Funding
Learning Objective: Identify typical credit exposure profiles for various derivative contracts and combination
profiles.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
51. A risk analyst is examining a firm’s foreign currency option price assumptions. The implied volatility is
relatively low for an at the at-the-money option and it becomes progressively higher as the option moves
either into the money or out of the money. Compared to the lognormal distribution with the same mean and
standard deviation, the distribution of option prices on this foreign currency implied by the Black-Scholes-
Merton model would have:
Correct Answer: B
Explanation: B is correct. For a foreign currency option, the implied distribution gives a relatively high
price for the option. The implied volatility is relatively low for at-the-money options, but
it becomes higher as the option moves either in-the-money or out-of-the-money. Thus,
the implied distribution has heavier tails than the lognormal distribution.
Reference: John Hull, Options, Futures, and Other Derivatives, 10th Edition (New York: Pearson,
2017). Chapter 20, Volatility Smiles.
Learning Objective: Compare the shape of the volatility smile (or skew) to the shape of the implied
distribution of the underlying asset price and to the pricing of options on the underlying
asset.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
52. A wealth management firm has JPY 72 billion in assets under management. The portfolio manager computes
the daily VaR at various confidence levels as follows:
What is the closest estimate of the daily ES at the 97.5% confidence level?
Correct Answer: C
Explanation: C is correct. An estimate of the expected shortfall (ES) can be obtained by taking the
average of the VaRs for the various confidence levels that are greater than 97.5%.
Therefore,
ES = (378,412,500+392,452,500+410,880,000+439,252,500)/4 = JPY 405,249,375
Reference: Kevin Dowd, Measuring Market Risk, 2nd Edition (West Sussex, England: John Wiley &
Sons, 2005). Chapter 3, Estimating Market Risk Measures: An Introduction and Overview.
Learning Objective: Estimate the expected shortfall given P/L or return data.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
53. A newly hired risk analyst is backtesting a firm’s VaR model. Previously, the firm calculated a 1-day VaR at the
95% confidence level. Following the Basel framework, the risk analyst is recommending that the firm switch to
a 99% VaR confidence level. Which of the following statements concerning this switch is correct?
A. The decision to accept or reject a VaR model based on backtesting results at the two-tailed 95%
confidence level is less reliable with a 99% VaR model than with a 95% VaR model.
B. The 95% VaR model is less likely to be rejected using backtesting than the 99% VaR model.
C. When backtesting using a two-tailed 90% confidence level test, there is a smaller probability of incorrectly
rejecting a 95% VaR model than a 99% VaR model.
D. Using a 99% VaR model will lower the probability of committing both type 1 and type 2 errors.
Correct Answer: A
Explanation: A is correct. The concept tested here is the understanding of the difference between the
VaR parameter for confidence (here, namely 95% vs. 99%) and the validation procedure
confidence level (namely 95%), and how they interact with one another.
Using a 95% VaR confidence level creates a narrower nonrejection region than using a
99% VaR confidence level by allowing a greater number of exceptions to be generated.
This in turn increases the power of the backtesting process and makes for a more reliable
test than using a 99% confidence level.
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition. (New York: McGraw-Hill, 2007). Chapter 6, Backtesting VaR.
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54. A hedge fund risk manager is looking at various models that are flexible enough to incorporate mean
reversion and risk premium into term structure modeling. Which of the following is correct about the Vasicek
model?
A. It incorporates the mean reversion feature and its drift is always zero.
B. It incorporates the mean reversion feature and models the risk premium as a component of a constant or
changing drift.
C. It cannot incorporate risk premium and its drift is always zero.
D. It cannot capture the mean reversion feature but can be used to model the time-varying risk premium.
Correct Answer: B
Explanation: B is correct. The Vasicek model incorporates mean reversion. The flexibility of the model
also allows for risk premium, which enters into the model as constant drift or a drift that
changes over time.
Reference: Bruce Tuckman and Angel Serrat, Fixed Income Securities, 3rd Edition (Hoboken, NJ: John
Wiley & Sons, 2011). Chapter 9, The Art of Term Structure Models: Drift.
Learning Objective: Describe the process of constructing a simple and recombining tree for a short term rate
under the Vasicek Model with mean reversion.
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55. A hedge fund that runs a distressed securities strategy is evaluating the solvency conditions of two potential
investment targets. Currently firm RST is rated BB and firm WYZ is rated B. The hedge fund is interested in
determining the joint default probability of the two firms over the next 2 years using the Gaussian default
time copula under the assumption that a 1-year Gaussian default correlation is 0.36. The fund reports that xBB
and xB are abscise values of the bivariate normal distribution presented in the table below where
xBB= N-1(QBB(tBB)) and xB= N-1(QB(tB)) with tBB and tB being the time-to-default of BB-rated and B-rated
companies respectively; and QBB and QB being the cumulative distribution functions of tBB and tB, respectively;
and N denotes the standard normal distribution:
Firm RST Firm WYZ
Firm RST Cumulative Firm WYZ Cumulative
Cumulative Standard Cumulative Standard
Default Firm RST Default Normal Firm WYZ Default Normal
Time in Default Probability Percentiles Default Probability Percentiles
Year Probability QBB(t) N-1(QBB(t)) Probability QB(t) N-1(QB(t))
1 5.21% 5.21% -1.625 19.06% 19.06% -0.876
2 6.12% 11.33% -1.209 10.63% 29.69% -0.533
3 5.50% 16.83% -0.961 8.24% 37.93% -0.307
4 4.81% 21.64% -0.784 6.10% 44.03% -0.150
5 4.22% 25.86% -0.648 4.03% 48.06% -0.049
Applying the Gaussian copula, which of the following corresponds to the joint probability that firm RST and
firm WYZ will both default before the end of year 2?
