BT P1-Interactive-Full-Mock-2-v5

Licensed to Guru. Downloaded November 13, 2020.
The information provided in this document is intended solely for you. Please do not freely distribute.
Part 1
Bionic Turtle FRM Full-Length Mock Exam 2
By David Harper, CFA FRM CIPM

www.bionicturtle.com
QUESTION 1: RISK TYPOLOGY .............................................................................................. 8

QUESTION 2: STATIONARY TIME SERIES ............................................................................. 8
QUESTION 3: LOOKBACK AND ASIAN (EXOTIC) OPTIONS ................................................. 9
QUESTION 4: CREDIT LOSS DISTRIBUTION ......................................................................... 9
QUESTION 5: PRIMITIVE RISK FACTORS AND TAIL RISK ..................................................10
QUESTION 6: REGRESSION DIAGNOSTICS .........................................................................10
QUESTION 7: OPTION SPREAD STRATEGIES .....................................................................11
QUESTION 8: INTERNAL RATING SYSTEMS & EXTERNAL CREDIT RATINGS .................11
QUESTION 9: RISK MANAGEMENT BUILDING BLOCKS .....................................................12
QUESTION 10: MULTIPLE REGRESSION ..............................................................................12
QUESTION 11: PROPERTIES OF STOCK OPTIONS .............................................................13
QUESTION 12: PREDICTING SOVEREIGN DEFAULT ...........................................................13
QUESTION 13: RISK APPETITE AND HEDGING ...................................................................14
QUESTION 14: STATIONARY TIME SERIES ..........................................................................14
QUESTION 15: CHOOSER AND BARRIER (EXOTIC) OPTIONS ...........................................15
QUESTION 16: KEY RATES VERSUS PARTIAL-01S VS FORWARD-BUCKETS .................15
QUESTION 17: RISK MANAGEMENT GOVERNANCE...........................................................16
QUESTION 18: LINEAR REGRESSION MODELS ..................................................................17
QUESTION 19: US TREASURY BONDS .................................................................................18
QUESTION 20: MULTI-FACTOR INTEREST RATE RISK MODELS .......................................18
QUESTION 21: CREDIT RISK TRANSFER MECHANISMS ....................................................19
QUESTION 22: P-VALUE AND CONFIDENCE INTERVALS...................................................19
QUESTION 23: EURODOLLAR FUTURES CONTRACTS & DURATION-BASED HEDGING 20
QUESTION 24: EFFECTIVE DURATION AND CONVEXITY ...................................................20
QUESTION 25: MODERN PORTFOLIO THEORY ...................................................................21
QUESTION 26: COSKEWNESS AND COKURTOSIS .............................................................21
QUESTION 27: GAP, FORWARD START & COMPOUND EXOTIC OPTIONS .......................22
QUESTION 28: COUPON EFFECT AND CARRY ROLL-DOWN SCENARIOS .......................22
QUESTION 29: PERFORMANCE MEASURES .......................................................................23
QUESTION 30: CONDITIONAL EXPECTATIONS AND THE I.I.D. PROPERTY......................24
QUESTION 31: FOREIGN EXCHANGE (FX) FORWARDS .....................................................24
QUESTION 32: GROSS VERSUS NET BOND RETURNS ......................................................25
QUESTION 33: MULTIFACTOR MODELS ..............................................................................25
QUESTION 34: COMMON UNIVARIATE RANDOM VARIABLES ...........................................26
QUESTION 35: PAR YIELD, CONVEXITY AND TERM STRUCTURE THEORIES..................26
2
QUESTION 36: FLATTENING AND STEEPENING OF RATE CURVES .................................27

QUESTION 37: RISK DATA AGGREGATION AND REPORTING PRINCIPLES ....................27
QUESTION 38: RANDOM VARIABLES ...................................................................................28
QUESTION 39: DURATION, MODIFIED DURATION AND DOLLAR DURATION ...................28
QUESTION 40: SPOT, FORWARD AND PAR RATES ............................................................29
QUESTION 41: ENTERPRISE RISK MANAGEMENT (ERM) ..................................................29
QUESTION 42: PROBABILITIES AND BAYES RULE ............................................................30
QUESTION 43: SPOT AND FORWARD RATES .....................................................................30
QUESTION 44: DISCOUNT FUNCTION AND THE LAW OF ONE PRICE ..............................31
QUESTION 45: ENTERPRISE RISK MANAGEMENT (ERM) ..................................................31
QUESTION 46: ONE- VERSUS TWO-TAILED HYPOTHESIS TESTS.....................................32
QUESTION 47: OPTIMAL CROSS-HEDGE & REDUCING PORTFOLIO BETA .....................32
QUESTION 48: DELTA HEDGING, SCENARIO ANALYSIS & PORTFOLIO INSURANCE ....33
QUESTION 49: LEARNING FROM FINANCIAL DISASTERS .................................................33
QUESTION 50: BAYES' THEOREM ........................................................................................34
QUESTION 51: FUTURES CONTRACTS ................................................................................35
QUESTION 52: FUTURES DELTA AND DYNAMIC DELTA HEDGING ..................................35
QUESTION 54: CENTRAL LIMIT THEOREM AND MIXTURE DISTRIBUTIONS ....................36
QUESTION 55: HEDGING VERSUS SPECULATION ..............................................................36
QUESTION 56: BLACK SCHOLES..........................................................................................37
QUESTION 58: SKEW, KURTOSIS, COSKEW AND COKURTOSIS ......................................38
QUESTION 59: MUTUAL FUNDS ............................................................................................38
QUESTION 60: LOGNORMAL PROPERTY OF STOCK PRICES & BLACK-SCHOLES ........39
QUESTION 61: ANATOMY OF THE GREAT FINANCIAL CRISIS ..........................................39
QUESTION 62: GAUSSIAN COPULA .....................................................................................40
QUESTION 63: INSURANCE COMPANY REGULATIONS AND PENSION FUNDS ...............40
QUESTION 64: BINOMIAL MODEL .........................................................................................41
QUESTION 65: GARP CODE OF CONDUCT ..........................................................................41
QUESTION 66: BIVARIATE NORMAL DISTRIBUTION ..........................................................42
QUESTION 67: LIFE INSURANCE PRODUCTS AND MORTALITY TABLES ........................43
QUESTION 68: SPECTRAL RISK MEASURES.......................................................................43
QUESTION 69: POLICY RESPONSES & EFFECTS OF GLOBAL FINANCIAL CRISIS .........44
QUESTION 70: CORRELATION ..............................................................................................44
3
QUESTION 71: LONG AND SHORT HEDGES ........................................................................45

QUESTION 72: PUTTING VALUE AT RISK (VAR) TO WORK ................................................45
QUESTION 73: MULTIFACTOR MODELS ..............................................................................46
QUESTION 74: LINEAR AND NONLINEAR TRENDS .............................................................46
QUESTION 75: COST OF CARRY AND NORMAL BACKWARDATION.................................47
QUESTION 76: STRESS TESTING VALIDATION AND INTERNAL AUDIT ............................47
QUESTION 77: FAMA-FRENCH THREE FACTOR MODEL....................................................47
QUESTION 78: BOOTSTRAPPING .........................................................................................48
QUESTION 79: QUOTED VERSUS CASH BOND PRICES .....................................................48
QUESTION 80: VALUE AT RISK (VAR) ESTIMATION APPROACHES..................................49
QUESTION 81: GETTING UP TO SPEED ON THE FINANCIAL CRISIS.................................50
QUESTION 82: SAMPLE MOMENTS AND BIAS ....................................................................50
QUESTION 83: SWAPS ...........................................................................................................50
QUESTION 84: CLASSICAL VALUE AT RISK (VAR) .............................................................51
QUESTION 85: PRINCIPLES FOR RISK DATA AGGREGATION...........................................51
QUESTION 86: HYPOTHESIS TESTING .................................................................................52
QUESTION 87: OPTION COMBINATION STRATEGIES .........................................................52
QUESTION 88: STRESS TESTING AND RISK MANAGEMENT TOOLS ................................53
QUESTION 89: CREDIT CRISIS OF 2007 ...............................................................................53
QUESTION 90: BLUE ESTIMATORS, LAW OF LARGE NUMBERS (LLN), AND CENTRAL
LIMIT THEOREM (CLT) ...........................................................................................................54
QUESTION 91: EXCHANGE OPTION, VOLATILITY SWAP, AND STATIC OPTION
REPLICATION..........................................................................................................................54
QUESTION 92: KEY RATE EXPOSURE TECHNIQUE IN MULTI-FACTOR HEDGING
APPLICATIONS .......................................................................................................................55
QUESTION 93: MECHANISMS FOR TRANSMITTING RISK GOVERNANCE ........................55
QUESTION 94: LINEAR TRANSFORMATION OF COVARIANCE AND CORRELATION ......56
QUESTION 95: PROPERTIES OF STOCK OPTIONS .............................................................56
QUESTION 96: EXTERNAL CREDIT RATING SCALES .........................................................57
QUESTION 97: TYPES OF RISK .............................................................................................57
QUESTION 98: PROBABILITY MATRIX.................................................................................58
QUESTION 99: ARBITRAGE AND THE COST OF CARRY MODEL ......................................58
QUESTION 100: SWAP RATES VERSUS SPOT RATES .......................................................59
ANSWERS & EXPLANATIONS ...............................................................................................63
4
Candidate Answer Sheet: Mark an X under your answer of choice.
Question # Answer A Answer B Answer C Answer D

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
5

41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
6

81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
7
Question 1: Risk typology

The classic risk management process affirms the job of a risk manager to include four activities:
identifying risks; analyzing and measuring risks; assessing the impact of risk events; and
managing risks. This process culminates in the series of decisions as to how to handle identified
risks. Which of the following is (TRUE as) a common activity of the risk manager?
a) To either avoid or transfer each risk

b) To quantify every risk in an exact way; i.e., single number
c) To eliminate each risk to the fullest extent possible
d) To help identify where the firm should add risk
Question 2: Stationary Time Series

Below are a set of innovations over ten steps (from initial t = 0 to t = 10) and the first innovation
ε(1) = 0.26. The innovations are random Gaussian white noise, ε(t) ~ N(0, σ^2 = 1).
Consider two time series models. The AR(1) model has an intercept, δ, of 0.70, and an AR
parameter, φ, of 0.50. The MA(1) model has a mean, μ, of 0.70, and a weight of 0.50. Which of
the following is nearest the value at t = 4; i.e., which are the missing values inside the red
rectangle?
a) AR(1) = 1.7650 and MR(1) = 1.2100

b) AR(1) = 1.9630 and MR(1) = 1.8550
c) AR(1) = 2.8600 and MR(1) = 2.2570
d) AR(1) = 3.2430 and MR(1) = 2.6800
8
Question 3: Lookback and Asian (exotic) options

Consider the price of an asset that begins and $30.00 and ends, after 20 periods, lower at
$8.55. Also highlighted are its maximum ($39.23) and minimum price ($6.79) during this 20-
period life:
Among the following choices, which lookback

option has the HIGHEST payoff if its life matches
the 20-period interval shown?
a) Floating lookback call

b) Floating lookback put
c) Fixed lookback call with strike = $30.00
(matching the initial asset price)
d) Fixed lookback put with strike = $30.00
(matching the initial asset price)
Question 4: Credit loss distribution

Consider a large $20.0 million portfolio of 100 loans. In its general form, the portfolio's
unexpected loss is given by:1
However, each loan in this portfolio has approximately the same characteristics and size; i.e.,
the size of each is about $200,000. For modeling purposes, we can set the pairwise correlation
coefficient to be constant ρ(i,j) = 0.160 for all i ≠ j. These assumptions greatly simplify the
calculation of the portfolio's unexpected loss and each loan's contribution to portfolio risk.
In this situation, which of the following statements is TRUE?
a) A practical problem with using the general form (i.e., specifying the correlation matrix) is
that default correlations are very difficult to observe
b) Under the simplifying assumptions, each loan's risk contribution (aka, unexpected loss
contribution, ULC) is conveniently 16.0% of its individual unexpected loss, UL
c) If we attempted to estimate the portfolio's unexpected loss by specifying the pairwise
correlation matrix of each ρ(i,j), then we would require 100! or 9.3E+157 correlation pairs
d) When estimating the portfolio's unexpected loss and its component contributions, banks
prefer these analytical approaches over numerical procedures because the latter are
cumbersome and prone to estimation errors
1
Gerhard Schroeck, Risk Management and Value Creation in Financial Institutions, (New York: Wiley, 2002
9
Question 5: Primitive risk factors and tail risk

A big part of a risk manager's job is to identify her firm's risk factors. Each of the following
statements about risk factors is true EXCEPT which is false?
a) Two examples of primary (aka, primitive) risk factors include the return on a broad stock
market index and the risk-free spot (aka, zero) interest rate
b) For any risk factors that are represented by categorical or discrete variables, the risk
manager should seek to replace them with either interval, ratio, or continuous risk factor
variables
c) One of the risk manager's key activities is to deconstruct primitive risk factors into the
important loss drivers, the relationship of the loss drivers with each other, and the wider
business environment
d) Machine learning, as a subset of artificial intelligence, holds the potential to help risk
managers identify the "unknown unknowns" (aka, unk-unks)
Question 6: Regression diagnostics

