1997 Financial Risk Manager Examination
Session I
Saturday, October 25th, 1997
Copyright 1997 The Global Association of Risk Professionals (GARP)
98 North Broadway, Suite 292, Tarrytown, NY 10591 USA
Note: Only multiple choices questions are selected here. Short essay questions are not
selected. The 1998 FRM Exam will have multiple choices questions only.
Quantitative Techniques
1. Suppose a risk manger has made the mistake of valuing a zero coupon bond using a swap (par) rate rather then a zero coupon rate. Assume the par curve is upward sloping. The risk manager is therefore:
a) indifferent to the rate used.
b) over-estimating the value of the bond.
c) under-estimating the value of the bond.
d) does not have enough information.
ANSWER: C
11. In pricing a foreign exchange option which expires in 21/2 years, a trader has volatilities for only 1 year (10%), 2 years (11%) and 4 years (9%). If he uses linear interpolation, what should the volatility of this option be?
a) 9.5%
b) 10.0%
c) 10.5%
d) 11.0%
ANSWER: C
12. A risk analyst is constructing a USD swap curve using future prices and swap yields. Which of the following approaches is appropriate?
a) Using the future prices and swap yields without any adjustments.
b) Adjusting the future prices only due to convexity effects in the market.
c) Adjusting the swap yields due to convexity effects in the market.
d) Adjusting both future prices and swap yields due to convexity effects in the market.
ANSWER: B
14. What is the implied correlation between JPY/DEM and DEM/USD when given the following volatilities for foreign exchange rates?
JPY/USD at 8%
JPY/DEM at 10%
DEM/USD at 6%.
a) 60%
b) 30%
c) -30%
d) -60%
ANSWER: D
VaR(J/U) = VaR(J/D) + VaR(D/U)
+
2std(J/D)std(D/U)
Correl(D/U)
82 = 102+62+2(6)(10)x
x = -0.6
QED
17. The measurement error in VaR, due to sampling variation, should be greater with:
a) more observations and a high confidence level (e.g. 99%).
b) fewer observations and a high confidence level.
c) more observations and a low confidence level (e.g. 95%).
d) fewer observations and a low confidence level.
ANSWER: B
20. Which of the following statements about day count basis is true?
I. Rates computed using Actual/365 and Actual/Actual are exactly the
same.
II. Rates computed using Actual/360 is always smaller than Actual/365.
III. Rates computed using 30/360 is closer to actual/360 then to actual/365.
a) I only
b) I and III only
c) I, II, and III
d) None of the above
ANSWER: D
21. The 9 month Banker's Acceptance is priced at a discount of 10% on Actual/360 basis and the 1- year Banker's Acceptance is priced at a discount of 11% on Actual/360 basis. What is the forward rate implied by those two instruments on 30/360 basis for the period from 9 months to 1 year?
a) 17.0%
b) 13.2%
c) 12.0%
d) 10.5%
ANSWER: B
Market Risk
7. Commercial rental property is usually financed with long term debt. What is the primary purpose of such financing?
a) To reduce interest rate exposure.
b) To closer match the cashflows.
c) To match assets and liabilities.
d) All of the above
ANSWER: D
10. Which currency pair would you expect to have the lowest volatility?
a) USD/DEM
b) USD/CAD
c) USD/JPY
d) USD/ITL
ANSWER: B
12. Which of the following products should have the highest expected volatility?
a) Crude oil
b) Gold
c) Japanese Treasury Bills
d) DEM/CHF
ANSWER: A
15. A measure of sensitivity of a bond's price to changes in yield is:
a) bond VaR.
b) modified duration.
c) yield spread.
d) convexity.
ANSWER: B
16. The risk of a stock or bond which is NOT correlated with the market (and thus can be diversified) is known as:
a) interest rate risk.
b) FX risk.
c) model risk.
d) specific risk.
ANSWER: D
17. A 100-year bond issue often yields only a few basis points above a similar 30-year bond from the same issuer. The reason for such a small spread is usually that a 100-year bond:
a) has a high duration.
b) is always callable.
c) has a high convexity.
d) has a low volatility.
ANSWER: C
(High convexity implies option value; this offsets risk from long maturity)
18. As compared with an identical bond without the call feature, a fixed rate coupon bond trading at par, in which the issuer has the right to pay back the principal at some day prior to maturity, has a:
a) higher convexity.
b) lower convexity.
c) higher duration.
d) lower volatility.
ANSWER: B
20. A ten year 8% coupon callable bond is priced at 103.25. The value of the imbedded call option has been calculated to be 3.25. Non-callable bonds of equal quality and maturity are currently yielding 7.50%. What is the option-adjusted yield spread between this bond and an equivalent straight bond?
a) 37 bp.
b) 50 bp.
c) 72 bp.
d) It cannot be determined from the information given.