Correct Answer: D
Reference: Gunter Meissner, Correlation Risk Modeling and Management (New York: John Wiley &
Sons, 2014). Chapter 4, Financial Correlation Modeling—Bottom-Up Approaches.
Learning Objective: Describe the Gaussian copula and explain how to use it to derive the joint probability of
default of two assets.
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56. A risk committee of the board of company ABC is discussing the difference between pricing deep out-of-the-
money call options on ABC stock and pricing deep out-of-the-money call options on the USD/GBP foreign
exchange (FX) rate using the Black-Scholes-Merton model. The committee considers pricing each of these two
options based on two distinct probability distributions of underlying asset prices at the option expiration date:
a lognormal probability distribution, and an implied risk-neutral probability distribution obtained from the
volatility smile for each aforementioned option of the same maturity and the same moneyness. If the implied
risk-neutral probability distribution is used instead of the lognormal distribution, which of the following is
correct?
A. The price of the option on ABC stock would be relatively high and the price of the option on USD/GBP FX
rate would be relatively low compared to those computed from the lognormal counterparts.
B. The price of the option on ABC stock would be relatively low and the price of the option on USD/GBD FX
rate would be relatively high compared to those computed from the lognormal counterparts.
C. The price of the option on ABC stock would be relatively low and the price of the option on USD/GBD FX
rate would be relatively low compared to those computed from the lognormal counterparts.
D. The price of the option on ABC stock would be relatively high and the price of the option on USD/GBD FX
rate would be relatively high compared to those computed from the lognormal counterparts.
Correct Answer: B
Explanation: B is correct. The implied distribution of the underlying equity prices derived using the
general volatility smile of equity options has a heavier left tail and a less heavy right tail
than a lognormal distribution of underlying prices. Therefore, using the implied
distribution of prices causes deep-out-of-the-money call options on the underlying to be
priced relatively low compared with using the lognormal distribution.
The implied distribution of underlying foreign currency prices derived using the general
volatility smile of foreign currency options has heavier tails than a lognormal distribution
of underlying prices.
Therefore, using the implied distribution of prices causes deep-out-of-the-money call
options on the underlying to be priced relatively high compared with using the lognormal
distribution.
Reference: John Hull, Options, Futures, and Other Derivatives, 10th Edition (New York: Pearson,
2017). Chapter 20, Volatility Smiles.
Learning Objective: Describe characteristics of foreign exchange rate distributions and their implications on
option prices and implied volatility.
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57. A CRO is concerned that a firm’s existing internal risk models are not adequate in addressing potential random
extreme losses of the firm. The CRO then recommends the use of extreme value theory (EVT). When applying
EVT and examining distributions of losses exceeding a threshold value, which of the following is correct?
A. As the threshold value is increased, the distribution of losses over a fixed threshold value converges to a
generalized Pareto distribution.
B. If the tail parameter value of the generalized extreme-value (GEV) distribution goes to infinity, then the
GEV essentially becomes a normal distribution.
C. To apply EVT, the underlying loss distribution must be either normal or lognormal.
D. The number of exceedances decreases as the threshold value decreases, which causes the reliability of
the parameter estimates to increase.
Correct Answer: A
Explanation: A is correct. A key foundation of EVT is that as the threshold value is increased, the
distribution of loss exceedances converges to a generalized Pareto distribution. Assuming
the threshold is high enough, excess losses can be modeled using the generalized Pareto
distribution. It is known as the Gnedenko–Pickands–Balkema–deHaan (GPBdH) theorem
and is heavily used in the peaks-over-threshold (POT) approach.
B is incorrect. If the tail parameter value of the generalized extreme-value (GEV)
distribution goes to zero, and not infinity, then the distribution of the original data (not
the GEV) could be a light-tail distribution such as normal or log-normal. In other words,
the corresponding GEV distribution is a Gumbel distribution.
C is incorrect. To apply EVT, the underlying loss distribution can be any of the commonly
used distributions: normal, lognormal, t, etc.
D is incorrect. As the threshold value is decreased, the number of exceedances increases.
Reference: Kevin Dowd, Measuring Market Risk, 2nd Edition (West Sussex, England: John Wiley &
Sons, 2005). Chapter 7, Parametric Approaches (II): Extreme Value
Learning Objective: Describe extreme value theory (EVT) and its use in risk management.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
58. In the Basel framework, a penalty is given to banks that have more than four exceptions to their 1-day 99%
VaR over the course of the last 250 trading days. Which of the following causes of exceptions is most likely to
lead to a penalty?
A. A large move in interest rates occurs in conjunction with a small move in correlations.
B. The bank’s model calculates interest rate risk based on the median duration of the bonds in the portfolio.
C. A sudden market crisis in an emerging market, which leads to losses in the equity positions in that
country.
D. A sudden devastating earthquake that causes major losses in the bank’s key area of operation.
Correct Answer: B
Explanation: B is correct. In the case of bad luck, no penalty is given, as would be the case for a bank
affected by unpredictable movements in rates or markets. However, when risk models
are not precise enough, a penalty is typically given since model accuracy could have
easily been improved.
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition. (New York: McGraw-Hill, 2007). Chapter 6, Backtesting VaR.