Below are displayed 15 pairwise (X,Y) trials. The simple regression line based on all 15
observations is given by Y1 = 0.488 + 0.425*X. We consider the possibility that the 12th Trial,
given by point (X = 2.50, Y = -3.00) might be an outlier. If this point is removed, then the
regression based on the remaining 14 observations is given by Y2 = 0.761 + 0.574*X. These
results are displayed, including selected summary statistics.
According to Cook's distance, is the

12th Trial an outlier?
a) No, because its Cook's

distance is negative
b) No, because its Cook's
distance is 3.341/(2*1.916)
= 0.872
c) Yes, because its Cook's
distance is +0.15 (as given
by the slope change)
d) Yes, because its Cook's
distance is 1.916/(2*0.223)
= +4.301
10
Question 7: Option spread strategies

Assume the current price of a stock is $30.00 and imagine that we can only trade the following
four options at two strike prices:
 At a strike price of $28.00, we can employ either a call or a put, where c(K=28.00) =
$3.98 and p(K=28.00) = $1.46
$2.05 and p(K=32.00) = $3.46
Each of these prices is approximately accurate for a six-month option when the volatility is
31.2% (but these details are not necessary to answer the question). If we want to implement a
bull spread, how could we do that?
a) We cannot create a bull spread with these options

b) Long the call with strike of 32.00 plus Short the put with strike of 28.00
c) Long the call with strike of 28.00 plus Short the call with strike of 32.00; or Long the put
with strike of 28.00 plus Short the put with strike of 32.00
d) Long the call with strike of 32.00 plus Short the call with strike of 28.00; or Short the put
with strike of 28.00 plus Long the put with strike of 32.00
Question 8: Internal rating systems & external credit ratings

Finlux International seeks to build an internal rating system for its considerable credit portfolio
and assigns the project to a team including Alice, Bob, Chris, and Denise. In order to cast a
wide net for ideas, each of the team members builds a mini-prototype:
I. Alice (A) developed an internal migration matrix based on a sample taken during a
recession such that (related) her probabilities are not Markovian, yet to retrieve 5-year
cumulative default probabilities she raises the matrix to the fifth power (i.e.., 5-year
cumulative matrix = M^5) a calculation that might be valid if her probabilities were
Markovian
II. Bob (B), in order to maximum the universe of rated bonds, combines ratings for all of the
major agencies across industries, countries, asset classes
III. III Chris (C) uses a method of polling the salespeople who originate the loans on the
theory that these are the people with the best "on the ground" knowledge of credit risk
IV. Denise (D) mixed at-the-point-in-time and through-the-cycle ratings because she was
unaware of which methodological assumption applied to each sourced dataset
Which of the following accurately matches each team member to the bias that afflicts their
approach?
a) Country A is the most likely to default because debt above 100% is highly predictive of
default and overwhelms the other indicators
b) Country B is the most likely to default because it is the only country with three (out of
four) negative indicators
c) Country C is the most likely to default because it has an autocratic government
d) It is unclear: each has two negative (and two positive) indicators; further, quantification
of this scorecard is an insufficient predictor
11
Question 9: Risk management building blocks

One of the risk management building blocks is enterprise risk management (ERM). Which of the
following is TRUE as a feature or implication of ERM?
a) ERM encourages organizational silos to sharpen their self-identities

b) ERM supports a firm's 360-degree view of risk which requires multiple tools
c) ERM enables a complex firm to summarize its overall risk into a single number
d) ERM replaces instances of judgment with the application of statistical science
Question 10: Multiple regression

Sally is a portfolio manager at an investment management firm. She wants to test her primary
equity portfolio's reaction to the factors in the Fama-French three-factor model. She collected
excess returns (i.e., net of the risk-free rate) over the last eight years, so that the sample size, n
= 96 months. The response (aka, explained, dependent) variable is the portfolio's excess return.
The three explanatory variables are the market factor (MKT), the size factor (SMB), and the
value factor (HML). The size factor captures the excess return of small capitalization stocks
(SMB = "small minus big") and the value factor captures the excess returns of value stocks
(HML = "high book-to-market minus low book-to-market")'. Sally's regression results are
displayed below.
Which of the following descriptions of her portfolio is the most accurate?
a) Her small capitalization, value-oriented low-beta portfolio has not generated alpha
b) Her large capitalization, growth-oriented high-beta portfolio has not generated alpha
c) Her large capitalization, growth-oriented low-beta portfolio has generated significantly
positive alpha
d) Her small capitalization, value-oriented high-beta portfolio has generated significantly
positive alpha
12
Question 11: Properties of stock options

Consider an at-the-money (ATM) stock option with a strike price of $50.00 and six months time
to expiration; i.e., S(0) = K = $50.00 and T = 0.5 years. Now imagine the following four
variations (I., II., III. and IV) on this option:
I. It is a European CALL option on a non-dividend-paying stock while the risk-free rate is
3.0%
II. it is a European CALL option on a stock that pays 1.60% dividend yield (D = $0.40) while
the risk-free rate is 3.0%
III. It is a European PUT option on a stock that pays 1.60% dividend yield (D = $0.40) while
IV. It is a European PUT option on a stock that pays 1.60% dividend yield (D = $0.40) while
the risk-free rate is ZERO!
For the three variations where the stock pays a continuous 1.60% dividend, the equivalent
present value (over the life of the option) is given by the lump sum, D = $0.40. For those
interested, although it is beyond the scope of this question, this translation is given by the
following: the PV of dividend, D = -S(0)*[exp(-q*T)-1]; in this case, D = $50.00*[exp(-
0.0160*0.5)-1] = $0.3980.
Each of the above options has a different minimum value (aka, lower bound). However, among
the four, which has the LOWEST minimum value?
a) (I.) European call option on non-dividend stock and risk-free rate of 3.0%
b) (II.) European call option on 1.60% dividend stock and risk-free rate of 3.0%
c) (III.) European put option on 1.60% dividend stock and risk-free rate of 3.0%
d) (IV.) European put option on 1.60% dividend stock and risk-free rate of zero
Question 12: Predicting sovereign default

As of the twentieth century (i.e., beginning 1900 and afterward), each of the following is TRUE
about the consequences of sovereign default EXCEPT which is false?
a) Renders banking system more fragile: the probability of a banking crisis increases in
countries that have defaulted
b) Increased probability of military occupation: subsequent to default, the probability of a
military show of force increases by 25.0%
c) Negative impact on economy: real GDP tends to drop between 0.5% and 2.0% albeit the
decline is short-lived and mostly in the first year subsequent to default
d) Negative impact on trade: export industries tend to be particularly hurt by sovereign
default; one study indicates a drop of 8.0% in bilateral trade subsequent to default
13
Question 13: Risk appetite and hedging

According to GARP, "a recent trend among corporations is to use a board-approved risk
appetite to guide management and (potentially) to inform investors." Which of the following
statements is TRUE about the firm's risk appetite?
a) Risk appetite is the total amount of risk a firm can bear without becoming insolvent
b) In practice, the risk appetite should be focused on a single thing: one broad, durable
philosophical statement that avoids linkages to the firm's day-to-day risk management
operations because these are bound to change
c) Although risk appetite has an upper bound (an upper trigger), it is similar to a one-sided
confidence interval: there is no such thing as a lower bound (a lower trigger) on risk
appetite given that less risk is better
d) A risk appetite includes the mechanisms (e.g., detailed policy, business-specific risk
statements, and a framework for risk limits) that link a top-level statement to the firm’s
day-to-day risk management operations

Shown below is the autocorrelation function (ACF) for a time series object that contains the total
quarterly beer production in Australia (in megalitres) from 1956:Q1 to 2010:Q2 (source:
https://cran.r-project.org/web/packages/fpp2/index.html).
About this ACF and its implications, each of the following statements is true EXCEPT which
statement is false?
a) ρ(1) and ρ(3) are insignificant

b) This time series is a white noise process
c) This ACF is compatible with a seasonal time series
d) This time series is a non-stationary process because it violates a property of covariance-
stationarity
14
Question 15: Chooser and barrier (exotic) options

A non-dividend paying stock is currently trading at a price $35.00 when its volatility is 30.0% and
the risk-free rate is 3.0%. Consider a chooser option with a strike price of $30.00 that gives the
holder the right to choose (a call or put option) in three months and the chosen option, at that
point in time, will have a remaining time to maturity of nine months; i.e., T1 = +0.25 years and
T2 = +1.0 years. The price of this chooser is $7.710. Which of the following changes, ceteris
paribus, will INCREASE the value of this chooser?
a) Dividend increase to 4%
b) Volatility decrease to 20%
c) Stock drops to $30.00
d) Increase T1 to six months
Question 16: Key rates versus partial-01s vs forward-buckets

The exhibit below combines Tuckman's Tables 5.6 and 5.7. The situation starts with the
underlying trade: a 5×10 payer swaption struck at 4.044% (which gives the buyer the right to
buy a fixed rate of 4.044% on a 10-year EUR swap in five years such that the underlying
security in this option is a 10-year swap). This initial swaption trade is highlighted in light blue
below. Additionally, the forward-bucket exposures of four swaps are shown in the upper panel.
The lower panel highlights three different hedges (discussed in Tuckman) and their respective
implied net positions:
About these hedges, which of the

following statements is TRUE?
a) Hedge #1 is exposed to the

risk of a steepening
b) Hedge #2 is exposed to the
risk of a steepening
c) Hedge #3 is the best hedge
d) As rates increase, the value of
the initial swaption (i.e., by
itself without hedges)
decreases
15
Question 17: Risk management governance

The global financial crisis (GFC) of 2007 to 2009 engendered regulatory responses to corporate
risk governance. Below are summarized ten key developments. The first Sarbanes-Oxley (SOX)
occurred prior to the GFC but is listed for context. The others are grouped naturally into three
responses: Basel III and BCBS, Dodd-Frank, and the European response.
I. Prior to the GFC, Sarbanes-Oxley (SOX) required that the CEO and CFO affirm the
accuracy of financial disclosures.
Basel III and BCBS:
II. Basel III (BIII) was a direct response to the GFC. BIII limited core Tier 1 capital to
common equity and retained earnings. BIII also imposed new ratios for short-term
liquidity (i.e., LCR) and long-term liquidity (i.e., NSFR).
III. Basel III designed a macroprudential overlay that included a 3.0% leverage ratio;
countercyclical capital buffer (CCCB; aka, CCyB); and total loss-absorbing capital
(TLAC) standards applicable to G-SIBs.
IV. The Basel III framework was revised again in 2016 with the Fundamental Review of the
Trading Book (FRTB; aka, part of Basel IV) which included enhanced disclosure
requirements.
V. The Basel Committee on Banking Supervision (BCBS) issued Corporate Governance
Principles for Banks which--in addition to identifying the importance of an independent
risk management function--defines roles for the board, board risk committees, senior
management, CROs and internal auditors
Dodd-Frank:
VI. The 2010 Dodd-Frank Act strengthened the regulatory reach of the Fed; ended too-big-
too-fail (TBTF); launched overhaul of derivatives markets; introduced the Volcker Rule;
created the Consumer Financial Protection Bureau (CFPB).
VII. The Dodd-Frank Act also instituted a new approach to scenario analysis and stress
testing that included: a top-down approach with macroeconomic scenarios unfolding
over several quarters; a focus on the effects of macroeconomic downturns on a series of
risk types, including credit risk, liquidity risk, market risk, and operational risk; an
approach that is computationally demanding, because risk drivers are not stationary, as
well as realistic, allowing for active management of the portfolios; a stress testing
framework that is fully incorporated into a bank’s business, capital, and liquidity planning
processes; and an approach that not only looks at each bank in isolation but across all
institutions. This allows for the collection of systemic information showing how a major
common scenario would affect the largest banks collectively.
The European response:
VIII. For banks in Europe, the Supervisory Review and Evaluation Process (SREP)
introduced three new principles to banking supervision: (i) A forward-looking emphasis
on the sustainability of each bank’s business model, including during conditions of
stress; (ii) An assessment methodology based on best practices within the banking
industry, and (iii) An expectation that every bank will ultimately operate under the same
standards.
IX. The two key components of SREP are (i) the internal capital adequacy assessment
process (ICAAP) and (ii) the internal liquidity adequacy assessment process (ILAAP).
The ICAAP incorporates scenario analysis and stress testing; it outlines how stress
16
testing supports capital planning. The ILAAP incorporates potential losses from asset
liquidations and increased funding costs during stressful periods.
X. European banks with assets of EUR 30 billion and above must run European Banking
Authority (EBA) stress tests. These stress tests are run at the consolidated banking
group level (insurance activities are excluded). Two supervisory macroeconomic
scenarios covering a three-year period are provided by the regulator: a baseline
scenario and an adverse scenario
In regard to the above list of regulatory responses to the GFC, which of the following statements
is TRUE?
a) The Basel III events (i.e., II to IV) are incorrectly summarized

b) The Dodd-Frank Act is (i.e., VI and VI) is incorrectly summarize
c) The European regulatory response to the GFC (i.e., VIII to X) is incorrectly summarized
d) All three responses (Basel III, the Dodd-Frank Act, and the European regulatory
response) are correctly summarized
Question 18: Linear regression models