ANSWER: B
21. What is the modified duration of a five-year zero coupon treasury bond?
a) Less than four years
b) Between four and five years
c) Five years
d) Greater than five years
ANSWER: C
23. Identify the MAJOR risks of being short 50M USD of gold two weeks forward and being long 50M USD of gold one year forward.
I. Gold Liquidity Squeeze
II. Spot Risk
III. Gold Lease Rate Risk
IV. USD Interest Rate Risk
a) II only
b) I, II, and III only
c) I, III, and IV only
d) I, II, III, and IV
ANSWER: C
24. Which of the following is NOT a property of bond duration?
a) For zero coupon bonds Macauley duration of the bond equals its years
to maturity.
b) Duration is usually inversely related to the coupon of a bond.
c) Duration is usually higher for higher yields to maturity.
d) Duration is higher as the number of years to maturity for a bond selling at par or
above increases.
ANSWER: C
25. A trader is long a five-year French IR swap with a DV01 of 100,000 and short a seven-year French IR swap with a DV01 of (100,000). Assuming current market conditions, which VaR figure at 95% confidence level 1-day holding period would be most representative of the risk of this position?
a) 0 FRF
b) 400,000 FRF
c) 3,000,000 FRF
d) 5,000,000 FRF
ANSWER: B
26. A 30-year US Treasury Bond is roughly ______ as risky as a 5-year US Treasury Bond assuming both bonds have the same market value.
a) two times
b) four times
c) six times
d) eight times
ANSWER: B
(30-year duration ~ 12 years; 5-year duration ~ 4.2 years)
27. Which of the following is NOT a risk for a German investor purchasing a USD denominated Brady Bond?
a) USD Interest Rate Risk
b) Credit Risk
c) USD/DEM Currency Risk
d) German Interest Rate Risk
ANSWER: D
29. A trader is bearish on the US bond market. Which mortgage derivative position will usually yield a profit if the trader is correct in her assumption?
a) IO (Interest Only)
b) PO (Principle Only)
c) Inverse Floater
d) None of the above
ANSWER: A
31. Which of the following statements are true regarding zero curves and forward curves?
I. When the zero curve is upward sloping, the forward curve is always
upward sloping.
II. When the zero curve is downward sloping, the forward curve is always downward sloping.
III. When the forward curve is upward sloping, the zero curve is always upward sloping.
IV. When the forward curve is downward sloping, the zero curve is always downward sloping.
a) I and II only
b) I and III only
c) III and IV only
d) I, II, III and IV
ANSWER: C
32. When modelling the market risk of a highly collateralized reverse repo, which of the following approaches is most appropriate?
a) Treat a reverse repo as a fixed rate loan.
b) Treat a reverse repo as the underlying collateral.
c) Treat a reverse repo as a fixed rate loan plus the underlying collateral.
d) Treat a reverse repo as a fixed rate loan minus the underlying collateral.
ANSWER: A
33. A risk analyst at a US bank is trying to determine the one-year forward for JPY. He knows the USD/JPY spot is at 100, the one-year JPY deposit rate is 2%, and the one-year USD deposit rate is 6%. What is the one-year USD/JPY forward rate?
a) 96
b) 100
c) 102
d) 104
ANSWER: A
x = 100(1+.02)/(1+.06)
34. A German corporate treasurer wants to hedge the risk in a USD cash flow one year later. He can use either a foreign exchange future or a foreign exchange forward to hedge all of the foreign exchange risk. What is the relationship between the notional of the future or forward required for the hedge?
a) The notional for the future is greater than that of the forward.
b) The notional for the future is less than that of the forward.
c The notional of the future may be less or greater than that of the forward depending on
the
deposit rates in both
currencies.
ANSWER: B
36. When applying a 1 bp. upward shift to a flat zero curve what is the corresponding effect on the forward curve?
a) The forward curve is shifted up by more than 1 bp.
b) The forward curve is shifted up by 1 bp.
c) The forward curve is shifted up by less than 1 bp.
d) The forward curve is shifted down by 1 bp.
ANSWER: C
37. You are asked to identify major risk factors for a portfolio of convertible bonds and currency swaps. What are the MAJOR risk factors?
I. Interest rate
II. Issuer Specific Risk
III. Foreign Exchange
IV. Equity price risk
a) I and III only
b) I and IV only
c) I, II, and III only
d) I, II, III, and IV
ANSWER: A
38. Which of the following instruments has non-linear risk to interest rates?
I. Interest swaps
II. Bonds
III. Interest futures
IV. Interest rate one-touch options
a) III only
b) IV only
c) I, II, and IV only
d) II, III and IV only
ANSWER: C Explain
(Interest futures, like the eurodollar contract, are linear in rates.)