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59. A fund manager owns a portfolio of options on TUV, a non-dividend paying stock. The portfolio is made up of
5,000 deep in-the-money call options on TUV and 20,000 deep out-of-the-money call options on TUV. The
portfolio also contains 10,000 forward contracts on TUV. Currently, TUV is trading at USD 52. Assuming 252
trading days in a year, the volatility of TUV is 12% per year, and that each of the option and forward contracts
is on one share of TUV, which of the following amounts would be closest to the 1-day 99% VaR of the
portfolio?
A. USD 11,557
B. USD 12,627
C. USD 13,715
D. USD 32,000
Correct Answer: C
Explanation: C is correct. We need to map the portfolio to a position in the underlying stock TUV. A
deep in-the-money call has a delta of approximately 1, a deep out-of-the-money call has
a delta of approximately zero and forwards have a delta of 1.
The net portfolio has a delta (Dp) of about 1*5,000 + 0*20,000 + 1*10,000 = 15,000 and is
approximately gamma neutral.
Let:
α = 2.326 (99% confidence level)
S = price per share of stock TUV = USD 52
Dp = delta of the position = 15,000
σ = volatility of TUV = 0.12
Therefore, the 1-day VaR estimate at 99% confidence level is computed as follows:
α *S*Dp*σ*sqrt(1/T) = (2.326)*(52)*(15,000)*(0.12/sqrt(252)) = USD 13,714.67
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition (New York: McGraw-Hill, 2007). Chapter 11, VaR Mapping.
Learning Objective: Describe the method of mapping forwards, forward rate agreements, interest rate
swaps, and options.
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60. When measuring risk in hedge funds that hold illiquid assets using monthly data, certain biases can create a
misleading picture. For example, these hedge funds might have the appearance of low systematic risk. Which
of the following represents an appropriate means of correction?
A. Account for negative serial correlation of returns by first differencing the data when extrapolating risk to
longer time horizons.
B. Account for positive serial correlation of returns by aggregating the data.
C. Use regressions with fewer lags of the market factors and sum the coefficients across lags.
D. Use regressions with additional lags of the market factors and sum the coefficients across lags.
Correct Answer: D
Explanation: D is correct. Artificially low asset class correlations leading to the appearance of low
systematic risk is a bias faced by hedge funds with illiquid holdings that use monthly
valuation data. One way to correct for this is to use enlarged regressions with additional
lags of the market factors and to sum the coefficients across lags.
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition (New York: McGraw Hill, 2007). Chapter 17 - VaR and Risk Budgeting in
Investment Management
Learning Objective: Describe the risk management challenges associated with investments in hedge funds.
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61. If the energy asset is dropped from the portfolio and the proceeds from liquidating the asset are not
reinvested in the portfolio, what will be the reduction in portfolio VaR?
A. CNY 2,252,250
B. CNY 3,494,700
C. CNY 5,746,950
D. CNY 6,999,300
Correct Answer: C
Explanation: C is correct. If the energy asset is dropped, the portfolio will contain only the financial
asset. Then the new portfolio VaR is that of the financial asset alone (CNY 3,494,700),
which implies that dropping the energy asset will result in a reduction in portfolio VaR of
CNY 9,241,650 – CNY 3,494,700 = CNY 5,746,950
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition (New York: McGraw-Hill, 2007). Chapter 7: Portfolio Risk — Analytical Methods.
Learning Objective: Define, calculate, and distinguish between the following portfolio VaR measures:
individual VaR, incremental VaR, marginal VaR, component VaR, undiversified portfolio
VaR, and diversified portfolio VaR.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
62. What is the closest to the correct estimate for the component VaR of the financial asset?
A. CNY 3,240,000
B. CNY 3,495,000
C. CNY 6,930,000
D. CNY 7,000,000
Correct Answer: A
Explanation: A is correct.
Since Marginal VaRF = βF*(Portfolio VaR)/(Portfolio Value), the beta of the financial asset
can be computed as:
βF = (Marginal VaRF*Portfolio Value)/(Portfolio VaR) = (0.216*30,000,000)/(9,241,650) =
0.7012.
Then, Component VaR = Portfolio VaR * Beta of Asset to Portfolio * Asset Weight to
Portfolio Component (Financial Asset) = CNY 9,241,650 * 0.7012 * 0.5 = CNY 3,240,000
B is incorrect. CNY 3,495,000 is close to the individual VaR of the financial asset.
C is incorrect. CNY 6,930,000 is the component VaR of the energy asset.
D is incorrect. CNY 7,000,000 is close to the individual VaR of the energy asset.
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition (New York: McGraw-Hill, 2007). Chapter 7: Portfolio Risk — Analytical Methods.
Learning Objective: Define, calculate, and distinguish between the following portfolio VaR measures:
individual VaR, incremental VaR, marginal VaR, component VaR, undiversified portfolio
VaR, and diversified portfolio VaR.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
63. An analyst regresses the returns of 400 stocks against the returns of a major market index. The resulting pool of
alphas has a residual risk of 13.78% and an information coefficient of 0.12. If the alphas are normally
distributed with a mean of 0%, roughly how many stocks have an alpha greater than 3.24% or less than -3.24%?
A. 5
B. 15
C. 20
D. 45
Correct Answer: C
Explanation: C is correct. The standard deviation of the alphas = Residual Risk (volatility) x Information
Coefficient (IC) = 0.1378 * 0.12 = 0.016536.