Debra is an analyst at a governmental agency. Her boss asked her to investigate whether the
Phillips curve applies during high-inflation regimes. To answer the question, Debra collected
data from the FRED database at the St. Louis Fed (https://fred.stlouisfed.org/). The Phillips
curve describes an inverse relationship between unemployment rates and inflation rates;
https://en.wikipedia.org/wiki/Phillips_curve. Debra collected monthly data and she regressed the
inflation rate against the unemployment rate
(conditional on high-inflation regimes simply
for narrative purposes). Her independent
variable is the unemployment rate (FRED
code: UNRATE) and here, the dependent
variable is the Inflation rate (CPIAUCSL).
The units are percentages not decimals; e.g.,
the dataset includes the month of January in
1982 when the unemployment rate was 8.90
and the inflation rate was 6.38. Her
regression results are presented here.
Debra wants to know if an inverse relationship is observed. Which of the following statements
about the regression is TRUE?
a) The regression is not useful because the intercept is too far away from (different than)
zero
b) The pattern of the standard errors, t-statistics, and p-values suggest there is a violation
in some assumption(s) of the classical linear regression model (CLRM)
c) There is an inverse relationship because, for each unit increase in the unemployment
rate (i.e., +1.0%), the inflation rate is expected to decrease on average by 1.10%
d) There is not an inverse relationship because, for each unit increase in the
unemployment rate (i.e., +1.0%), the inflation rate is expected to increase on average by
5.60%
17
Question 19: US Treasury bonds

[This is tedious and difficult. Inspired by the final LO above and Hull's2 EOC Question 6.11]
Today it is December 31, 2018. The cheapest-to-deliver bond in an August 2019 Treasury bond
futures contract is a 9.0% coupon bond, and delivery is expected to be made on August 28,
2019. Coupon payments on the bond are made on April 2 and October 2 each year. In this
case, therefore, as of settlement today (December 31, 2018) there were 90 days since the last
coupon and there will be 92 days until the next coupon. Delivery will be in 240 days (and
subsequent coupon date 35 days after delivery, or 275 days from today). The term structure is
flat, and the rate of interest with continuous compounding is 3.0% per annum. The conversion
factor for the bond is 1.380. The current quoted bond price (for this bond which is assumed to
be the cheapest to deliver) is $115.00.
What is the quoted futures price for the contract?
a) $73.59
b) $80.70
c) $94.75
d) $106.44
Question 20: Multi-factor interest rate risk models

Suzanne the Risk Analyst is building an interest rate term structure and she is evaluating
various candidate models. Her first candidate is Tuckman's Model 13 (aka, normally distributed
rates and no drift) which has the advantage of extreme simplicity and is specified by (Tuckman
9.1)3: dr σ*dw. Her colleague Peter observes this is a single-factor model: the model's only
factor is the short-term interest rate.
Among the following, which is probably the strongest criticism against this model as a single-
factor model?
a) It compels us to assume yield to maturity (YTM) as the interest rate

b) A single-factor model incorporates yield volatility but cannot capture the convexity effect
c) It implies a parallel shift: if we shock the short rate by X basis points, it assumes all rates
shock by X basis points
d) It necessarily must assume a perfectly flat term structure; aka, the flat yield curve
assumption that is common for exams but unrealistic
2
John C. Hull, Options, Futures, and Other Derivatives, 10th Edition (New York: Pearson Prentice Hall, 2017)
3
Bruce Tuckman's Fixed Income Securities, 3rd Edition (Hoboken, NJ: John Wiley & Sons, 2011)
18
Question 21: Credit risk transfer mechanisms

The Acme Investment Trading Company perceives the credit risk of a certain public retailer is
mispriced by the market. Acme is considering buying or selling a credit default swap (CDS) for
the purpose of speculating on this view with respect to the retailer's credit profile. In comparison
to buying or shorting the retailer's cash bond, Acme has already identified an advantage to the
CDS: it has better liquidity. On the other hand, which of the following is a disadvantage of the
CDS?
a) The CDS will introduce a new counterparty risk and legal risk
b) The CDS will introduce basis risk because Acme, who cannot be naked, will need to also
purchase the retailer's bond(s) that are referenced by the CDS
c) Although the CDS is a good vehicle for expressing Acme's view on the retailer's default
risk, it will not adjust for mere credit deterioration
d) Unlike credit ratings which are frequently updated, Acme will need to wait until it sells the
CDS in order to obtain price discovery with respect to a change in retailer's credit risk
Question 22: P-value and confidence intervals

Mary belies that the average net promoter score (NPS) in financial services, as a population, is
at least 50. Her one-sided null hypothesis is H0: μ(NPS) ≤ 50 and her alternative hypothesis is
HA: μ(NPS) > 50. Among a collected sample of 40 firms, her staff observes a sample average
NPS of 53.60 with a standard deviation of 9.0. Her staff informs her that the test statistic is 2.53
and the two-sided p-value is 1.556% per the Excel function T.DIST.2T(2.530, 39) = 0.015563.
Their report also includes these 95.0% critical t-values: T.INV(0.95, 39) = 1.685 and
T.INV.2T(0.050, 39) = 2.023; as expected, these values are slightly higher than, respectively,
the critical Z-values of 1.645 and 2.33. Each of the following is true EXCEPT which is false?
a) The power of Mary's one-sided test is 99.22%

b) The one-sided 95.0% confidence interval is [51.2, ∞)
c) Mary can reject a one-sided null hypothesis, H0: μ(NPS) ≤ 50, with 95.0% confidence
d) Mary can reject a one-sided null hypothesis, H0: μ(NPS) ≤ 50, with 99.0% confidence
19
Question 23: Eurodollar futures contracts & duration-based

hedging
It is August and Sally is a fund manager with $50.0 million invested in government bonds who is
worried that interest rates are expected to be volatile over the next quarter (note: this question is
inspired by Hull's EOC Problem 6.18). She decides to use the December Treasury bond ("T-
bond") futures contract to hedge the value of the portfolio. The current futures price is 108-00 or
$108.00. Because each contract is for the delivery of $100,000 face value of bonds, the futures
contract price is therefore $108,000.00. Suppose the modified duration of the bond portfolio in
three months will be 13.0 years. The cheapest-to-deliver (CTD) in the T-bond contract is
anticipated to be a bond with 18.0 years to maturity that pays a 5.0% semi-annual coupon; at
maturity, the duration of this CTD bond is expected to be about 12.0 years.
However, the manager does not want to completely neutralize duration. Rather, she wants to
REDUCE the portfolio's duration by 7.0 years, from 13.0 years to 6.0 years. About how many T-
bond futures contracts should she trade to achieve this reduction in duration of the net portfolio?
a) 15 contracts
b) 270 contracts
c) 333 contracts
d) 502 contracts
Question 24: Effective duration and convexity

The exhibit below modifies Tuckman's Table 4.24 and shows the prices on May 28, 2019 for two
instruments: 10-year U.S. note futures contracts, TYU0, and call options with a strike of 120 on
the same futures contracts, TYU0C 120.
What is the effective duration of,

respectively, the futures, TYU0, and the
options, TYU0C 120?
a) 4.2 and 106.3 years

b) 8.4 and 212.5 years
c) 33.5 and 850.1 years
d) 41.8 and 1,062.6 years
4
Bruce Tuckman, Fixed Income Securities, 3rd Edition (Hoboken, NJ: John Wiley & Sons, 2011
20
Question 25: Modern portfolio theory

Consider the market portfolio plus three other portfolios (A, B, C) with the following features
while the risk-free rate is 3.0%:
Please note the returns are expected gross

returns; e.g., the market's expected return is
9.0% so that its expected excess return is
6.0%. If we assume the capital asset pricing
model (CAPM) is valid then which of the
following statements is TRUE?
a) Portfolio A is mispriced, or it cannot

exist in equilibrium due to both its beta and standard deviation
b) Portfolio B is mispriced, or it cannot exist in equilibrium due to its standard deviation
c) Portfolio C is mispriced, or it cannot exist in equilibrium due to its beta
d) All three portfolios can exist in equilibrium under the CAPM
Question 26: Coskewness and cokurtosis

Below is the probability mass function (pmf) of a binomial random variable where the probability
of success over 15 trials is 10.0%; i.e., p = 0.10 and n = 15.
What is the interquartile range (IQR) of this probability distribution?
a) Zero
b) 1.0
c) 2.5
d) 4.0
21
Question 27: Gap, forward start & compound exotic options

Consider an asset with a current price of $120.00 and volatility of 16.0% while the risk-free rate
is 3.0%. A regular (aka, vanilla) but deeply out-of-the-money (OTM) one-year European put
option on the stock with a strike price of $100.00 has a price of $0.740; i.e., p(S = $120.00, K =
$100.00, σ = 0.160, Rf = 0.030, T = 1.0 year) = $0.740.
Now consider the modification of this regular put option into a gap put option with the addition of
a trigger price, denoted K2. In this case, the price of the gap put option is given by p(S =
$120.00, K1 = $100.00, K2 = trigger price, σ = 0.160, Rf = 0.030, T = 1.0 year). Each of the
following statements about this gap option is true EXCEPT which is false?
a) If K1 = K2 = $100.00, then the gap option also has a price of $0.740

b) If the strike price, K1= $100.00 and the trigger price, K2 = $110.00, then the gap option
has a negative price
c) If the strike price, K1 = $100.00 and the trigger price, K2 = $90.00, then the gap option
price is greater than $0.740
d) Given a strike price, K1 = 100.00, among various trigger prices, the gap option has its
highest price when the trigger, K2 = $100.00
Question 28: Coupon effect and carry roll-down scenarios

As shown in the exhibit below in a format similar to Tuckman's table 3.25, the price of a bond as
of 5/28/2019 is $113.335. This bond pays a semi-annual 10.0% coupon and has maturity of 1.5
years; that is, it matures on 11/30/2020. Currently, the six-month forward rates are 0.60%,
1.00% and 1.50% (see green row).
If we make a scenario assumption of UNCHANGED TERM STRUCTURE, which of the

following is nearest to the carry roll-down over the next six months?
a) -$4.185
b) -$1.090
c) +$3.270
d) +$5.990
5
Bruce Tuckman, Fixed Income Securities, 3rd Edition (Hoboken, NJ: John Wiley & Sons, 2011
22
Question 29: Performance measures

Let Rm(P) denote the monthly return of the portfolio and Rm(B) denote the monthly return of its
benchmark. Over a three-year measurement period, the following statistics are calculated:
 The average monthly return for, respectively, the portfolio and the benchmark was
Rm(P) = 8.50% and Rm(B) = 6.90%; therefore, on average, the portfolio outperformed
its benchmark by +1.60%.
 The monthly standard deviation of the difference between the portfolio's and
benchmark's return, σ[Rm(P) - Rm(B)] = 11.80%
 A regression of the portfolio's excess return against the benchmark's excess return
produced the sample regression function, ERm(P) = -0.0140 + 1.35 * ERm(B); therefore,
the regression intercept (aka, alpha) is -1.40%
 The standard error of the regression (SER), which approximates the volatility of alpha,
σ(α), is 11.0%
Although the periodicity is monthly, an information ratio is generally annualized. In regard to

annualized information ratios, which of the following statements is accurate?
a) The (both annualized) active information ratio is +0.136 and the residual information ratio
is +1.426
b) The (both annualized) active information ratio is +0.470 and the residual information ratio
is -0.441
c) The (both annualized) active information ratio is +0.636 and the residual information ratio
is -0.127
d) The (both annualized) active information ratio is -0.250 and the residual information ratio
is +0.889
23
Question 30: Conditional expectations and the i.i.d. property

Below is the joint distribution of analyst ratings (i.e., negative, neutral, or positive) and stock
returns (-5, zero, or +5 in percentage terms).
We are interested in the conditional distribution of stock returns given a negative analyst rating.
For example, the expected stock return conditional on a negative analyst rating is [-5.0 *
(20.0%/25.0%)] + [0 * (5.0%/25.0%)] + [+5 * (0%/25.0%)]= -4.0. The variance of the stock return
conditional on a negative analyst rating is [-5.0 - (-4.0)]^2 * 80% + [0 - (-4.0)]^2 * 20% + [+5.0 - (-
4.0)]^2 * 0% = 4.0. What is the skew of the stock return conditional on a negative analyst rating?
a) -6.00
b) -3.50
c) +1.50
d) +12.00
Question 31: Foreign exchange (FX) forwards

