2011 Fi a c l a l Risk Manager Exami nation (FRM') Pract!

ce Exam

5, John is forecasting a stock's performance in 201 0 conditional on the state of the economy of the country in
which the flrm is based. He divides the economy's performance into three categories of " GOOD ' NEUTRAL"
and "POOR" and the stock's perfo rmance into three categories of " increase" , constant " and "decrease "

He estimates

The probability that the state of the eco nomy is GOOD is 20%. If the state of the economy is GOOD , the
probability that the stock price in creases is 80% and the pro bability that the stock price dec reases is 10% .
The probability that the state of the econo my is NEUTRAL is 30% . If the state of the economy is
NEUTRAL , the probability that the sto ck price increases IS 50% and the probabilit y that the stock pri ce
decreases is 30%.
. If the state of the economy is POO R, the probability that the stoc k price increases is 15% and the
probability that the stock price is 70 %.

Bill y, his supervisor, asks him to estimate the probability that the state of the econ o my is NEUTRAL gi v en that
the stock performance is constan t. John's b est assessment o f that probability is closest to

a. 15.5%

b , 19.6%

c:. 20.0%

d. 38.7%

Answer: d

Explanation:
Use Bayes ' Theorem :

P( NEUTRAL I Co nstant) = P(Constant I Neutral) * P(Neutral) / P(C o nstant)

= 0.2 0 .3 / (0.1 0 .2 + 0.2 * 0 .3 + 0 .15 * 0. 5) = 0 .387

a: This is the Prob ( Constant)

b: This is the Prob(Constant)
c: This is the Prob(Neutra I Decrease)

Topic: Quantitative Anal ysis

Subtopic: Probability Distributions
AIMS: Define Bayes' the o rem and apply Bayes' formula to determine the pro bab ility o f an event
Reference: Dam o dar Gujarati , Essentials of Econometri cs, 3rd Edition, Chapter 2 (New York: McGraw-Hill , 200 6

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2011 Financial Risk Manager Examination (FRM Practice Exam

9. If the daily, 95% confidence level , value-at-risk (VaR) of a portfolio is correctly estimated to be USD 10 , 000 ,
one would expect that in one out of

a. 20 days the portfolio value w ill decline by USD 10 ,000 or less.

b. 95 days . the portfolio value will decline by USD 10 ,000 or less
c_ 95 days , the portfolio value will decline by USD 10 ,000 or more
d, 20 days the portfolio va lue will decline by USD 10 ,000 or more

Answer: d.

Explanation:

If the daily. 95% confidence level Value at Risk (VaR) of a portfolio is correctly estimated to be USD 10 ,000 , one

would expect that 95% of the time (19 out of 20) , the portfolio will lose less than USD 10 ,000; equivalently, 5% of

the time (1 out of 20) the portfolio will lose USD 10 ,00 0 or more.

opic :
Foundation of Risk Management

Subtopic: Creating Value with Risk Management

AIMS: Define value-at-risk (VaR) and describe how it is used in risk management

Reference: Philippe Jorion , Va/ue-at-Risk: The New 8enchmark for Managing Fnancia/ Risk, 3rd Edition (New York:

cGraw-Hill 2007). Chapter 1-The Need for Risk Management

10. Tom is evaluating 4 funds run by 4 independent managers relative to a benchmark portfolio that has an
expected return of 6 .4% and volatility of 12%. He is inter sted in irlesting in the fund wi th the highest
information ratio that also meets the following conditions in his investment guidelines:

Expected resiclual return must be at least 2%

11 The Sharpe ratio must be at least 0 .2

Based on the fOllowing information and a risk free rate of 5% , which fund should he choose?

Fund Expected Return Volatility Residual Risk Information Ratio

Fund A 8 .4% 143% 11
Fund B 16 .4% 2.4% 0 .9
Fund C 17. 8 % 1.5% 1.3
Fund D 8.5% 19.1% 1. 8%

a. Fund A
b, Fund B
c. Fund C
d. Fund D

Answer: a

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2011 Financial Risk Ma age r Exa.-" i I at i on (FRM ') Drac tice Exam

12. On Nov 1, Dane Hudson , a fund manager of an USD 50 million US large cap equity portfolio , considers locking
up the profit from the recent rally The S&P 500 index and its futures with the multiplier of 250 are trading at
USD 1,000 and USD 1,100 , respectlvely , Instead of selling off his holdings , he would rather hedge his market
exposure over the remaining 2 months Given that the correlation between Dane's portfolio and the S&P 500
,

index futures is 0 92 and the volatilities of the equity fund and the futures are 0.55 and 0 .4 5 per year
,

respectively, what position should he take to achieve his objective?