3.24% is 1.96 times the standard deviation of the alphas. The alphas follow a normal
distribution with a mean of 0, so about 5% of the alphas are out of the interval [-3.24%,
3.24%]. The total number of stocks is 400, so roughly there are 20 alphas that are out of
the range.
Reference: Richard Grinold and Ronald Kahn, Active Portfolio Management: A Quantitative
Approach for Producing Superior Returns and Controlling Risk, 2nd Edition (New York:
McGraw-Hill, 2000). Chapter 14, Portfolio Construction.
Learning Objective: Distinguish among the inputs to the portfolio construction process.
Evaluate the methods and motivation for refining alphas in the implementation process.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
64. A risk analyst at an investment bank is conducting performance analyses of hedge funds and real estate funds.
Each year, whenever a hedge fund stops reporting its performance, the hedge fund is removed from the
database of hedge funds. Assets owned by the real estate funds are valued only once a year due to infrequent
trading. Which of the following best describes the impacts on the hedge fund and real estate fund analyses
performed using these databases?
A. The average Sharpe ratio of hedge funds is understated and the average Sharpe ratio of real estate funds
is overstated.
B. The average Sharpe ratio of hedge funds is overstated and the average Sharpe ratio of real estate funds is
also overstated.
C. The average volatility of hedge funds is overstated and the average volatility of real estate funds is
overstated.
D. The average volatility of hedge funds is overstated and the average volatility of real estate funds is
understated.
Correct Answer: B
Explanation: B is correct. Typically, poor performance is a reason some hedge funds stop reporting. As
poor performers drop out of the database, the average performance increases.
The removal of poor performers could actually reduce average volatility and the
correlation of returns. The Sharpe ratio tends to get inflated due to survivorship bias.
With infrequent trading, estimates of volatilities, correlations, and betas are too low
when computed using reported returns. Thus, Sharpe ratios would be higher under the
circumstances.
Reference: Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 10th Edition (New York: McGraw-
Hill, 2014). Chapter 24, Portfolio Performance Evaluation.
Andrew Ang, Asset Management: A Systematic Approach to Factor Investing (New York:
Oxford University Press, 2014), Chapter 13, Illiquid Assets.
Learning Objective: Explain the difficulties in measuring the performance of hedge funds.
Assess the impact of biases on reported returns for illiquid assets.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
65. A money manager wants to invest a small amount of new capital that has recently come into a fund. The fund
is benchmarked to an index and, rather than adding a new holding, the manager is considering increasing the
holdings of one of the four assets whose performances, during the most recent evaluation period, are
described in the following table:
The portfolio manager wants to select the asset that has the lowest marginal VaR as long as its Jensen’s alpha
is greater than or equal to the market risk premium. Assuming the risk-free rate is 3% and the market return is
8%, which asset should the portfolio manager select?
A. Asset BDE
B. Asset JKL
C. Asset MNO
D. Asset STU
Correct Answer: B
where W = VaRp/Valuep
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition (New York: McGraw-Hill, 2007). Chapter 7 - Portfolio Risk: Analytical Methods.
Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 10th Edition (New York: McGraw-
Hill, 2014). Chapter 24 - Portfolio Performance Evaluation
Learning Objective: Explain the difference between risk management and portfolio management, and
describe how to use marginal VaR in portfolio management.
Describe and distinguish between risk-adjusted performance measures, such as Sharpe’s
measure, Treynor’s measure, Jensen’s measure (Jensen’s alpha), and information ratio.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
66. A risk analyst at an insurance company has determined that a counterparty to the company has a constant
default probability of 5% per year. What is the probability that this counterparty survives the first 2 years and
defaults in year 3?
A. 4.51%
B. 5.00%
C. 9.50%
D. 15.00%
Correct Answer: A
Explanation: A is correct.
Probability (Survives the first 2 years and defaults in year 3) = (1–0.05) (1–0.05) (0.05) =
0.0451 = 4.51%.
B is incorrect. It is simply the default probability per year, which equals 5.00%.
C is incorrect. It is 2*(1–0.05) (0.05) = 9.50%
D is incorrect. It is 0.05*3 = 0.1500 = 15.00%
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 12 - Default
Probabilities, Credit Spreads, and Funding Costs
Learning Objective: Calculate risk-neutral default probabilities, and compare the use of risk-neutral and real-
world default probabilities in pricing derivative contracts.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
67. The board of directors of a manufacturing company is considering the funding risk of the defined benefit plan
of the company’s pension fund. Which of the following statements about the pension fund’s funding risk is
correct?
Correct Answer: B
Explanation: B is correct. Funding risk of a defined benefit plan is the risk that the value of the pension
plan assets will not be sufficient to meet the pension plan liabilities. If the plan has a
deficit (that is, if the surplus turns negative), the plan sponsor (the manufacturing
company) has to provide additional contributions to the fund. This additional
contribution (the funding risk) is borne by the company’s shareholders (and not by the
employees). Thus, the funding risk represents a true long-term risk to the company (plan
sponsor).
The time horizon of payouts does not eliminate funding risk. In fact, it is the mismatch
between assets and liabilities that creates funding risk. In a low interest rate
environment, the value of assets (equities on the asset side) will rise; however, the value
of liabilities is likely to increase more, thereby exacerbating funding risk. Immunizing the
portfolio, essentially matching duration of assets and liabilities, will reduce funding risk.
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition (New York: McGraw Hill, 2007). Chapter 17, VaR and Risk Budgeting in
Investment Management.