You are trying to model the theoretical forward price of silver using the cost of carry model. Your
model is informed by the following four propositions. Each is correct except which is FALSE?
a) Storage costs can be treated as negative income in the cost of carry model
b) Investment assets have a positive convenience yield in futures markets due to the
optionality of liquid markets
c) A positive (negative) lease rate tends to contribute to backwardation (contango) in the
gold futures curve, ceteris paribus
d) Normal backwardation in a consumption commodity could be explained by some
combination of non-zero convenience yield and/or systematic risk (i.e., positive beta) of
the commodity
24
Question 32: Gross versus net bond returns

Let the two-year term structure of zero rates include the following four spot rates: 1.0% @ 0.5
years, 2.0% @ 1.0, 3.0% @ 1.5, and 4.0% @ 2.0 years. Using these discount rates, the price of
a two-year $100.00 face value bond with 4.0% coupon rate is $100.10 (see blue cell) as shown
in the exhibit below, where $100.10 is the sum of four discounted cash flows:
Assume the term structure above (i.e., 1.0% @ 0.5 years, 2.0% @ 1.0, 3.0% @ 1.5, and 4.0%
@ 2.0 years) remains valid, but a different bond trades at a price of only $95.12. Which of the
following is nearest to this bond's spread?
a) 30 basis points
b) 90 basis points
c) 140 basis points
d) 270 basis points
Question 33: Multifactor models

Each of the following statements is true about the arbitrage pricing theory (APT) model EXCEPT
which is false?
a) APT says that systemic factors explain asset returns and that diversification both
eliminates specific risk and precludes arbitrage opportunities
b) If the return process for 30 firms is a five-factor market model, then the number of
parameters to be estimated is 160 parameters as given by 30*5 + 5*(5-1)/2
c) As a special case of the capital asset pricing model, a key advantage of the APT is that
matrix transformation identifies via deductive guidance the model's relevant
macroeconomic factors and their risk premiums
d) The extended 2015 Fama-French model includes five factors, the market's price of risk,
small minus big (SMB), high minus low (HML), robust minus weak (RMW) and
conservative minus aggressive (CMA), but they found HLM and CMA somewhat
redundant
25
Question 34: Common univariate random variables

Let X = µ + σ*T be the generalized student's t distribution where X is a linear transformation of
the classic student's t distribution, as represented by T ~ t(df) or sometimes T ~ t(v).
Consequently, X is a generalized random variable denoted by X ~ Gen. t(v)(µ, σ^2). If the
generalized student's t distribution happens to be standardized, then it could be represented as
X ~ Gen. t(v)(0, 1). If X is a generalized student's t distribution with µ = 2.0 and σ = 3.0 with
degrees of freedom, v = 8, then each of the following is true EXCEPT which is false?
a) The mean of X is 2.0

b) The variance of X is 12.0
c) The skew of X is 1.5; i.e., positive or right-skew
d) The kurtosis of X is 4.5; i.e., excess kurtosis is 1.5
Question 35: Par yield, convexity and term structure theories

Consider the following upward-sloping but smooth zero rate curve:
There are various theories that attempt to explain the factors that determine the shape of the
zero-rate curve. If the above zero curve is observed, each of the following theories is plausible
EXCEPT which of the following theories is the LEAST LIKELY to be true, if only because it
does not comport with the observed zero curve?
a) Under pure expectations, the expected future six-month spot rate, E[S(2.0, 2.5)], is
3.00%
b) Under liquidity preference, the expected future six-month spot rate, E[S(2.0, 2.5)], is
3.00%
c) Under liquidity preference, the expected future six-month spot rate, E[S(2.0, 2.5)], is
2.40%
d) Under preferred habitat (market segmentation), the expected future six-month spot rate,
E[S(2.0, 2.5)], could be 3.15%
26
Question 36: Flattening and steepening of rate curves

Below is a graph of swap rates (represented by the solid green line) and the corresponding,
implied six-month forward rates (represented by the dotted orange line). Specifically, the six-
month, 1.0-year, 1.5-year, 2.0-year and 2.5-year swap rates are, respectively, 0.70%, 1.20%,
1.50%, 1.50% and 2.0%. The six-month forward rates implied by this swap rate curve are: f(0,
0.5) = s(0.5) = 0.7000%; f(0.5, 1.0) = 1.7043%; f(1.0, 1.5) = 2.1089%; f(1.5, 2.0) = 1.5000%;
f(2.0, 2.5) = 4.0674%.
Consider the fixed side of a 2.5-year swap which

pays the swap rate of 2.0%. Because 2.0% is the
2.5-year par rate, the present value of 100 face
amount of the fixed side of the 2.5-year swap is
100. Consider the price of the swap over the
following year, in two six-month steps:
 After six months, as the swap ages
(toward maturity) from 2.5-year to a 2.0-
year swap (but with the same fixed rate, of
course)
 After another six months, as the swap
ages from a 2.0-year swap to a 1.5-year
swap
If we assume an unchanged term structure as the swap matures from a 2.5-year swap to a 1.5-
year swap, what happens to the price of the fixed side?
a) The price decreases during both six-month periods

b) The price increases during both six-month periods
c) The price increases (during first six months), then decreases (during next six months)
d) The price decreases (during first six months), then increases (during next six months)
Question 37: Risk Data Aggregation and Reporting Principles

Relative to the other principles, compliance rates have been stronger for the Risk Reporting
Practices outlined in BCBS 239. In regard to effective risk reporting, each of the following is true
EXCEPT which is false?
a) Aggregated data should be Material, Conservative, Elastic, and Cost-based (Principles 3
to 6)
b) The four primary types of data models include: semantic data, conceptual data, logical
data, and physical data.
c) Compliance rates are generally poor, or at least lagging, for Principle 2 (Data
architecture and IT infrastructure)
d) Adaptability (Principle 6) matters because a bank should be able to generate a range of
on-demand, ad hoc requests including, for example, integrated stress scenarios or
upcoming regulations
27
Question 38: Random variables

Let Z be a random variable that is a linear function of random variables X and Y, where Z = 3*X
+ 7*Y? If the standard deviation of X and Y, respectively, are σ(X) = 4.0 and σ(Y) = 5.0 and the
correlation between X and Y is ρ(X,Y) = 0.50, then what is the standard deviation of Z, σ(Z)?
a) 6.40
b) 7.81
c) 37.00
d) 42.30
Question 39: Duration, modified duration and dollar duration

A three-year bond $1,000.00 face value bond pays a 10.0% semi-annual coupon and has a
semi-annual (aka, bond equivalent) yield of 14.0%. Its price is therefore $904.67. The chart
below also shows cash flows as proportional weights:
We can use modified duration to estimate the price impact of a small change in yield. Which of
the following is NEAREST to a duration-based (i.e., linearly approximate) estimate of the bond's
price change given a 26 basis point (0.26%) drop (shock down) to the yield?
a) $5.81
b) $6.00
c) $6.18
d) $7.25
28
Question 40: Spot, forward and par rates

Assume the following discount function (note that a discount function is a series of discount
factors):
Which of the following is nearest to the implied six-month forward rate starting in two years,
f(2.0, 2.5)? Assume rates are expressed as per annum with semi-annual compounding.
a) 4.30%
b) 5.83%
c) 7.95%
d) 10.72%
Question 41: Enterprise Risk Management (ERM)

According to GARP, each of the following is one of the top ten benefits of enterprise risk
management (ERM) EXCEPT which is NOT a benefit of ERM?
a) Hedges risks using derivative instruments

b) Focuses oversight on the most threatening risks
c) Optimizes risk transfer expenses in line with risk scale and total cost
d) Manages emerging enterprise risks such as cyber risk, anti-money laundering (AML)
risk, and reputation risk
29
Question 42: Probabilities and Bayes rule

Among a set of filtered stocks, a stock screener assigns stocks to one of three style categories:
value, quality, or momentum. At the end of each month, the stock's performance is compared to
the S&P such that it either beats or does not beat the index The prior beliefs (aka, unconditional
probabilities) are the following: Pr(Style = Value) = 15.0%, Pr(Style = Quality) = 30.0%, and
Pr(Style = Momentum) = 55.0%. The stock screener also knows that a Moment stock is more
likely than a Quality stock, and much more likely than a Value stock, to beat the index;
specifically, the screener knows the following conditional probabilities:
 Pr(Beat | Value) = 40.0%

 Pr(Beat | Quality) = 60.0%
 Pr(Beat | Momentum ) = 80.0%
If we observe that a stock beats the index, what is the probability it is a momentum stock; i.e..,
what is Pr(Momentum | Beat)?
Bonus question: if we observe the stock beats the index two months in a row, what is the
probability it is a momentum stock; i.e., what is Pr(Momentum | Two consecutive Beats)?
a) 39.6%
b) 55.0%
c) 64.7%
d) 83.3%
Question 43: Spot and forward rates

Consider the steep spot (aka, zero) rate curve illustrated below: 3.0% at 0.5 years, 4.0% at 1.0
year, 4.6% at 1.5 years and 5.0% at 2.0 years. Each of these zero rates is per annum with
continuous compounding.
Which of the following is nearest to the theoretical price of a

two-year $100.00 face value bond that pays an 8.0% semi-
annual coupon (4.0% coupon every six months)?
a) $97.31
b) $99.47
c) $102.38
d) $105.62
30
Question 44: Discount function and the Law of One Price

In regard to Tuckman's discussion of the components and structure of U.S. Treasury STRIPS,
which of the following statements is TRUE?
a) The holder of a U.S. Treasury STRIP is immunized against inflation risk but exposed to
significant liquidity risk and call risk
b) The Law of One Price says an arbitrage profit is necessarily available when two
securities offer identical cash flows but sell at different market prices
c) If we apply the discount function implied only by C-STRIPS (i.e., without P-STRIPS) to
infer the price of a U.S. Treasury bond, we are likely to undervalue the security relative
to its actual market price
d) Because C-STRIPS and P-STRIPS are perfect commodities, arbitrage enforces the law
of one price to ensure that, with respect to U.S. Treasury bonds, theoretical (aka, model)
prices equal market prices

Scenario analysis is an ascendant tool. After the global financial crisis (GFC), regulators insisted
that systemically important banks demonstrate their ability to withstand adverse and severely
adverse scenarios. Meanwhile, GARP explains, "Scenario analysis, along with stress and
sensitivity testing, have risen to become the preeminent risk identification tools for many
enterprise risk management (ERM) programs. This is a result of the weaknesses in probabilistic
risk metrics (e.g., VaR) that were revealed by the global financial crisis of 2007–2008."
Which of the following statements is TRUE about scenario analysis?
a) An advantage of scenario analysis is that data science enables the bank to generate a
virtually infinite number of scenarios
b) Scenario analysis involves changing one parameter or variable in a risk model to see
how sensitive the model result is to the analysis
c) A disadvantage of scenario analysis is its necessary dependence on referencing actual
historical events such as the global financial crisis (GFC)
d) An advantage of scenario analysis is that it does not need to consider risk frequency
beyond plausibility; i.e.., scenario analysis may be entirely qualitative
31
Question 46: One- versus two-tailed hypothesis tests

Barbara observes a sample with the following statistics: mean of X and standard deviation of Y.
She thinks the true (aka, population) mean is Z. She does NOT know the population's variance
nor does she even know the population's distribution, including she cannot assume it is normal.
If she wants to conduct a hypothesis test of the observed sample mean, each of the following
statements is true EXCEPT which is incorrect?
a) If the sample is small (i.e., n < 30), there is no valid test statistic
b) If the sample is large, she is justified in conducting a hypothesis test of the mean with a
student's t distribution (and she may even approximate the student's t with a normal
distribution)
c) A one-tailed test is more appropriate if (i) the sample mean is either greater than, or less
than, the null hypothesized value or (ii) the metric is financial such as in this case of a
mutual fund's mean return
d) If the sample is large, there is a valid test statistic and for a given observed X either (i) a
switch from two-tailed to one-sided confidence and/or (ii) an increase in the sample size
will increase the likelihood of rejecting the null
Question 47: Optimal cross-hedge & reducing portfolio beta

Sally the portfolio manager oversees a $9.0 million large-cap equities portfolio with a beta of
1.30. She has decided the portfolio's beta is too high and calibrates a new target beta of 0.70. If
she employs S&P 500 index futures contracts to reduce the beta when the index futures price is
2,400 (the contract size is $250 * S&P 500 index per the specification), then which is nearest to
the trade?
a) Short 9.0 contracts

b) Short 27.0 contracts
c) Short 54.0 contracts
d) Long 13.0 contracts
32
Question 48: Delta hedging, scenario analysis and portfolio

insurance
On Monday, a bank's position (the underlying portfolio) on the dollar-euro exchange rate has an
initial position delta of 11,300 and a position gamma of -25,000. The exchange rate is EURUSD
$0.860; i.e., per the currency priority convention, Euro is the base currency. By the end of the
week, on Friday, the exchange rate had jumped by +$0.050 to $0.910. The bank entered two
trades:
 On Monday, while the exchange rate is EURUSD $0.860, the bank's first trade
neutralized delta; aka, makes the net position "delta neutral"
 On Friday, after the exchange rate had increased to EURUSD $0.910, the bank's
second trade re-established the net position's delta neutrality
Which of the following were the bank's trades? Please note: this question is inspired by Hull's
EOC Problem 19.226.
a) Long 11,300 Euros on Monday, then short an additional 565 Euros on Friday
b) Long 11,300 Euros on Monday, then unwind (purchase) 565 Euros on Friday
c) Short 25,000 Euros on Monday, then short an additional 2,250 Euros on Friday
d) Short 25,000 Euros on Monday, then unwind (purchase) 1,250 Euros on Friday
Question 49: Learning from financial disasters