39. An ALM manager is trying to hedge the interest rate risk of a US dollar bond with Eurodollar futures. The DV01 for the bond is $1,000. How many future contracts should he buy to hedge the interest rate risk?
a) 10
b) 40
c) 100
d) 1000
ANSWER: B
40. A risk manager is comparing a 30-year bond with a perpetual bond using duration as a measure of risk. What can be said about the duration of these bonds?
a) The duration the 30-year bond is definitely smaller than that of the
perpetual bond.
b) The duration the 30-year bond is definitely bigger than that of the perpetual bond
c) The duration the 30-year bond may be smaller or bigger than that of the perpetual bond.
d) The duration of a perpetual bond is infinite.
ANSWER: C
41. You are analyzing the risk of an option on the current inflation-proof bond issued by the US Treasury. What are the option's major risk factors?
I. Inflation
II. US Treasury bond yield
III. Change in inflation index calculation
a) II only
b) I and II only
c) II and III only
d) I, II, and III
ANSWER: C
42. What is the relationship between yield on the current inflation-proof bond issued by the US Treasury and a standard treasury bond with similar terms?
a) The yields should be about the same.
b) The yield of the inflation bond should be approximately the yield on the treasury minus
the real interest.
c) The yield of the inflation bond should be approximately the yield on the treasury plus
the real interest.
d) None of the
above
ANSWER: D
43. Which of the following statements about the S&P 500 index is true?
I. The index is calculated using market prices as
weights.
II. The implied volatilities of options of the same maturity on the index are
different.
III. The stocks used in calculating the index remain the same for each year.
IV. The S&P 500 represents only the 500 largest US Corporations.
a) II only
b) I and II only
c) II and III only
d) III and IV only
ANSWER: A
44. A trader runs a cash and future arbitrage book on the S&P 500 index. Which of the following are the MAJOR risk factors?
I. Interest rate
II. Foreign exchange
III. Equity price
IV. Dividend Assumption Risk
a) I and II only
b) I and III only
c) I, III, and IV only
d) I, II, III, and IV
ANSWER: C
45. In the commodity markets being long the future and short the cash exposes you to which of the following risks?
a) Increasing backwardation
b) Increasing contago
c) Change in volatility of the commodity
d) Decreasing convexity
ANSWER: B
46. Consider a portfolio of 100M GBP of government bonds. The modified portfolio duration is five years, and the worst increase in yields observed over a month at the 95% level was 40 bp. What is the approximate portfolio monthly VaR at the 95% level?
a) £ 5 million
b) £ 3.26 million
c) £ 2 million
d) £ 400,000
ANSWER: C
5(0.4) = % change in value
47. Assume an asset portfolio is ten million FRF and the liability portfolio is nine million FRF. If the duration of the asset portfolio and the liability portfolio is four years and five years respectively, what is the duration of the surplus, which is defined as the asset portfolio net of the liability portfolio?
a) 4.5
b) 4.47
c) 0.10
d) -5.00
ANSWER: D
10(4)-9(5)= -5.00
48. ABC bond is a zero coupon bond with a ten-year maturity. The bond is callable at 65 in five years and the investors can put the bond at 65 also in five years. Assume a flat yield curve at 10%. What is the approximate duration?
a) 10 years
b) 7 years
c) 6 years
d) 5 years
ANSWER: D
49. A money markets desk holds a floating rate note with an eight-year maturity. The interest rate is floating at three-month LIBOR rate, reset quarterly. The next reset is in one week. What is the approximate duration of the floating rate note?
a) 8 years
b) 4 years
c) 3 months
d) 1 week
ANSWER: D
50. Strip Interest Only CMOs are bonds that only pay the interest portion of mortgages. Assuming the CMO is traded at par value, the duration is ________ and the convexity is ________.
a) positive . . . negative
b) positive . . . positive
c) negative . . . negative
d) negative . . . positive
ANSWER: C
51. A risk manager would like to measure VaR for a bond. He notices that the bond has a putable feature. What affect on the VaR will this putable feature have?
a) The VaR will increase.
b) The VaR will decrease.
c) The VaR will remain the same.
d) The affect on the VaR will depend on the volatility of the bond.