Learning Objective: Distinguish among the following types of risk: absolute risk, relative risk, policy-mix risk,
active management risk, funding risk, and sponsor risk.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
68. A portfolio manager is evaluating the risk profile for a portfolio of stocks. Currently, the portfolio is valued at
CAD 20 million and contains CAD 5 million in stock XYZ. The standard deviation of returns of stock XYZ is 15%
annually and that of the overall portfolio is 12% annually. The correlation of returns between stock XYZ and
the portfolio is 0.3. Assuming the portfolio manager uses a 1-year 99% VaR and that returns are normally
distributed, what is the estimated component VaR of stock XYZ?
A. CAD 162,972
B. CAD 234,906
C. CAD 523,350
D. CAD 632,152
Correct Answer: C
Explanation:
C is correct.
Let;
α(99%) represent the 99% confidence factor for the VaR estimate, which is 2.326,
ρ represent the correlation of stock XYZ with the portfolio, which is 0.3, and
VXYZ represent the value of stock XYZ, which is CAD 5 million.
Then,
VaRXYZ = VXYZ*σXYZ*α(99%) = CAD 5,000,000 x 0.15 x 2.326 = CAD 1,744,500
Component VaRXYZ = ρ*VaRXYZ = 0.30 x CAD 1,744,500 = CAD 523,350
Section: Risk Management and Investment Management
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition. (New York: McGraw-Hill, 2007). Chapter 7: Portfolio Risk: Analytical Methods.
Learning Objective: Define, calculate, and distinguish between the following portfolio VaR measures:
individual VaR, incremental VaR, marginal VaR, component VaR, undiversified portfolio
VaR, and diversified portfolio VaR.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
69. A newly established risk division of a regional financial institution is setting up a Monte Carlo simulation
methodology to estimate the firm’s aggregate operational loss distribution. Which of the following loss
frequency and loss severity distribution pairs is the most appropriate to use?
Correct Answer: C
Explanation: C is correct. Poisson distribution is appropriate for loss frequency while lognormal
distribution is generally used for loss severity.
Learning Objective: Explain how frequency and severity distributions of operational losses are obtained,
including commonly used distributions and suitability guidelines for probability
distributions.
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The CRO also reports the minimum regulatory capital requirements under the revised capital framework as
presented in the table below. The capital ratios also include the capital conservation buffer of 2.5% (phased-in at an
annual increment of 0.75%, starting January 2016) and a G-SIB surcharge of 3.0% (phased-in at an annual increment
of 0.625%, starting January 2016) of risk-weighted assets to be reached by January 2019:
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
70. Given the regulatory benchmarks and the bank’s performance, which of the capital requirements does Bank
LGX satisfy as of January 2017?
Correct Answer: D
Explanation: D is correct. The bank’s CET1 capital ratio = (CET 1 capital)/(risk-weighted assets)=
(1,515/26,395) = 5.74%. This ratio meets and exceeds the 5.25% minimum CET1 capital
requirement;
The bank’s leverage ratio = (Tier 1 capital)/(Exposure) = (1,515 + 100)/(47,460) = 3.40%.
This ratio does not meet the 4.0% minimum leverage ratio requirement;
The bank’s Tier 1 capital ratio = (Tier 1 capital)/(risk-weighted assets)= (1,515 +
100)/26,395) = 6.12%. This ratio does not meet the 6.75% minimum Tier 1 capital
requirement;
The bank’s Total capital ratio = (Total capital)/(risk-weighted assets)= (1,515 + 100 +
827)/26,395) = 9.25%. This ratio meets and exceeds the 8.75% minimum Total capital
requirement.
Reference: John Hull, Risk Management and Financial Institutions, 4th Edition (Hoboken, NJ: John
Wiley & Sons, 2015). Chapter 16. Basel 2.5, Basel III, and Other Post-Crisis Changes.
Learning Define in the context of Basel III and calculate where appropriate:
Objective:
• Tier 1 capital and its components
• Tier 2 capital and its components
• Required Tier 1 equity capital, total Tier 1 capital, and total capital.
Describe and calculate ratios intended to improve the management of liquidity risk,
including the required leverage ratio, the liquidity coverage ratio, and the net stable
funding ratio.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
71. In viewing the results of this capital analysis report and other considerations for Bank LGX’s capital planning,
which of the following conclusions is correct?
Correct Answer: C
Explanation: C is correct. Increasing CVA charge increases the amount of risk-weighted assets.
A is incorrect. According to Basel, the conservation buffer can only be met by additional
CET 1 capital.
B is incorrect. Derivative exposure (as well as other off-balance sheet items) are part of
the total exposure. As exposure declines, Total capital ratio increases (assuming no
change in Total capital).
D is incorrect. The NSFR = (amount of stable funding)/(required amount of stable
funding). CET 1 capital, which goes to the numerator, has a weight of 100%. Gold, which
goes to the denominator, has a weight of 50%. Thus, the increase to the numerator and
denominator will not be exactly the same, so the NSFR changes.
Reference: John Hull, Risk Management and Financial Institutions, 4th Edition (Hoboken, NJ: John
Wiley & Sons, 2015). Chapter 16. Basel 2.5, Basel III, and Other Post-Crisis Changes.
Learning Objective: Define in the context of Basel III and calculate where appropriate:
• Tier 1 capital and its components
• Tier 2 capital and its components
• Required Tier 1 equity capital, total Tier 1 capital, and total capital.