Three famous financial disasters are Continental Illinois (whose failure in 1984 was the largest
bank failure in US history prior the global financial crisis), Lehman Brothers (who was the fourth-
largest U.S. investment bank before filing for bankruptcy in 2008), and Northern Rock (who was
a fast-growing British mortgage bank, who in 2008 was forced into public ownership as an
alternative to insolvency). What did Continental Illinois, Lehman Brothers, and Northern Rock
have in common?
a) Excessive reliance on certain short-term liabilities

b) Insufficient geographical diversification of funding sources
c) Asset-to-equity ratios were too low for banks to be profitable
d) Improper application of Federal Reserve stress testing programs
6
John C. Hull, Risk Management and Financial Institutions, 4th Ed. (Hoboken, NJ: John Wiley & Sons, 2015).
33
Question 50: Bayes' Theorem

An analyst at your firm has developed a new trading strategy called AlphaGen. She claims there
is a 70.0% probability on any given day that the strategy offers true alpha and will generate a
profit. After observing ten (10) days of performance, in fact the strategy was profitable only four
days. Assume there are only two possible states of the world: either the analyst is correct and
the strategy offers true alpha; or the strategy does not offer true alpha and the profit/loss
outcome is equally likely to be a gain or loss on any given day. Your prior assumption was that
the two states of the world are equally likely: there is s 50.0% probability the strategy offers true
alpha, and a 50% probability it does not. These assumptions are illustrated below; e.g., if the
strategy does generate alpha, then P[Profit | Alpha] = 70.0%, but if the strategy does not
generate alpha, then P[Profit | No Alpha] = 50.0%.
We can also represent the prior probabilities as follows: P[p = 0.70] = 50.0% and P[p = 0.50] =
50.0%. Additionally, because you are an FRM candidate, you are already able to compute the
following binomial probabilities:
 Prob[Exactly 4 profits out of 10 days | True Alpha] = binomial[4 successes, 10 trials, p =

0.70, false = p.m.f.] = 0.70^4*0.30^6*C(10,4) = 3.68%
 Prob[Exactly 4 profits out of 10 days | No Alpha] = binomial[4 successes, 10 trials, p =
0.50, false = p.m.f.] = 0.50^4*0.50^6*C(10,4) = 20.51%.
Given the evidence that the strategy was profitable on four days out of ten, which is nearest to
the (posterior) probability that the analyst is correct, and the strategy generates true alpha?
(note: this question is inspired by Miller's EOC question 6.4)7.
a) 15.20%
b) 25.00
c) 31.80%
d) 50.0%
7
Michael Miller, Mathematics and Statistics for Financial Risk Management, 2nd Edition (Hoboken, NJ: John Wiley &
Sons, 2013)
34
Question 51: Futures contracts

Barbara is a value investor who bought 1,000 shares of Apple (ticker: AAPL) in 2014 when the
share price was $95.00, and she considered them under-valued. In hindsight, her view was
correct as the shares currently (as of mid-2017) trade at $140.00. She now thinks the shares
are slightly over-valued. However, she does not want to sell them unless there is a market
crash. This is because she believes the shares are likely to trade in a range and may even gain
modestly in the future. However, she also believes there is something like a 10.0% probability of
a technology sector crash (a possibility enabled by the low interest rate regime). If the
technology sector does crash, she fears the AAPL shares could plummet. If the AAPL shares
drop, Barbara does wants to sell, however she does not want to sell in a panic at fire-sale
prices.
Specifically, if the shares were to quickly lose more than 13.0% of their current value, Barbara
will be eager to sell them. However, she also wants to ensure that she realizes a minimum
holding period return (HPR) of 30.0%; and to this HPR dividends have already contributed
6.0%. Therefore, she only wants to sell if the price appreciation (from her $95.00 cost basis) is
at least +24.0%. She justifies this conditional view on a belief that if the shares plunge too far
such that she cannot realize her HPR threshold, the market will have overreacted. In this case
of an over-reaction, she believes it will be better to avoid selling in a panic and instead she will
be better off to await an eventual recovery. Which of the following orders is most consistent
with her strategy?
a) A market order
b) A limit order at $121.80 plus a market order at $135.57
c) A stop-limit order with stop at $121.80 and limit at $117.80
d) Two stop-loss orders: a soft-stop at $121.80 and a hard-stop at $105.00
Question 52: Futures delta and dynamic delta hedging

A market maker takes a short position in 1,000 European call options on copper futures. The
options mature in three months, and the futures contract underlying the option matures in four
months. The current four-month futures price is $3.30 per pound, the exercise price of the
options is $3.00, the risk-free interest rate is 4.0% per annum, and the volatility of silver futures
prices is 20.0% per annum. Which is nearest to the position delta? (note: this question is
inspired by Hull's EOC Question 19.10)8
a) -833.0
b) -525.0
c) -314.0
d) +267.0
8
35

In early 2012, J.P. Morgan Chase (JPM) lost billions on trades executed by the London Whale,
the notorious nickname for Bruno Iksil, who assumed massive exposures (masquerading as
hedges) in a large credit derivative portfolio. Which of the following BEST summarizes the root
cause of the debacle?
a) Lack of formal risk limits
b) A poor risk culture enabled by failures in corporate governance
c) The chief investment officer (CIO) lacked the sophistication to correctly value certain
credit derivatives
d) The chief investment officer (CIO) used only one metric, value at risk (VaR), an over-
reliance owing to JPM's pioneering use of VaR
Question 54: Central limit theorem and mixture distributions

Your colleague Peter is selecting probability distributions in order to perform several Monte
Carlo simulations. Each of the following choices appears to be logical or sensible, EXCEPT
which choice prima facie appears be a mistake?
a) To model recovery rates for high yield bonds, he selects a beta distribution
b) To model a continuous variable that is non-negative, right-skewed and tends toward the
normal distribution as the degrees of freedom (d.f.) increase, he selects either a chi-
square or F-distribution
c) To model a light-tailed distribution (aka, platykurtosis where kurtosis < 3) he selects
either a Poisson distribution or a student's t distribution whose degrees of freedom (df) is
less than 30
d) To model a continuous outcome within a finite range (a,b) using a distribution that is only
slightly more complex than a uniform distribution, but allows him to specify a unique
mode, he selects a triangular distribution with parameter (c) equal to the mode
Question 55: Hedging versus speculation

PlanetZim Financial Bank just entered a position in a derivatives contract. Which of the following
features of the derivative position is MOST likely to indicate the trade is a case of
SPECULATION, in contrast to a case of a hedge, arbitrage or market-making?
a) If a hedge has no basis risk, then the hedged outcome is always superior to the un-
hedged outcome
b) In distinguishing from an arbitrage or a hedge, the key feature of a speculation is the use
of high leverage
c) Although put options can be used as a hedge or insurance, a position in call options
implies the investor is speculating rather than hedging
d) In Hull, the theoretical price of futures contracts and stock options (per Black-Scholes
Merton) depend on an assumption that no riskless arbitrage opportunities exist
36
Question 56: Black Scholes

Mark the Risk Analyst is evaluating an at-the-money (ATM) call option on a non-dividend-paying
stock when the stock's price is $30.00; i.e., S(0) = K = $30.00. For this option, he has the table
shown below. The table displays option prices generated by the Black-Scholes-Merton option
pricing model according to selected input variations of volatility and maturity. In other words, the
table displays different values of c = BSM[S(0) = $30.00, K = $30.00, σ, Rf = 0.030, T].
Mark's option actually expires in in eight months; T = 8/12. Further, he observes that the option's
traded price (aka, observed market price) is $3.00. In this case, which of the following is
nearest to the call option's implied volatility?
a) 24.5%
b) 28.0%
c) 31.5%
d) 35.0%

The Volkswagen emissions scandal concerned over ten million cars during the years 2009 to
2015. The scandal unfolded with significant financial repercussions and massive reputational
damage to the company. GARP writes that "the damage to Volkswagen, the world’s biggest
carmaker, was significant ... Its reputation, particularly in the important US market, took a severe
hit. The reputational effect extended beyond the company itself as German government officials
expressed concerns that the value of the imprimatur 'Made in Germany' would be diminished
because of Volkswagen’s actions." Which of the following most accurately summarizes the
Volkswagen emissions case study?
a) Volkswagen deliberately programmed emission controls to activate only during

regulatory testing but not during real-world driving
b) Volkswagen did not conduct adequate quality assurance (QA) on its emission controls
and consequently, a meaningful percentage of them failed during real-world driving
c) The Volkswagen case study illustrates how reputation risk can materialize despite the
good intentions of managers who disclose problems immediately and cooperate with
regulators
d) Volkswagen had effective emission control devices (i.e., hardware), however, the
software contained an undetected bug that caused the controls to inadvertently fail
during real-world driving
37
Question 58: Skew, kurtosis, coskew and cokurtosis

Portfolio manager Peter manages a large portfolio with 100 component positions. He is
interested in analyzing the non-trivial cross moments in the portfolio (trivial cross-moments are
the position's coskew/cokurtosis with itself, which is simply the position's standard skew or
kurtosis, so these are analogous to the diagonal of a covariance matrix which is mere variances.
Each of the following statements is true EXCEPT which is inaccurate?
a) Between any two (n = 2) positions in the portfolio, the number of non-trivial coskew
moments between them is two
b) Between any two (n = 2) positions in the portfolio, the number of non-trivial cokurtosis
moments between them is three
c) Given a sub-portfolio consisting of any two positions, lower coskew values (i.e., where
positives are gains and negatives are losses) imply greater risk for the sub-portfolio
d) Although it is easy to estimate this portfolio's set of higher-order cross moments,
standard skew and kurtosis are preferred because they are BLUE and the informational
utility of coskew and cokurtosis is negligible
Question 59: Mutual funds

The Investment Committee at your endowment just analyzed the historical performance of its
asset allocation to hedge funds, which was 20.0% of the fund. It has determined that net of fees
these hedge funds did not outperform the S&P 500 on a risk-adjusted basis. Consequently, the
Committee wants to re-allocate this portion to a fund that tracks the S&P 500 index; and the
Committee is comfortable mirroring the index with minimum tracking error. An outside
consultant proposes an exchange-traded fund (ETF) such as the "Spider" (ticker SPY), but
some members want to compare the ETF to an open-ended or closed-ended mutual fund that
tracks the S&P 500.
In addition to highlighting the fact that the expense ratios tend to be lower for ETFs than mutual
funds, the consultant offers the following arguments in favor of an ETF:
I. In contrast to an open-ended mutual fund, advantage of the SPDR ETF can be traded at
any time, can be shorted, and does not have to be partially liquidated to accommodate
redemptions
II. In contrast to a closed-ended mutual fund whose price tends to trade at a discount to its
fair market value, there is never any appreciable difference between the traded price of
the SPDR EFT and its fair market value.
Which of the consultant's argument(s) is (are) TRUE?
a) Neither is true
b) Only I. is true, but II. is false
c) Only II. is true, but I. is false
d) Both are true.
38
Question 60: Lognormal property of stock prices and Black-

Scholes-Merton
A stock has a current price of $71.00 and follows geometric Brownian motion. It offers an
expected return of 14.0% with volatility of 23.0% per annum. Which is nearest to the probability
that a deeply out-of-the-money (OTM) European call option on the stock with a maturity of one
year (T = 1.0 year) and an exercise price of $100.00 will be exercised?
a) 16.0%
b) 23.5%
c) 31.8%
d) 40.0%
Question 61: Anatomy of the Great Financial Crisis

According to GARP, "a wave of uncertainty over the valuation of asset-backed structured
products exacerbated the [global financial] crisis" as counterparty risk suddenly became priced
expensively by counterparties. Consequently, the valuation of these illiquid assets became
problematic due to their inherent opacity (until mid-2007 counterparty risk was a factor that
effectively had NOT even been priced by the market!). Coincidentally, with these VALUATION
and TRANSPARENCY issues, which of the following is TRUE about the ensuing liquidity
crunch?
a) A solvency crisis led to a liquidity crisis

b) The OIS-swap spread narrowed to almost zero
c) Short-term wholesale funding markets started to freeze
d) Systemic reduction in collateral haircuts led to a liquidity crunch
39
Question 62: Gaussian Copula