ANSWER: D
52. A convertible bond trader has purchased a long dated convertible bond with a call provision. Assuming there is a 50% chance that this bond will be converted into stock, which combination of stock price and interest rate level would constitute the WORST case scenario?
a) Decreasing rates and decreasing stock prices
b) Decreasing rates and increasing stock prices
c) Increasing rates and decreasing stock prices
d) Increasing rates and increasing stock prices
ANSWER: C
53. In general, when the maturity of a USD Treasury bond increases, the volatility of the bond's price will ________ and the volatility of the bond's yield will ________.
a) increase . . . increase
b) increase . . . decrease
c) decrease . . . increase
d) decrease . . . decrease
ANSWER: C
54. Illiquid describes an instrument which:
a) does not trade in an active market.
b) does not trade on any exchange.
c) can not be easily hedged.
d) is an over-the-counter (OTC) product.
ANSWER: A
55. Consider two positions in different markets. A trader deals in the DM/$ rate, which has an annualized volatility of 12%, and another trader deals in one-year bills, with an annualized volatility of 1%; both distributions of returns are assumed normal. The foreign exchange trader returns a profit of $1 million on a notional amount of $10 million. The bill trader returns a profit of $50,000 on a notional amount of $2 million. For performance measurement purposes, VaR is defined using a one-year horizon and 99% confidence level. What are the risk-adjusted returns on capital for the currency trader and for the bill trader, respectively?
a) 0.10 and 0.025
b) 0.83 and 2.49
c) 0.05 and 0.02
d) 0.36 and 1.07
ANSWER: D
Risk Measurement Techniques
2. Historical simulation is generally NOT used for which of the following?
a) Taking into account implicit historical correlations in a portfolio
b) Forecasting market volatility
c) Back-testing
d) Calculating portfolio VaR
ANSWER: C
3. One advantage of historical simulation over the variance-covariance method when measuring market risk is that historical simulation allows you to:
a) apply RiskMetrics(tm)
b) use GARCH analysis.
c) compute VaR using exponential weighting.
d) analyze the distribution of P/L.
ANSWER: D
4. The use of scenario analysis allows one to:
a) assess the behavior of portfolios under large moves.
b) research market shocks which occurred in the past.
c) analyze the distribution of historical P/L in the portfolio.
d) perform effective back-testing.
ANSWER: A
5. Which of the following would NOT be an appropriate methodology for calculating interest rate VaR?
a) Historical simulation
b) Monte Carlo simulation
c) Principal components analysis
d) None of the above
ANSWER: D
6. Making offsetting commitments to minimize the impact of adverse market movements is referred to as a:
a) reverse repo.
b) back to back.
c) settlement transaction.
d) hedge.
ANSWER: D
7. To convert VaR from a one day holding period to a ten day holding period the VaR number is generally multiplied by:
a) 2.33
b) 3.16
c) 7.25
d) 10.00
ANSWER: B
9. Which of the following models is used to estimate future volatility?
a) GARCH Model
b) Hull-White Model
c) Black-Scholes Model
d) GARP Model
ANSWER: A
12. Delta-normal, historical-simulation, and Monte-Carlo are various methods available to compute VaR. If underlying returns are normally distributed, then the:
a) delta-normal method VaR will be identical to the
historical-simulation VaR.
b) delta-normal method VaR will be identical to the Monte-Carlo VaR.
c) Monte-Carlo VaR will be approach the delta-normal VaR as the number of replications
("draws") increases.
d) Monte-Carlo VaR will be identical to the historical-simulation VaR.
ANSWER: C
15. The standard VaR calculation for extension to multiple periods assumes that returns are serially uncorrelated. If prices display trends, the true VaR will be:
a) the same as the standard VaR.
b) greater than standard VaR.
c) less than standard VaR.
d) unable to be determined.
ANSWER: B
Regulatory and Compliance
1. Why is back-testing performed? To:
a) estimate statistical parameters.
b) shock the portfolio with large market moves.
c) compare historical and implied volatilities.
d) check the validity of VaR models.
ANSWER: D
2. The pre-commitment approach is a proposal from the Federal Reserve Bank to:
a) reduce capital requirements for the US banks.
b) allow banks to allocate capital based on internal models.
c) to perform independent monitoring of systemic risk.
d) to revise trading policy for banks.
ANSWER: B
3. To develop an effective risk management function within a large financial institution, the head of risk management should report to whom?
a) The head of trading
b) The head of IT
c) The board of directors
d) Depends on the institution
ANSWER: C
4. What did The Group of 30 develop?
a) A set of risk management principles
b) A regulatory framework for the Federal Reserve and the BIS
c) A manual for derivatives users
d) A set of recommendations for international futures exchanges
ANSWER: A
5. Some large losses occurred in the past from derivatives trading because:
a) derivatives brokers significantly over-charged their clients.
b) institutions did not understand the leverage of their transactions.
c) money managers engaged in intra-day trading.
d) money managers embezzled money using derivatives.
&nbs