Describe and calculate ratios intended to improve the management of liquidity risk,
including the required leverage ratio, the liquidity coverage ratio, and the net stable
funding ratio.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
72. CMM’s CRO was concerned about the bank’s liquidity position and decided to review the impact of the
devaluation and other capital market events on its net stable funding ratio (NSFR). Ignoring any changes in the
market value of CMM’s sovereign debt holdings, which of the following is correct?
A. The NSFR will not be impacted by the sovereign credit rating changes because the overall sovereign debt
portfolio remains investment grade.
B. The NSFR will be reduced by the sovereign credit rating changes but this effect can be offset by selling A-
rated sovereign debt and investing the proceeds in gold.
C. The NSFR will not be impacted by the change in demand deposits because the bank’s overall deposit level
is unchanged.
D. The NSFR will be reduced by the change in demand deposits but this effect can be offset by issuing
common stock.
Correct Answer: D
Explanation: D is correct. The shift in the demand deposit base from retail demand deposits to
wholesale demand deposits with terms less than 1 year would reduce the NSFR. The
change in retail deposit behavior would likely cause a shifting of demand deposit
classification from “stable” to “less stable” also reducing the NSFR. The downward
sovereign credit migration would increase the required stable funding factor applied to
these bonds and reduce the NSFR. The issuance of common stock, which should be
classified as Tier 1 capital, would increase the NSFR.
Reference: Allan Malz, Financial Risk Management: Models, History, and Institutions (Hoboken, NJ:
John Wiley & Sons, 2011). Chapter 12 - Liquidity and Leverage.
Kevin Dowd, Measuring Market Risk, 2nd Edition (West Sussex, England: John Wiley &
Sons, 2005). Chapter 14 - Estimating Liquidity Risks.
John Hull, Risk Management and Financial Institutions, 4th Edition (Hoboken, NJ: John
Wiley & Sons, 2015). Chapter 16 - Basel II.5, Basel III and Other Post-Crisis Changes
Learning Objective: Summarize the asset liability management process at a fractional-reserve bank, including
the process of liquidity transformation.
Define liquidity risk and describe factors that influence liquidity including the bid-ask
spread.
Describe and calculate ratios intended to improve the management of liquidity risk,
including the required leverage ratio, the liquidity coverage ratio, and the net stable
funding ratio.
Define in the context of Basel III and calculate where appropriate: Tier 1 capital and its
components, Tier 2 capital and its components, required Tier 1 equity capital, total Tier 1
capital, and total capital.
Describe the motivations for and calculate the capital conservation buffer and the
countercyclical buffer introduced in Basel III.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
73. Before the devaluation of CNY, CMM’s trading desk had established a short call options position on the USD-
CNY (CNY per USD) exchange rate that was made delta-neutral through a spot USD transaction. The position
was no longer delta-neutral after the devaluation came into effect and the desk wanted to take steps to make
it delta-neutral again. The bank was concerned about whether this would involve buying or selling USD and
what impact this might have on liquidity. The trader who initiated the position suggested that, once it was
made delta-neutral, the short call options position would be an effective way to hedge the bank’s long CNY
exposure against further devaluations and that the bank should consider increasing the size of the position
accordingly. In considering this situation, what should the CRO conclude?
A. The bank will have to buy USD to make the position delta neutral, but the delta-neutral short call options
position is not an effective way to hedge an underlying long CNY exposure against further devaluations.
B. The bank will have to sell USD to make the position delta neutral, but the delta-neutral short call options
position is not an effective way to hedge an underlying long CNY exposure against further devaluations.
C. The bank will have to buy USD to make the position delta neutral, and the delta-neutral short call options
position is an effective way to hedge an underlying long CNY exposure against further devaluations.
D. The bank will have to sell USD to make the position delta neutral, and the delta-neutral short call options
position is an effective way to hedge an underlying long CNY exposure against further devaluations.
Correct Answer: A
Explanation: A is correct. If the desk had sold call options on the dollar, it had to buy dollar spot to be
delta-neutral. Because the options were more in-the-money, their absolute value delta
increased, so dollars had to be bought. This eliminates choices B and D. The delta-neutral
short-call options position would, at best, earn the risk-free rate if it was dynamically
hedged. Static hedging would likely result in losses if the CNY devalued further.
Regardless, it would not be an effective hedge for an underlying long CNY exposure.
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition (New York: McGraw-Hill, 2007). Chapter 11 – VaR Mapping.
John Hull, Options, Futures, and Other Derivatives, 10th Edition (New York, NY: Pearson,
2017). Chapter 19 – The Greek Letters (FRM Part I, Valuation and Risk Models)
John Hull, Options, Futures, and Other Derivatives, 10th Edition (New York, NY: Pearson,
2017). Chapter 20 – Volatility Smiles
Learning Objective: Describe the method of mapping forwards, forward rate agreements, interest rate
swaps, and options.
Explain how to implement and maintain a delta-neutral and a gamma-neutral position.
Describe the dynamic aspects of delta hedging and distinguish between dynamic hedging
and hedge-and-forget strategy.
Describe characteristics of foreign exchange rate distributions and their implications on
option prices and implied volatility.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
74. CMM had CNY-denominated loans outstanding to TVR, a foreign manufacturing firm that generated its
revenue in CNY. To hedge some of its risk, CMM had bought CDS protection on TVR from a bank from the
same country as TVR, Bank EP. Assuming the default probability of TVR increases unexpectedly, and the
default correlation between TVR and Bank EP is positive and remains constant, which of the following is
correct?