Below are the joint probabilities for a cumulative bivariate normal distribution with a correlation
parameter, ρ, of 0.30.
If V(1) and V(2) are each variables characterized by a uniform distribution, which is nearest to
the joint probability Pr[V(1) < 0.050, V(2) < 0.050] under a Gaussian copula model?
a) 0.25%
b) 0.71%
c) 1.36%
d) 1.82%
Question 63: Insurance company regulations and pension

funds
A defined benefit pension fund is 50.0% invested in equities and 50.0% invested in bonds. If we
assume the simplest possible balance sheet, which is MOST LIKELY to be the net effect of a
scenario where equities are approximately flat, but interest increase by 100 basis points?
Please note this is inspired by Hull's EOC Question 3.189, so it makes simplifying assumptions
such as (i) the rate increase is a parallel shift of both short- and long-term interest rates, (ii)
durations are not managed, and (iii) the fund is not hedged.
a) Improvement in funded status because present value of liabilities decreases more than
assets decrease
b) Improvement in funded status because present value of assets increases more than
liabilities increase
c) Deterioration in funded status because present value of liabilities increases more than
assets increase
d) Deterioration in funded status because present value of liabilities decreases more than
assets decrease
9
Source for Hull's 3.18: John C. Hull, Risk Management and Financial Institutions, 5th edition (Hoboken, New
Jersey: John Wiley & Sons, 2018).
40
Question 64: Binomial model

Peter initially values a one-year European put option on a non-dividend-paying (q = 0%) stock
with the following assumptions:
 One-year put option maturity with twelve steps in the binomial model (one for each
month): Δt = 1/12
 The strike price is equal to the stock's current price of $40.00; i.e., at-the-money
 Volatility of stock, σ = 25.0% per annum
 Riskfree rate is 3.0% per annum with continuous compounding, r = 3.0%
Once he performs the twelve-step valuation, he decides to re-price the same option but with
only one difference: he will increase the number of steps in the binomial tree to 50 (one for each
week) so that each time step Δt = 1/50. In regard to the switch from twelve steps to 50 steps
(i.e., Δt = 1/12 → Δt = 1/50), each of the following statements is true EXCEPT which is false?
a) In switching from monthly to weekly steps, the number of terminal stock prices increases
from 13 to 51
b) In switching from monthly to weekly steps, the SMALLEST terminal stock price (in the
binomial tree) decreases from $16.82 (when Δt = 1/12) to $6.83 (when Δt = 1/50)
c) In switching from monthly to weekly steps, the LARGEST terminal stock price (in the
binomial tree) increases from $95.10 (when Δt = 1/12) to $234.31 (when Δt = 1/50)
d) In switching from monthly to weekly steps, the probability that the terminal stock price
equals EXACTLY $40.00 (i.e., same as the initial price) approximately doubles because
SQRT(50/12) ≈ 2.0
Question 65: GARP Code of Conduct

Peter is a Risk Analyst (and certified FRM) tasked by his firm to evaluate a half dozen vendors
and make a recommendation to purchase one of their risk management software packages.
The firm has a specific need, and the Risk Committee of the board has given the list of six
vendors to Peter because they are each reputable vendors in the software category. Upon
seeing the list, Peter realizes that he is friends with one of the CEOs (among the six vendors)
because they both volunteer their time to a local charity and, due to this shared interest, they
frequently socialize together.
According to GARP's Code of Conduct, should Peter take any action with respect to a potential
conflict of interest?
a) No action is necessary because the Code is silent with respect to conflicts of interest
b) Peter must withdraw from the task because an FRM must avoid actual, perceived, or
potential conflicts of interest
c) Peter should disclose his potential conflict to his superior(s), but he should be able to
retain the task
d) Peter should cease contact with the CEO (and hiatus the volunteering) because an FRM
must avoid all actual conflicts of interest
41
Question 66: Bivariate normal distribution

The data and plot below show a bivariate normal sample distribution. The first two columns, z(1)
and z(2), display random standard normal variables, N(0,1). Because X(1) is a (non-standard)
random normal variable with mean, µ, of 2.0 and standard deviation, σ, of 4.0, it is given by X(1)
= 2.0 + 4.0 * z(1). On the other hand, X(2) is correlated with X(1) according to the selected
correlation parameter, ρ(X1, X2), of 0.80.
What is the missing third realization ("???") of X(2)?
a) -1.27
b) +3.03
c) +8.50
d) +13.12
42
Question 67: Life insurance products and mortality tables

Below is an extract (selected rows) from a mortality table:
Which is nearest to the probability of a man aged 80 years old dying in the second year
(between ages 81 and 82)?
a) 0.39%
b) 1.76%
c) 6.20%
d) 7.31%
Question 68: Spectral risk measures

In the event of certain operational loss, the severity of the loss ranges from three to 18. As luck
would have it, the loss distribution is similar to the roll of three dice.
For example, in the event of a loss occurrence, the probability of a loss of either three (the
minimum loss) or 18 (the maximum loss) is given by approximately (1/6)^3 = 0.4630%; the
probability of a loss of four or 17 is 3/6^3 = 1.389%. Which are nearest, respectively, to the
95.0% value at risk (VaR) and 95.0% expected shortfall (ES) for the severity of this loss?
a) 14.5 (95.0% VaR) and 15.5 (95.0% ES)

b) 15.0 (95.0% VaR) and 16.4 (95.0% ES)
c) 15.5 (95.0% VaR) and 17.1 (95.0% ES)
d) 16.0 (95.0% VaR) and 18.0 (95.0% ES)
43
Question 69: Policy responses & effects of global financial

crisis
Gorton says, "The recent crisis is often described as being the worst global crisis since the
Great Depression, and the evidence supports this label."10 The financial crisis included two main
panic periods: August 2007 and September‐October 2008. Gorton's literature review compares
the crisis to the long history of previous and numerous financial crises. This comparison
produced two interesting features: on the one hand, the authors found a crucial SIMILARITY to
historical predicates but, on the other hand, they found a novel DIFFERENCE from previous
crises. Which of the following best summarizes, respectively, the feature common (aka,
similarity) to previous crises and the novel difference observed in the recent crisis?
a) Dependence on fiat money (similarity or feature in common) and Innovation in financial

instruments (the novel difference)
b) Growth in notional derivatives outstanding (similarity) and Acceleration in leverage (the
novel difference)
c) Central banking support and intervention (similarity) and Erosion of lending standards
(the novel difference)
d) Acceleration in leverage prior to the crisis (similarity) and Shadow banking system as the
location of bank runs (the novel difference)
Question 70: Correlation

You have assumed a single-index model and regressed the returns for two stocks, stock (A)
and stock (B), against the index in separate univariate regressions. This produced the following
two linear functions, such that β(A) is 0.80 and β(B) is 1.40:
, = + , + ,
= 0.020 + 0.80 +
= 0.050 + 1.40 +
Additionally, the volatility of the index, σ(M), is 20.0%, the volatility of stock A, σ(A), is 32.0%
and the volatility of stock B, σ(B), is 40.0%. Which of the following is the implied correlation
between the two stocks?
a) 0.2240
b) 0.3500
c) 0.4900
d) 1.1200
10
Gary Gorton and Andrew Metrick, 2012. “Getting Up to Speed on the Financial Crisis: A One-Weekend-Reader’s
Guide”, Journal of Economic Literature 50:1, 128—150.
44
Question 71: Long and short hedges

You are meeting with your FRM study group when one of the members of the group says they
are a bit unclear on the definition of the term "short hedge." The following conversation ensues:
I. Albert says, "It's simple, if a company owns an asset but wants to hedge its plan to
sell the asset at the future spot price, a short hedge is appropriate"
II. Barbara says, "Yes, Albert that is true, but if the company plans to sell the
commodity in the future at a predetermined price, then a long hedge is appropriate!"
III. Chris says, "Barbara is correct because a short hedge is simply a hedge where a
short futures position is taken."
IV. Donald says, "Exactly true, Chris. And that means that a short hedge can also be a
cross-hedge; i.e., these terms are not mutually exclusive."
V. Erin says, "And I would like to add that the company does not need to own the asset
in order to conduct a short hedge."
VI. Fred says, "And I would like to add that a short hedge implies negative basis, just as
a long hedge implies positive basis."
Which of the statements is (are) accurate?
a) Only Donald and Erin are accurate

b) Only Albert, Chris, and Fred are accurate
c) All of the statements are accurate, except Barbara's
d) All of the statements are accurate, except Fred's
Question 72: Putting value at risk (VaR) to work

Patricia the Portfolio Manager owns an option portfolio that contains both long and short
positions in European call and put options. The position gamma of the portfolio is negative,
specifically it is -19,500. Recall that position gamma is the product of option quantity and each
option's percentage gamma. For example, a long position in 10,000 call options that each have
a percentage (per option) gamma of 0.050 has a position gamma of +500; on the other hand, a
short position in the same number of options has a position gamma of -500. Position gamma
can be summed across the option portfolio.
Patricia initially estimates her option portfolio's value at risk (VaR) based on a delta
approximation. Her analysis quotes VaR in Loss(+)/Profit(-) format; aka, L/P units. In this way,
losses and VaR are expressed as positive values. However, she realizes that such an estimate
omits the portfolio's negative position gamma, so she re-computes the portfolio's VaR by using
a DELTA-GAMMA approximation. How does the revised estimate compare to the first delta-only
estimate?
a) The delta-gamma L/P VaR is higher

b) The delta-gamma L/P VaR is lower
c) If the position delta is positive, the L/P VaR is lower; but if the position delta is negative,
the L/P VaR is higher.
d) We need more information
45

Suppose that three factors have been identified for the U.S. economy:
 Expected inflation rate (IR) is +2.00%

 Expected 10-year Treasury yield (T-NOTE) is 2.40%
 Expected growth in productivity (PROD) is +3.00%
A stock with an expected return of 9.0% has the following betas with respect to these factors:
β(IR) = +1.50, β(T-NOTE) = -1.20 and β(PROD) = 0.70. In turns out that that economy's actual
factor performance is the given by the following set of results:
 Actual inflation rate (IR) is + 2.60%

 Actual 10-year Treasury yield (T-NOTE) is 3.00%
 Actual growth in productivity (PROD) +2.00%
What is the revised estimate of the stock's expected rate of return (note: this is a variation on
Bodie's Problem 10.111)?
a) 8.480%
b) 9.000%
c) 9.250%
d) 10.375%
Question 74: Linear and nonlinear trends

You would like to describe an account that begins at TIME(0) = $100.00 and compounds
continuously at 9.0% per annum. What is a function that characterizes the value of this account,
A(t), over time according to such a continuous and constant growth trend?
a) A(t) = $100*exp[0.090*TIME(t)]
b) ln[A(t)] = ln($100) + 0.09*TIME(t)
c) Neither (A) nor (B)
d) Both (A) and (B)
11
Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 10th Edition (New York: McGraw-Hill, 2013)
46
Question 75: Cost of carry and normal backwardation

The current price of a technology index is 3,000 and its yield, q, is 2.0% per annum with
continuous compounding; i.e., about 2.010% per annum with semi-annual compounding. The
risk-free rate is 3.0% per annum with continuous compounding. The discount rate for the index
can be determined by the capital asset pricing model (CAPM) where its beta is 1.80 and the
market's expected return is 9.0%; i.e., the market's expected excess return is 6.0%. Which is
nearest to the index's expected future spot price in 10 months, E[S(+0.833)]?
a) $3,025.10
b) $3,127.64
c) $3,309.99
d) $4,005.05
Question 76: Stress testing validation and internal audit

Which of the following statements is TRUE about the role of validation in stress testing
governance?
a) Stress that cannot be fully validated should not be used

b) Stress-test estimates should be continuously backtested against realized outcomes
because quantitative backtest results are a common, critical validation metric
c) Expert-based judgement should be applied to ensure that test results are intuitive and
logical, and to add additional perspective on stress-test performance
d) If a model fails to perform strongly in the data-rich environment of a baseline (e.g., good
times) setting, then it cannot be trusted to estimate stressed outcomes
Question 77: Fama-French three factor model

Assume a sock's returns are accurately characterized by the Fama-French three-factor model.
The stock's own factor betas and the risk model's risk premiums are given here:
What is the firm's size/value style characteristics and what is the

firm's required rate of return?
a) Small-cap, growth-oriented with a required return of 5.50%

b) Small-cap, value-oriented with a required return of 6.00%
c) Large-cap, growth-oriented with a required return of 3.50%
d) Large-cap, value-oriented with a required return of 8.00%
47
Question 78: Bootstrapping

What is the crucial difference between bootstrapping and Monte Carlo simulation?
a) One uses artificial data but the other requires actual data
b) One requires random number generation, but the other does not rely on randomness
c) One requires a distributional assumption, but the other does not permit a distributional
assumption
d) There is no crucial difference between bootstrapping and Monte Carlo simulation
Question 79: Quoted versus cash bond prices

The price of a 72-day Treasury bill is quoted as 7.00. Which is nearest to the continuously
compounded return (on an actual/365 basis) that an investor will earn on the Treasury bill for
the 72-day period? (note: inspired by Hull's EOC Problem 6.8)12
a) 1.40000% per annum with continuous compounding

b) 5.60000% per annum with continuous compounding
c) 5.71790% per annum with continuous compounding
d) 7.14737% per annum with continuous compounding
12
48
Question 80: Value at risk (VaR) estimation approaches

