Financial Risk Manager (FRM ) Examination

Sample Questions
PART I

Financial Risk Manager Examination (FRM) Sample Questions

Financial Markets and Products

1.

When a stock pays a dividend, what happens to the prices of an American call option and an American put option? a. b. c. d. Both option values increase. The call options value increases and the put options value decreases. The call options value decreases and the put options value increases. Both option values decrease.

Answer: c Explanation: American call and put options allow for early exercise. Cash dividends affect option prices, because they affect the underlying stock price. Since the stock price drops by the amount of the dividend on the ex-dividend date, the call options value decreases as well. Correspondingly, the put options value increases if the stock price decreases. Topic: Financial Markets and Products Subtopic: American options, effects of dividends, early exercise AIMS: Discuss the effects dividends have on the putcall parity, the bounds of put and call option prices, and on the early exercise feature of American options Reference: Hull, Options, Futures, and Other Derivatives, 7th Edition, Chapter 9

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Financial Risk Manager Examination (FRM) Sample Questions

2.

Consider an investor with an equity portfolio of USD 50 million. The portfolio beta relative to the S&P 500 is 2.2. The investor has bearish expectations for the next couple of months and wishes to reduce the systematic risk in her portfolio such that the portfolio beta becomes 1.5. The S&P 500 futures price is USD 1,250 and the multiplier is 250. Determine the number of futures contracts that she needs to buy or sell to accomplish this: a. b. c. d. Sell 112 futures contracts Sell 352 futures contracts Buy 112 futures contracts Buy 352 futures contracts

Answer: a Explanation: The proper trade to accomplish the investors objective is to: short the number of contracts given by: ( *) x (P/F) = number of futures contracts to be sold (2.2 1.5) x [50,000,000/(1250 x 250)] = 112 : current beta * : target beta P: portfolio value F: futures price Topic: Financial Markets and Products Subtopic: Minimum Variance Hedge Ratios AIMS: Define, compute and interpret the minimum variance hedge ratio and hedge effectiveness. Define, compute and interpret the optimal number of futures contracts needed to hedge an exposure, including a tailing the hedge adjustment Reference: John Hull, Options, Futures, and Other Derivatives, 7th Edition (Pearson, 2009), Chapter 3

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Financial Risk Manager Examination (FRM) Sample Questions

Foundations of Risk Management

1.

A high net worth investor is monitoring the performance of an index tracking fund in which she has invested. The performance figures of the fund and the benchmark portfolio are summarized in the table below: Year 2005 2006 2007 2008 2009 Benchmark Return 9.00% 7.00% 7.00% 5.00% 2.00% Fund Return 1.00% 3.00% 5.00% 4.00% 1.50%

What is the tracking error of the fund over this period? a. b. c. d. 0.09% 1.10% 3.05% 4.09%

Answer: c Explanation: Relative risk measures risk relative to a benchmark index, and measures it in terms of tracking error or deviation from the index. We need to calculate the standard deviation (square root of the variance) of the series: {0.08, 0.04, 0.02, 0.01, 0.005}. Perform the calculation by computing the difference of each data point from the mean, square the result of each, take the average of those values, and then take the square root. This is equal to 3.05%. Topic: Foundations of Risk Management Subtopic: Tracking Error AIMS: Compute and interpret tracking error, the information ratio, and the Sortino ratio Reference: Noel Amenc and Veronique Le Sourd, Portfolio Theory and Performance Analysis (John Wiley, 2003), Chapter 4The Capital Asset Pricing Model and Its Application to Performance Measurement

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Financial Risk Manager Examination (FRM) Sample Questions

Quantitative Analysis

1.

SunStar is a mutual fund with a stated objective of controlling volatility, as measured by the standard deviation of monthly returns. Given the information below, you are asked to test the hypothesis that the volatility of SunStars returns is equal to 5%. Mean Monthly Return Monthly Standard Deviation Number of Observations T-table df\p 0.40 26 27 28 29 30 0.255955 0.255858 0.255768 2.5% 4.9% 30