A. The value of the CDS will increase and CMM has a wrong-way risk with Bank EP.
B. The value of the CDS will decrease and CMM has a wrong-way risk with Bank EP.
C. The value of the CDS will increase and CMM has a right-way risk with Bank EP.
D. The value of the CDS will decrease and CMM has a right-way risk with Bank EP.
Correct Answer: A
Explanation: A is correct. Since the default probability of the reference entity (TVR) increases, the CDS
spread would widen which would increase the value of the CDS from the perspective of
CMM (buyer of the CDS). At the same time, as the default probability of TVR increases,
so will the default probability of Bank EP, given their positive correlation. Therefore, the
value of the CDS (exposure amount) is increasing as the default probability of the CMM’s
counterparty (Bank EP) is increasing. This is a wrong-way risk that CMM has with Bank
EP.
Both B and D are incorrect as the value of CDS should increase as explained in A above.
C is incorrect because CMM has a wrong-way risk, not a right-way risk, with EP.
Reference: Gunter Meissner, Correlation Risk Modeling and Management, (New York: John Wiley &
Sons, 2014). Chapter 1 - Some Correlation Basics.
Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 17 - Wrong-way
Risk.
Learning Objective: Describe financial correlation risk and the areas in which it appears in finance.
Identify examples of wrong-way risk and examples of right-way risk.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
75. A large bank is reviewing its processes and procedures to manage operational risk in accordance with best
practices established by the Basel Committee. In implementing the three lines of defense model, which of the
following statements is correct?
A. The internal audit function should serve as the first line of defense and continually validate operational
procedures used by the business lines.
B. Business line managers, as part of the first line of defense, should provide a credible challenge to the
internal audit function.
C. The corporate operational risk function, as part of the second line of defense, should challenge risk inputs
from business line managers.
D. The corporate operational risk function should serve as the third line of defense and validate model
assumptions made by senior management.
Correct Answer: C
Explanation: C is correct. The Basel three lines of defense model establishes the following lines of
defense: In the first line of defense business line managers manage the risk of their
business lines, in the second line of defense the corporate operational risk function
(CORF) reviews the risk controls put in place by the first line of defense and establishes
firm-wide risk management procedures, and in the third line of defense, an independent
review (such as an internal auditor) reviews the effectiveness of the risk controls in the
first two lines of defense. C is correct, since as part of the second line of defense, the
CORF should challenge inputs from business line managers.
A is incorrect, as internal audit is part of the third line of defense and the validation team
is generally part of the corporate risk function as part of the second line of defense.
B is incorrect, business line managers do not challenge the audit function as part of the
first line; rather, they manage the risk of the business lines.
D is incorrect, as the CORF is the second line of defense.
Reference: “Principles for the Sound Management of Operational Risk,” (Basel Committee on
Banking Supervision Publication, June 2011).
Learning Objective: Describe the three “lines of defense” in the Basel model for operational risk governance.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
76. A CRO at an investment bank has asked the risk department to evaluate the bank’s 3-year derivative exposure
position with a counterparty. The 1-year CDS on the counterparty is currently trading at a spread of 180 bps.
The table below presents trade and forecast data on the CDS spread, the expected exposure, and the recovery
rate on the counterparty:
Additionally, the CRO has presented the risk team with the following set of assumptions to use in conducting
the analysis:
• The investment bank and the counterparty have signed a credit support annex to cover this exposure,
which requires collateral posting of AUD 13 million throughout the life of the contract.
• The current risk-free rate of interest is 2% and the term structure of interest rates remains flat over the 3-
year horizon.
• Collateral and exposure values remain stable as projected over the life of the contract.
Given the information and the assumptions above, what is the correct estimate for the credit valuation
adjustment for this position?
Correct Answer: A
Explanation: A is correct. To derive the credit valuation adjustment (CVA), we use the standard
formula:
𝑛𝑛
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
𝑛𝑛
𝐶𝐶𝐶𝐶𝐶𝐶 = �(1 − 𝑅𝑅𝑅𝑅𝑡𝑡 )(𝐸𝐸𝐸𝐸𝑡𝑡 )(𝑃𝑃𝑃𝑃𝑡𝑡 )(𝐷𝐷𝐷𝐷𝑡𝑡 ) = 0.0333 + 0.0482 + 0.0586 = 0.1401
𝑡𝑡=0
C is incorrect. AUD 0.442 million is the result obtained when the recovery rate and not the
LGD is used.
D is incorrect. AUD 1.051 million is the result obtained when collateral is not considered.
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 14 - Credit and
Debt Value Adjustments.
Allan Malz, Financial Risk Management: Models, History, and Institutions (Hoboken, NJ:
John Wiley & Sons, 2011). Chapter 7, Spread Risk and Default Intensity Models.
Learning Objective: Calculate CVA and CVA spread with no wrong-way risk, netting, or collateralization.
Define the hazard rate and use it to define probability functions for default time and
conditional default probabilities.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
77. The CEO of a large bank has reported that the bank’s framework for managing operational risk is consistent
with Basel II and Basel III model for operational risk governance. Which of the following actions and principles
of the bank is correct?
A. The bank considers identification and management of risk as the second line of defense.
B. The bank considers independent review and audit of the risk processes and systems as the third line of
defense.
C. The bank includes damaged reputation due to a failed merger in its measurement of operational risk.
D. The bank excludes destruction by fire or other external catastrophes from its measurement of operational
risk.