Linda Allen13 introduces the following value at risk (VaR) estimation approaches:
 Historical simulation (HS)
 GARCH (1,1)
 Hybrid
 Multivariate density estimation (MDE)
 Historical standard deviation (STDEV)
 Adaptive volatility (AV)
Consider these six summary descriptions:

I. The simplest parametric approach whose weakness is sensitivity to window
length and extreme observations
II. The most convenient and prominent non-parametric approach whose weakness
is inefficient use of data
III. An interpretation of the exponentially weighted moving average (EWMA) that
gives the risk manger a rule that can used to adapt prior beliefs about volatility in
the face of news
IV. A parametric approach that assumes conditional returns are normal but
unconditional tails are heavy; and that returns are not correlated but conditional
variance is mean-reverting
V. An approach that weights past squared returns not by time but instead according
to the difference between current and past states of the world
VI. An approach that modifies historical simulation by assigning exponentially
declining weights to past data such that recent (distant) returns are assigned
more (less) weight
Which sequence below correctly matches the VaR estimation approach with its summary
description?
a) I = HS, II = AV, III = GARCH, IV = MDE, V = Hybrid, VI = STDEV

b) I = GARCH, II = MDE, III = Hybrid, IV = STDEV, V = HS, VI = AV
c) I = STDEV, II = HS, III = AV, IV = GARCH, V = MDE, VI = Hybrid
d) I = AV, II = Hybrid, III = STDEV, IV = HS, V = GARCH, VI = MDE
13
Linda Allen, Jacob Boudoukh and Anthony Saunders, Understanding Market, Credit and Operational Risk: The
Value at Risk Approach (Oxford: Blackwell Publishing, 2004)
49
Question 81: Getting up to Speed on the Financial Crisis

According to Ben Bernanke, among the following trigger/vulnerability pairs, which were the
primary TRIGGERS and (among) the primary VULNERABILITIES, respectively, that led to the
financial crisis?
a) Derivatives (trigger); and Monetary policy (vulnerability)
b) Deficiencies in Risk Management (trigger); and The prospect of losses on subprime
mortgage loans (vulnerability)
c) Leverage (trigger); and Sudden stop in syndicated lending to large, relatively risky
corporate borrowers (vulnerability)
d) The prospect of losses on subprime mortgage loans (trigger); and Dependence on
unstable short-term funding (vulnerability)
Question 82: Sample moments and bias

During a recent workweek, Peter recorded the number of dropped calls to the company's
support line. For the tiny sample of five days (n = 5), the average number of dropped calls was
9.60 per day. Peter used Excel's VAR.P() to retrieve the variance and the result was 1.840.
However, his colleague Mary pointed out that this is a biased estimate of the unknown
population variance. What is the unbiased estimate of the variance?
a) 1.472
b) 1.840
c) 2.300
d) Needs more information
Question 83: Swaps

A $100.0 million interest rate swap has a remaining life of 15 months. Under the terms of the
swap, six-month LIBOR is exchanged for 3.60% per annum (compounded semiannually). Six-
month LIBOR forward rates for all maturities are 3.00% (with semiannual compounding). Two
Three months ago, the six-month LIBOR rate was 2.90% (this assumption is shown in purple
cell below). OIS rates for all maturities are 2.80% with continuous compounding.
Which is nearest to the current value of the swap

to the counterparty who is paying the floating rate?
(Inspired by Hull's EOC Problem 7.2, 10th
Edition)14
a) -$295,850
b) +$931,000
c) +$1.80 million
d) +$2.14 million
14
Hull, Options, Futures, and Other Derivatives, 10th Edition (New York: Pearson, 2017).
50
Question 84: Classical value at risk (VaR)

Rebecca has determined that her equity portfolio's 25-day 95.0% confident absolute value at
risk (aVaR) is given by -µ*Δt + σ*α*sqrt(Δt) = -12,000 + 208,000 = $196,000. She subsequently
decides that she wants to translate this into a 10-day 99.0% confident aVaR. If the returns are
i.i.d. and normally distributed, which of the following is nearest to the translated VaR?
a) 133,300
b) 150,000
c) 181,530
d) 195,400
Question 85: Principles for risk data aggregation

Among the Basel Committee's Principles for effective risk data aggregation and risk reporting,
Principle 2 is "Data architecture and IT infrastructure: A bank should design, build and maintain
data architecture and IT infrastructure which fully supports its risk data aggregation capabilities
and risk reporting practices not only in normal times but also during times of stress or crisis,
while still meeting the other Principles."15 The principle includes paragraph 33, where two terms
have been replaced with "[keyword #1]" and "[keyword #2]":
"A bank should establish integrated data [keyword #1 here] and architecture across the banking
group, which includes information on the characteristics of the data--i.e., [keyword#2 inserts
here]--as well as use of single identifiers and/or unified naming conventions for data including
legal entities, counterparties, customers and accounts." The first keyword, [keyword #1], refers
to the categorization or classifications of data; for example, market risk and credit risk are
categories of risk. The second keyword, [keyword #2], refers to information about the data."15
Which terms correctly replace, respectively, [keyword #1] and [keyword #2]?
a) Aggregation and principles

b) Capabilities and architecture
c) Taxonomies and metadata
d) Timeliness and accuracy
15
“Principles for Sound Stress Testing Practices and Supervision” (Basel Committee on Banking Supervision
Publication, May 2009)
51
Question 86: Hypothesis testing

Peter Parker at Betalab Bank emailed a survey to the bank's customers. The survey included a
question that asked them to rank their customer satisfaction on a scale from one to 10. She
received 51 responses, and she considers that a random sample (n = 51). Among this sample,
the average satisfaction score (on a scale of one to 10) is 8.50 with a sample standard deviation
of 1.90. Betalab's CEO is Mary-Jane, FRM, and she hopes that the bank's average customer
satisfaction is at least 9.0. Mary-Jane holds the FRM designation, so she understands that
acceptance of the null is more accurately a failure to reject the null, but she is a practical
person. Her null hypothesis is that the population's average customer satisfaction is at least 9.0
(i.e., H0: μ ≥ 9.0 and H1: μ < 9.0). Peter shares his sample findings with five of his colleagues,
and each colleague gives different input, as follows:
I. Albert says the test statistic is (8.5 - 9.0) ÷ [1.90 / SQRT(51)] = -1.88, or |-1.88| =
1.88
II. Betty says that if the sample size were doubled, ceteris paribus (i.e., same sample
mean and sample standard deviation), the test statistic will increase about +41%
III. Chris says that (for n = 51) Mary should use a one-sided test, and with one-sided
95.0% confidence (aka, 5.0% significance) she should reject the null
IV. Derek says that (for n = 51) Mary can accept (aka, fail to reject) the CEO's null
hypothesis with 95.0% confidence but only if she artificially switches to a two-sided
hypothesis (i.e., H0: μ = 9.0 and H1: μ ≠ 9.0). Notice how this insincerely "games"
the test: the setup here calls for a one-sided test.
V. Erin agrees with Chris and says that Mary should use a one-sided test per the CEO's
one-sided hypothesis but notes that Peter can accept (aka, fail to reject) the null with
one-sided 99.0% confidence (aka, 1.0% significance)
Which of the five statements is (are) correct?

a) None of the statements are correct
b) Only I. and II. are correct
c) Only IV and V. are correct
d) All five of the statements are correct
Question 87: Option combination strategies

As she analyzes a stock, Barbara contemplates a straddle because she wants to express her
view that there will be a big change in the stock price, either dramatically up or down, but she is
uncertain as to the direction. In this way, she wants an option combination strategy that is "long
volatility." However, the straddle is more expensive than she anticipated. Which of the following
will allow her to generally express her "long volatility" view (giving her the potential for a large, or
even uncapped, payoff in the event of a dramatic price move) but with a cost that is REDUCED
in comparison to the straddle?
a) Strip
b) Strap
c) Strangle
d) Reverse butterfly spread
52
Question 88: Stress Testing and Risk Management Tools

Shown below is a bank's portfolio of wholesale exposures (this is Siddique and Hasan's Table
2.2):16
The bank needs to estimate the sensitivities of this portfolio's losses to changes in two macro
variables: gross domestic product (GDP) growth and unemployment. If the bank conducts a
stress test, each of the following is likely--or at least reasonable--to be included in the bank's
stress test assumptions EXCEPT which is the LEAST likely to be an assumption in the stress
test?
a) An abrupt increase in exposures (EAD); e.g., EADs increase by 30.0%

b) Transition to lower rating buckets; e.g., $500 million transitions to Rating 7
c) Stressed default probabilities (PDs); e.g., for Rating bucket 3 the PD spikes to 4.0%
d) Stressed loss given default (LGD); e.g., LGD increases by 10.0% for all rating buckets
Question 89: Credit Crisis of 2007

“Agency costs” is a term used to describe the costs in a situation where the interests of two
parties are not perfectly aligned. In the events leading up to the Global Financial Crisis (CFC;
aka, credit crisis), which of the following was a source of agency cost?
a) Home appraisers seeking loan-to-value ratios

b) Rating agencies paid by issuers
c) Annual (end-of-year) bonuses
d) All of the above
16
Akhtar Siddique and Iftekhar Hasan, Stress Testing: Approaches, Methods, and Applications (London: Risk Books,
2013)
53
Question 90: BLUE estimators, Law of large numbers (LLN),

and central limit theorem (CLT)
Barbara just received a dataset. She runs the dataset through five different regression models,
where each regression model employs a different estimator for the slope. The properties of the
slope estimators include the following:
 Estimator A is biased but has the smallest variance (3.7)

 Estimator B is linear and biased but has a small variance (4.6)
 Estimator C is linear and unbiased but has a medium variance (9.5)
 Estimator D is nonlinear and biased but is consistent and has a large variance (11.8)
 Estimator E is nonlinear and unbiased but has the largest variance (14.1)
Which of these estimators is BLUE?
a) None of the estimators are BLUE

b) Estimators A and B are both BLUE, but none of the others are BLUE
c) Estimator C might be BLUE, but none of the others are BLUE
d) Estimators D and E might both be BLUE, but none of the others are BLUE
Question 91: Exchange option, volatility swap, and static

option replication
Patricia wants to hedge her portfolio of exotic options. The portfolio consists mostly of barrier
options. She is comparing a classic delta-hedge to a static options replication; the static option
replication entails shorting a portfolio that replicates certain boundary conditions. Each of the
following is a good argument in favor of a static option replication, for the purpose of hedging
her portfolio, EXCEPT which is WEAKEST argument?
a) The delta of barrier options is discontinuous at the barrier and consequently difficult to
delta-hedge
b) The delta-hedged portfolio can still experience losses due to large moves in the
underlying asset price
c) Static options replication has a key advantage over delta-hedging in that it does not
require frequent rebalancing
d) Her underlying position is already options and static option replication is not designed to
hedge options, as it would add risk to hedge options with options
54
Question 92: Key rate exposure technique in multi-factor

hedging applications
Assume we follow Tuckman's17 illustration and estimate the key rate exposures (i.e., KR01s and
key rate durations) for a zero-coupon bond with 30 years to maturity; e.g., C-STRIP. The key
interest rate is a par yield. The analysis selects four key rates: 2-year, 5-year, 10-year, and 30-
year. Further, as Tuckman explains about the rule for rates between neighbors, "each of the
four shapes is called a key-rate shift. Each key rate affects par yields from the term of the
previous key rate (or zero) to the term of the next key rate (or the last term). For example, the
10-year key rate affects par yields of terms 5 to 30 years only. Furthermore, the impact of each
key rate is normalized to be one basis point at its own maturity and then assumed to decline
linearly, reaching zero at the terms of the adjacent key rates. For the two-year shift at terms of
less than 2 years and for the 30-year shift at terms greater than 30 years, however, the
assumed change is constant at one basis point."17
About this key rate exposure technique, each of the following statements is true EXCEPT which
is false?
a) It is possible for a 30-year zero coupon bond to have a non-zero key-rate with respect to
the 10-year shift
b) Due to the linear decline between neighbors, we need to double (i.e., multiply by 2) the
sum of the four KR01s to approximate the DV01 of the security
c) The shift in the 10-year par yield (as the key rate) implies a shift of greater than one
basis point in the 10-year spot rate and a negative shift in the 30-year spot rate
d) If the key-rate '01 with respect to the 5-year shift is -0.0035, KR01(5.0) = -0.0035, then
the security's price increases by $0.0035 per $100 face value amount for a positive one-
basis point shift in the five-year key rate
Question 93: Mechanisms for transmitting risk governance