a. Sell 40 futures contracts of S&P 500

b, 5ell 135 futures contracts of S&P 500

c. Sell 205 futures contracts of S&P 500

d, 5ell 355 futures contracts of S&P 500

Answer : c

Explanation:
The calculation is as follows
The equity fund is worth USD 50 million . The Optimal hedge ratio is given by
h = 0 ,92 * 0 ,55 / 0 , 45 =1,124
The number of futures contracts is given by

N = 1,124 50 ,000 ,000 / (1 ,100 250) = 204 ,36" 205 , round up to nearest integer,

Topic: Financial Markets and Products

Subtopic: Minimum Variance Hedge Ratio
AIMS: Define , compute and interpret the o ptimal number of futures contracts needed to hedge an exposure ,
including a tailing the hedge" adjustment
Reference: Hull , tions F u tures and Other Derivatives, 7th Editio Chapter 3

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, ,

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 2011 Financial Risk Manager Examination (FR M P rlctlc e Exam

13. In late June , Simon purchased two September si'l ver futures contract s. Each contract si;!:e is 5 ,000 ounces of
silver and the futures price on the date of purchase was USD 18.62 per ounce. The broker requires an initial
margin of USD 6 ,000 and a malntenance margin of USD 4 .500. You are given the foliowing price history f o r
the September silver futures

Oay Futures Price (USO) Oaily Gain (Loss)

June 29 18.62 O
June 30 18.69 700

3
()(())()
()U(
J80
July 1 1803
July 2 17.72

nu ()
July 6 18.00
July 7 17.70

July 8 17.60

On which days did Simon receive a margin cali?

a. July 1 only
b. July 1 and July 2 only
c. July 1, July 2 and July 70 nly
d. July 1, July 2 and July 8 only

Answer: b

Explanation:
Here is the complete h tory of the margin account and margin calls

Day Futures Daily Cumulative Margin Account Margin Call

Price Gain (Loss) Gain (Loss) Balance
6/29/ 2010 18.62 6 ,000 O
6/ 30/2010 18.69 700 700 6.700 O
'/1/2010 18.03 -6 ,600 -5 ,9 00 100 5 ,900
, / 2/ 2010 17.72 -3.100 -9 .000 2.900 3 ,100
, /6/2010 18.00 2 ,800 -6.20 0
-9 .200
8.800 O
O
/ /2010 17. 70 3 .000 5 ,800
, /8/ 2010 17. 60 -1. 000 -10 ,200 4.800 O

Margin calls happened on July 1 and Jul y 20nly.

Topic: Financial r1arkets and Products

Subtopic: Futures , forwards , swaps and options
AIMS:Describe the rationale for margin requ irements and explain how they work
Reference: John Huli , 0 tions Futures and Other Deriva tives, 7th Edition (New Yor k: Pearso n , 2009) Chapter 2
Mechar ics of Futures Marke t.s.

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2011 Fina cia l Risk Manager Examination (FRM' ) Practice Exam

14. The yi Id curve is upward sloping. You have a short T-Bond interest rate futures position . The following
bonds are eligible for delivery:

Bonds Spot-Price(USD) Conversion Factor Coupon Rate

A 102.40 0.8 4%
B 100 .4 0 1.5 5%
C 99.60 1.1 3%

The futures price is USD 104 and the matunty date of th contract is Septen ber 1. The bonds pay their
coupon amount semi-annually on June 30 and December 3 1. With these data , which bond is che apest-to
deliver?

a. Bond A
b. Bond B
c. Bond C
d. Insufficient information to determine

Answer: b

Explanation:

The cheapest to deliver bond on maturity is defined to be the one for w hich the adjusted spot price is the lowest

Adjusted Spot Price = Spot Price / Conversion factor. Computation of adjusted price is shown below for each of the

bonds:

Bond A = 102.4 /0.8 = 128%

Bond B =100 .4 / 1. 5 = 67%

Bond C = 99.6 /1.1 = 91%

So. bond B is the cheapest to deliver bond and option c is correct.

Topic: Financial Markets and Products

SUbtopic: Cheapest to deliver bond , conversion factors

AIMS: Describe the impact of the level and shape of the yield curve on the che apest-to-deli ver bond decision

Reference: Hull , Options Futures and Other Den atives 7th Edto Chapter 6.

15. A stock index is valued at USD 800 and pays a continuous dividend at the rate of 3% per year. The 6-month
futures contract on that index is trading at USD 758. The continuously compounde d risk free rate is 2.5%
per year. There are no transaction cost5 or ta xes. 15 the futures contract priced so that there is an arbitrage
oppo rtunity? If yes , w hich of the foliowing numbers comes closest to the arbitrage profit you could realize by
taking a position in one futures contract?

a. 38
b, 40
c. 42
d. There is no arbitrage op portunity.