Correct Answer: B
Explanation: B is correct. Sound operational risk governance, according to Basel, relies on three lines
of defense: (i) First line of defense - business line management, which is responsible for
identifying and managing the risks inherent in the products, activities, processes and
systems for which it is accountable; (ii) Second line of defense – an independent
corporate operational risk management function, generally complementing the business
lines’ operational risk management activities; (iii) Third line of defense – an independent
review – review and audit of the bank’s operational risk management controls, processes
and systems.
Basel II and Basel III define operational risk (inclusive of technological risk) as “the risk of
direct or indirect loss resulting from inadequate or failed internal processes, people and
systems or from external events.” Although a number of financial institutions add
reputation risk and strategic risk (e.g., due to a failed merger) as part of a broadened
definition of operational risk, they are not within the scope of definition by Basel II/III.
Reference: Principles for the Sound Management of Operational Risk, (Basel Committee on Banking
Supervision Publication, June 2011).
Learning Objective: Summarize the fundamental principles of operational risk management as suggested by
the Basel committee.
135
2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
78. A risk manager has asked a junior analyst to estimate the implied default probability for a BBB-rated discount
corporate bond. The continuously compounded annual yields of other fixed-income securities are given
below:
• 3-year Treasury note (a risk-free bond): 3%
• 1-year BBB-rated discount bond: 5%
• 2-year BBB-rated discount bond: 8%
• 3-year BBB-rated discount bond: 9%
If the recovery rate on that BBB-rated bond is expected to be 0% in the event of default, which of the
following is the best estimate of the risk-neutral probability that the BBB-rated discount bond defaults within
the next 3 years?
A. 12.29%
B. 13.76%
C. 14.61%
D. 16.47%
Correct Answer: D
Explanation: D is correct. The continuously compounded spread for the BBB-rated discount bond is
0.09 - 0.03 = 0.06 per year. Thus, the default probability for the next 3 years is: 1 - exp(-
0.06*3) = 16.47%
A is incorrect. 12.29% is the 3-year cumulative probability of default of the 3-year BBB-
rated bond while incorrectly using the credit spreads of the 1-year, 2-year, and 3-year
BBB-rated bonds, and also failing to scale the hazard rates (credit spreads) by the factor
of time.
B is incorrect. 13.76% is the result obtained as the probability of default of the 3-year
BBB-rated bond in the third year (i.e., between end of second year and end of third
year).
C is incorrect. 14.61% is the result obtained as the probability of default of the 3-year
BBB-rated bond in the third year (i.e., between end of second year and end of third year)
and incorrectly using the credit spreads of the 1-year, 2-year, and 3-year BBB-rated
bonds.
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 12 - Default
Probabilities, Credit Spreads, and Funding Costs
Learning Objective: Calculate risk-neutral default probabilities, and compare the use of risk-neutral and real-
world default probabilities in pricing derivative contracts.
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2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
79. Pension fund managers must deal with a range of policy, risk, and return requirements. Which of the following
statements about risk management in the pension fund industry is correct?
A. A pension plan’s total VaR is equal to the sum of its policy-mix VaR and active management VaR.
B. Pension fund risk analysis does not consider performance relative to a benchmark.
C. In most defined-benefit pension plans, if liabilities exceed assets, the shortfall does not create a risk for
the plan sponsor.
D. From the plan sponsor’s perspective, nominal pension obligations are similar to a short position in a long-
term bond.
Correct Answer: D
Explanation: Liabilities at a pension fund are typically composed of accumulated benefit obligations,
measured by the present value of all pension benefits owed to employees discounted by
an approximate interest rate. When liabilities consist mostly of nominal payments, their
value in general will behave like a short position in a long-term bond.
A is incorrect. The policy-mix VaR and active-management VaR do not always add up to
the total-asset VaR. In fact, there is a slightly negative correlation between the two,
leading to a lower overall asset VaR.
B is incorrect. Pension funds always benchmark their performance to a portfolio of index
funds.
C is incorrect. In fact, if the assets of a pension fund are not sufficient to cover these
liabilities, the shortfall will have to be made up by the fund’s owner.
Reference: Philippe Jorion, Value-at-Risk: The New Benchmark for Managing Financial Risk, 3rd
Edition. Chapter 17, VaR and Risk Budgeting in Investment Management.
Learning Objective: Describe the investment process of large investors such as pension funds.
137
2018 Financial Risk Manager Examination (FRM) Part II Practice Exam
80. A financial institution has a two-way credit support annex (CSA) with a counterparty covering a portfolio
valued at JPY 400 million. The margining terms of the collateralized portfolio include a threshold of
JPY 180 million, a minimum transfer amount of JPY 30 million, and a margin period of risk of 10 days. Which of
the following is correct?
A. A lower threshold value implies that a larger portion of exposure is protected by collateral.
B. A shorter margin period of risk implies that a smaller portion of exposure is protected by collateral.
C. A lower independent amount implies that a larger portion of exposure is protected by collateral.
D. The protection from collateral specified in the CSA is uniform throughout the life of the exposure profile.
Correct Answer: A
Reference: Jon Gregory, The xVA Challenge: Counterparty Credit Risk, Funding, Collateral, and
Capital, 3rd Edition (West Sussex, UK: John Wiley & Sons, 2015). Chapter 6 - Collateral
Learning Objective: Describe the terms of a collateral and features of a credit support annex (CSA) within the
ISDA Master Agreement including threshold, initial margin, minimum transfer amount
and rounding, haircuts, credit quality, and credit support amount.
138
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