0.25 0.684043 0.683685 0.683353

0.10 1.314972 1.313703 1.312527 1.311434 1.310415

0.05 1.705618 1.703288 1.701131 1.699127 1.697261

0.025 2.05553 2.05183 2.04841 2.04523 2.04227

0.01 2.47863 2.47266 2.46714 2.46202 2.45726

0.005 2.77871 2.77068 2.76326 2.75639 2.75000

0.0005 3.7066 3.6896 3.6739 3.6594 3.6460

0.255684 0.683044 0.255605 0.682756

Chi-Square Table df\ 0.990 0.975 area 26 27 28 29 30 12.19815 12.87850 13.56471 14.25645 14.95346 13.84390 14.57338 15.30786 16.04707 16.79077

0.950 15.37916 16.15140 16.92788 17.70837 18.49266

0.900 17.29188 18.11390 18.93924 19.76774 20.59923

0.100 35.56317 36.74122 37.91592 39.08747 40.25602

0.050 38.88514 40.11327 41.33714 42.55697 43.77297

0.025 41.92317 43.19451 44.46079 45.72229 46.97924

0.010 45.64168 46.96294 48.27824 49.58788 50.89218

0.005 48.28988 49.64492 50.99338 52.33562 53.67196

What is the correct test to be used and what is the correct conclusion at the 5% level of significance? a. b. c. d. Chi-Square test; reject the hypothesis that volatility is 5%. Chi-Square test; do not reject the hypothesis that volatility is 5%. t-test; reject the hypothesis that volatility is 5%. t-test; do not reject the hypothesis that volatility is 5%.

Answer: b

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Financial Risk Manager Examination (FRM) Sample Questions

Explanation: Since you are trying to test population variance, it is appropriate to use the Chi-Square test for the equality of two variances: Ho : 2 = .0025 H1 : 2 .0025 with the test statistic X2 = (n 1) ^2 o o2

^ n = 30,2 = .0492= .0024,2 = .052= .0025 X2 = (29) .0024 .0025 = 27.84

For 29 observations, Chi square values at probability of 0.975 and .025 are 16.04707 and 45.72229. We reject the hypothesis if computed value is <16.04707 or >45.72229. Since the computed value is 27.84 we do not reject the hypothesis that sample standard deviation is 5% Topic: Quantitative Analysis Subtopic: Statistical inference and hypothesis testing AIMS: Define and interpret the null hypothesis and the alternative hypothesis. Define, calculate and interpret chi-squared test of significance Reference: Damodar Gujarati, Essentials of Econometrics, 3rd Edition (McGrawHill, 2006), Chapter 5

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Financial Risk Manager Examination (FRM) Sample Questions

Valuation and Risk Models

1.

Mixed Fund has a portfolio worth USD 12,428,000 that consists of 42% of fixed income investments and 58% of equity investments. The 95% annual VaR for the entire portfolio is USD 1,367,000 and the 95% annual VaR for the equity portion of the portfolio is USD 1,153,000. Assume that there are 250 trading days in a year and that the correlation between stocks and bonds is zero. What is the 95% daily VaR for the fixed income portion of the portfolio? a. b. c. d. USD USD USD USD 21,263 46,445 55,171 72,635

Answer: b Explanation: The computation follows: VaR2 (portfolio) = VaR2 (stocks) + VaR2 (fixed income), assuming the correlation is 0 (1,367,000)2 = (1,153,000)2 + VaR2 (fixed income) VaR (fixed income) = 734,357 Next convert the annual VaR to daily VaR: 734,357/(250)(1/2) = 46,445 Topic: Valuation and Risk Models Subtopic: VaR for linear and non-linear derivatives AIMS: Describe the delta-normal approach to calculating VaR for non-linear derivatives Reference: Linda Allen, Jacob Boudoukh and Anthony Saunders, Understanding Market, Credit and Operational Risk: The Value at Risk Approach (Oxford: Blackwell Publishing, 2004). Chapter 3Putting VaR to Work

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About GARP | The Global Association of Risk Professionals (GARP) is a not-for-profit global membership organization dedicated to preparing professionals and organizations to make better informed risk decisions. Membership represents over 150,000 risk management practitioners and researchers from banks, investment management firms, government agencies, academic institutions, and corporations from more than 195 countries and territories. GARP administers the Financial Risk Manager (FRM) and the Energy Risk Professional (ERP) exams; certifications recognized by risk professionals worldwide. GARP also helps advance the role of risk management via comprehensive professional education and training for professionals of all levels. www.garp.org.

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