Answer: b

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2011 F1nancia l sk Manager Examination (FR " ) Pra cti ce Exam

20. Assume that options on a non dividend paying stock with price of USD 150 expire in a year and all have a
strike price of USD 140 , The risk -free rate is 8% , Which of the following values is ciosest to the Black-Scholes
values of these optlons assuming N(d 1) = 0 7327 and N(d 2 ) = 0 6164
, ,

a. Value of Am rican call option is USD 30 , 25 and of American put option is USD 9 .4 8
b. Value of American call option is USD 9 , 48 and of American put option is USD 30 , 25
c. Value of American call option is USD 30 , 25 and of American put option is USD 0 , 00
d. Value of Ame r ican call option is USD 9 , 48 and of American put option is USD 0 , 00

Answer: a ,

Explanation .
a: is correct , With the given data the value of European call option is USD 30 , 25 and value of European put o ption
is USD 9 ,48 , We know that American options are neve r less than cor responding Euro pean option in valuation , Also,
the American call option price is exactl y the same as the European call option price under the usual Black-Scholes
world with no dividend Thus only 'a ' the correct option
,

Topic: Valuation and Risk Models

Subtopic: Black-Scholes-Merton m ode l
AIMS: Compute the value of a European option usi 9 the Black-Scholes-Merton model on a non-dividend-paying
stock
Reference: Hull , 0 tions Futures, and Other erivatives 7th Editio Chapter 13-The Black-Sch ole s-M rton Model

21. Which of the following portfolios would ha ve the highest vega assuming all options invol ved are of the same
strikes and maturities?

a. Long a call
b. Short a put
c. Long a put and long a call
d. A short of the underlying , a short in a put , and a long in a call

Answer: c

Explanation:
a and b are standard cal l/p c is a straddl d is a col,lar. A collar limits exposure to vol atility, while a straddle
increases this exposure Vega is the sensitivity of a portfol io to volatility

Topic: Valuation and Risk Mo dels

Subtopic: Greek Letters
AIMS: Define , compute and describe delta , theta , gamma , veg a, and rho for option positions
Reference: Hull tio ns Futures, and Other Derivatives, 7th Edition , Chapter 17

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 2011 F j 3 c l al Risk Manager E xa mi r tion (FRM ' ) Pract ice Ex am

22. Which of the following statements is incorrect , given the following one-year rating transition matrix?

From/To (%) AAA AA A BBB BB B CCC/C D Non Rated

AAA 8 7. 44 7.37 0.46 0.09 0 .06 0.00 0.00 0.00 4 .59
AA 060 86.65 7.78 58 0 .06 0 .11 0.02 0.01 4 .2 1
A 0.05 205 86.96 5.50 0.43 0.16 0.03 0 .04 4 .79
BBB 0 .02 0.21 3.85 84.13 4 .39 0.77 0.19 0.29 6.14
BB 0.04 0 .08 0.33 5.27 75 .7 3 7. 36 0.94 1.2 0 9.06
B 0 .00 0 .07 0.20 0 .28 5.21 7295 4.23 5 .7 1 11 .36
CCC/C 0 .08 0.00 0.31 0.39 1.3 1 9.74 46 .83 28.83 12.52

a. 'AA loans have 0% chance of ever defaulting

b. 'AA' loans have a 86.65% chance of staying at AA for one year
C. loans have a 13 .04% chance of receiving a ratings change.
d. 'B BB ' loans have a 4.08% chance of being upgraded in one year.

Answer: a.

Explanation:

AAA loans can default eventually, through consecutive downgrading , even though they are calculated to not default

In one year.

AA AA is 86.65%

A A is 86.96%

BBB AAA/AA/A (sum) = 4.08%

Topic: Valuation and Risk Models

Subtopic : Credit transition matrices

AIMS: Define and explain a ratings transition matrix and its elements

Reference: Caouette , Altman. Narayan an and Nimmo . Managing Credit Risk, 2nd Editio n. Chapter 6- The Rating

Agencies

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 2011 Fi nallcial Risk Manager Examlnatio n ( FR ' ) prac ti ce Exam

25. Which of the following statements is correct?

1. The Rho of a call option changes with the passage of time and tends to approach zero as expiration
approaches , but this is not true for the Rho of put options
11. Theta is always negative for long calls and long puts and positive fo r short calls and short puts

a. lonly
b. 11 only
c. 1and 11
d. Ne ither

Answer: b

Explanation:
Statement 1 is false rho of a call and a put will change , with expiration of time and it tends to approach zero as
expiration approaches
Statement 11 is true

Topic: Valuation and Risk Models

Subtopic : Greek Letters
AIMS: Define , compute and describe delta. theta , gamma , vega , and rho for option positions
.R eference: John Hull tions Futures and Other Derivatives, 7th Edition CNew York: Prentice Hall , 2009)

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