Each of the following is true about the re-empowered role of the Chief Risk Officer (CRO)
a) The CRO should report to line business management, but should be independent of
both the CEO and the board's risk committee
b) The CRO must evaluate all new financial products to verify that the expected return is
consistent with the risks undertaken
c) CROs should not just be after-the-fact risk managers but also risk strategists
d) The CRO they should play a significant role in determining the risks that the bank
assumes as well as helping to manage those risks.
17
Bruce Tuckman, Fixed Income Securities, 3rd Edition (Hoboken, NJ: John Wiley & Sons, 2011)
55
Question 94: Linear transformation of covariance and

correlation
Over the previous six months, two assets generated the monthly returns displayed below under
columns X(i) and Y(i). The third and fourth columns display the squared difference-from-
average-returns that inform the univariate variance; the fifth column shows the associated
cross-product that informs their covariance.
Because this is a very small sample, we want to retrieve unbiased sample moments. What are,
respectively, the unbiased sample variances of the two variables and their sample covariance?
a) The unbiased sample variances, σ^2(X) = 2.16 and σ^2(Y) = 2.50 and sample
covariance σ(X,Y) = 3.67
b) The unbiased sample variances, σ^2(X) = 4.67 and σ^2(Y) = 6.25 and sample
c) The unbiased sample variances, σ^2(X) = 4.67 and σ^2(Y) = 6.25 and sample
d) The unbiased sample variances, σ^2(X) = 5.60 and σ^2(Y) = 7.50 and sample

The price of a dividend-paying stock is $44.00 while the riskfree rate is 3.0%. Consider a
European call option and a European put option with identical strike prices, K = $40.00, and
identical times to expiration of nine months, T = 0.75 years. The call has a price of $8.95 and
the put has a price of $5.36. What is the present value of the dividends expected during the life
of the option?
a) Zero
b) $0.19
c) $1.30
d) $4.75
56
Question 96: External credit rating scales

Consider the following one-year rating transition (aka, migration) matrix illustrated below:
About this migration matrix, each of the followings statements is true EXCEPT which is false?
a) Bonds rated either A, AA, or AAA will not default within one year
b) Over a one-year period, the most likely outcome for any rated bond is an unchanged
rating
c) At the end of two years, a bond with an AAA-rating will necessarily still be an
investment-grade obligor
d) The probability that a bond with an AAA-rating will have the same rating at the end of
two years is greater than 0.940^2 = 88.360%
Question 97: Types of risk

Crouhy writes that "understanding [the difference between expected loss and unexpected loss]
is the key to understanding modern risk management concepts such as economic capital
attribution and risk-adjusted pricing."18 Which of the following statements is TRUE about
unexpected loss (UL)?
a) Unexpected loss levels tend to be higher for a consumer credit card portfolio than a
corporate loan portfolio
b) In a credit portfolio, higher default correlation implies lower portfolio unexpected losses
c) Unexpected loss (UL) it typically priced into the products or services offered to
customers, while expected loss is the denominator of risk-adjusted return on capital
(RAROC)
d) Market risk value at risk (MVaR) can be expressed as either relative MVaR or absolute
MVaR but it is "relative MVaR" that matches (better captures) unexpected losses (UL)
18
Michel Crouhy, Dan Galai, and Robert Mark, The Essentials of Risk Management, 2nd Edition (New York:
McGraw-Hill, 2014)
57
Question 98: Probability matrix

A stock (X1) has three possible returns: -5%, 0, or +5%. The analyst rating (X2) can be negative
(denoted by X2= -1), neutral (X2 = 0), or positive (X2 = +1). The probability matrix is displayed
below (inside the square). Six joint probabilities are given, but three are missing; for example,
the joint probability of a negative analyst rating and a negative stock return, P(X1 = -5% ∩ X2 =
-1) = 14.0%.
The bottom row (outside the square) displays the unconditional (aka, marginal) probabilities for
the stock; for example, the unconditional Pr(X1 = -5%) = 20.0%. What is the unconditional (aka,
marginal) probability that the analyst rating is positive, Pr(X2 = +1)?
a) 28.0%
b) 39.0%
c) 46.0%
d) 60.9%
Question 99: Arbitrage and the cost of carry model

The spot price of wheat is $5.00 per bushel while the risk-free rate is 3.0% per annum with
continuous compounding. The cost to store wheat is 12.00% per annum as a proportion of the
spot price. The traded (observed) price of a nine-month wheat futures contract, F(0, 0.75), is
$5.430. Among the following choices, which of the following scenarios is the most likely?
a) Arbitragers will immediately compel the futures contract price to increase by $0.165
b) Arbitragers will immediately compel the futures contract price to increase by $1.370
c) We can currently conduct a cash-and-carry arbitrage, borrowing to buy the asset at the
current spot price, for a future profit of about $0.316 per bushel
d) The market is concerned that a possible shortage (i.e., lack of supply) in wheat might
occur and this is reflected in a convenience yield of about 4.0% per annum as a
proportion of the spot price
58
Question 100: Components of Country Risk

Peter works for an ESG fund that evaluates political risk. Among the components of political
risk, Peter's fund assigns the greatest weight to corruption. If corruption is the most important
criteria, into which of the following countries is Peter's firm MOST LIKELY to invest; i.e., which
is least corrupt?
a) Libya
b) Mexico
c) Venezuela
d) New Zealand
59
Instructor Answer Sheet: An X is marked under the correct answer.

1 D
2 X
3 X
4 X
5 X
6 X
7 X
8 X
9 X
10 X
11 X
12 X
13 X
14 X
15 X
16 X
17 X
18 X
19 X
20 X
21 X
22 X
23 X
24 X
25 X
26 X
27 X
28 X
29 X
30 X
31 X
32 X
33 X
34 X
35 X
36 X
37 X
38 X
39 X
40 X
60
41 X
42 X
43 X
44 X
45 X
46 X
47 X
48 X
49 X
50 X
51 X
52 X
53 X
54 X
55 X
56 X
57 X
58 X
59 X
60 X
61 X
62 X
63 X
64 X
65 X
66 X
67 X
68 X
69 X
70 X
71 X
72 X
73 X
74 X
75 X
76 X
77 X
78 X
79 X
80 X
81 X
82 X
83 X
84 X
61
85 X
86 X
87 X
88 X
89 X
90 X
91 X
92 X
93 X
94 X
95 X
96 X
97 X
98 X
99 X
100 X
62
Answers & Explanations

Question 1: Risk typology
The classic risk management process affirms the job of a risk manager to include four activities:
identifying risks; analyzing and measuring risks; assessing the impact of risk events; and
managing risks. This process culminates in the series of decisions as to how to handle identified
risks. Which of the following is (TRUE as) a common activity of the risk manager?
a) To either avoid or transfer each risk
b) To quantify every risk in an exact way; i.e., single number
c) To eliminate each risk to the fullest extent possible
d) To help identify where the firm should add risk
Answer: D. TRUE: To help identify where the firm should add risk
As GARP (Chapter 1, 2020) explains, "The risk management process culminates in a series of
choices that both manage risk and help to define the identity and purpose of the firm.
 Avoid Risk: There are risks that can be sidestepped by discontinuing the business or
pursuing it using a different strategy. For example, selling into certain markets, or
offshoring production, might be avoided to minimize political or foreign exchange risks.
 Retain Risk: There are risks that can be retained within the firm’s risk appetite. Large
risks can be retained through mechanisms such as risk capital allocation, self-insurance,
and captive insurance.
 Mitigate Risk: There are risks that can be mitigated by reducing exposure, frequency,
and severity (e.g., improved operational infrastructure can mitigate the frequency of
some kinds of operational risk, hedging unwanted foreign currency exposure can
mitigate market risk, and receiving collateral against a credit exposure can mitigate the
severity of a potential default).
 Transfer Risk: There are risks that can be transferred to a third party using derivative
products, structured products, or by paying a premium (e.g., to an insurer or derivatives
provider)."19
In regard to (A), (B) and (C), each is FALSE
 In addition to avoid or transfer, we can retain or mitigate a risk
 Not nearly every risk can be quantified, but we should at least attempt to determine
frequency and severity distributions (or ranges)
 The goal is not necessarily to eliminate or reduce every risk. This is a crucial feature of
modern risk management: it seeks to add value and offer inputs into strategy. As GARP
explains (emphasis ours), "As the risk taker improves its risk management strategy, it
will begin to avoid or mitigate non-essential or value-destroying risk exposures, which in
turn will allow it to assume more risk in areas where it can pursue more value-creating
opportunities for its stakeholders ... In modern economies, risk management is therefore
not only about corporate survival. It is critically important to the broader processes of
specialization, scaling, efficiency, and wealth creation."19
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-20-1-building-

block-of-risk-management-risk-typology.22992/
19
2020 FRM Part I: Foundations of Risk Management, 10th Edition. Pearson Learning Solutions, 10/2019
63

Below are a set of innovations over ten steps (from initial t = 0 to t = 10) and the first innovation
ε(1) = 0.26. The innovations are random Gaussian white noise, ε(t) ~ N(0, σ^2 = 1).
Consider two time series models. The AR(1) model has an intercept, δ, of 0.70, and an AR
parameter, φ, of 0.50. The MA(1) model has a mean, μ, of 0.70, and a weight of 0.50. Which of
the following is nearest the value at t = 4; i.e., which are the missing values inside the red
rectangle?
a) AR(1) = 1.7650 and MR(1) = 1.2100

b) AR(1) = 1.9630 and MR(1) = 1.8550
c) AR(1) = 2.8600 and MR(1) = 2.2570
d) AR(1) = 3.2430 and MR(1) = 2.6800
Answer: A. True: AR(1) = 1.7650 and MR(1) = 1.2100
For the AR(1) model:

At t = 3, the value is 0.70 + 0.50*0.8200 + 1.92 = 3.0300
At t = 4, the value is 0.70 + 0.50*3.0300 - 0.45 = 1.7650
At t = 5, the value is 0.70 + 0.50*1.7650 - 0.30 = 1.2825
For the MA(1) model:

At t = 3, the value is 0.70 + 0.50*(-0.36) + 1.92 = 2.440
At t = 4, the value is 0.70 + 0.50*1.92 - 0.45 = 1.2100
At t = 5, the value is 0.70 + 0.50*(-0.45) - 0.30 = 0.1750
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-22-stationary-

time-series-autoregressive-ar-and-moving-average-ma-processes.23527/
64
Question 3: Lookback and Asian (exotic) options

Consider the price of an asset that begins and $30.00 and ends, after 20 periods, lower at
$8.55. Also highlighted are its maximum ($39.23) and minimum price ($6.79) during this 20-
period life:
Among the following choices, which lookback option has the HIGHEST payoff if its life matches
the 20-period interval shown?
a) Floating lookback call

b) Floating lookback put
c) Fixed lookback call with strike = $30.00 (matching the initial asset price)
d) Fixed lookback put with strike = $30.00 (matching the initial asset price)
Answer: B. Floating lookback put payoff equals $30.68. Payoffs are given by:
 Floating lookback call: S(T) - min(...) = $8.55 - $6.79 = $1.75

 Floating lookback put: max(...) - S(T) = $39.23 - $8.55 = $30.68
 Fixed lookback call (K = $30.00): max[max(...) - K, 0] = $39.23 - $30.00 = $9.23
 Fixed lookback put (K = $30.00): max[K - min(...), 0] = $30.00 - $6.79 = $23.21
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-731-lookback-

and-asian-exotic-options-hull-chapter-26-cont.10749/
65
Question 4: Credit loss distribution

Consider a large $20.0 million portfolio of 100 loans. In its general form, the portfolio's
unexpected loss is given by:20
However, each loan in this portfolio has approximately the same characteristics and size; i.e.,
the size of each is about $200,000. For modeling purposes, we can set the pairwise correlation
coefficient to be constant ρ(i,j) = 0.160 for all i ≠ j. These assumptions greatly simplify the
calculation of the portfolio's unexpected loss and each loan's contribution to portfolio risk.
In this situation, which of the following statements is TRUE?
a) A practical problem with using the general form (i.e., specifying the correlation matrix) is
that default correlations are very difficult to observe
b) Under the simplifying assumptions, each loan's risk contribution (aka, unexpected loss
contribution, ULC) is conveniently 16.0% of its individual unexpected loss, UL
c) If we attempted to estimate the portfolio's unexpected loss by specifying the pairwise
correlation matrix of each ρ(i,j), then we would require 100! or 9.3E+157 correlation pairs
d) When estimating the portfolio's unexpected loss and its component contributions, banks
prefer these analytical approaches over numerical procedures because the latter are
cumbersome and prone to estimation errors
Answer: A. True. Default correlations are very difficult to observe.
Schroeck: "If one tried to estimate the portfolio UL by using Equation (5.8), one would need to
estimate [n(n – 1)]/2 pairwise default correlations. Given that typical loan portfolios contain many
thousand credits, this is impossible to do. Additionally, one needs to consider the fact that
default correlations are very difficult, if not impossible, to observe."20
In regard to (B), (C) and (D), each is FALSE.

 In regard to false (B), each loan's risk contribution is given by, ULC(u) = UL(i)*sqrt(ρ);
in this case, each loan's contribution is sqrt(0.16) = 40.0% of its individual unexpected
loss
 In regard to false (C), we would "only" require 100*99/2 = 4,950 pairwise correlations
 In regard to false (D), says Schroeck, "Overall, the analytical approach is very
cumbersome and prone to estimation errors and problems. To avoid these difficulties,
banks now use numerical procedures to derive more exact and reliable results."20
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-922-quantifying-

the-credit-loss-distribution-schroeck.22892/
20
Gerhard Schroeck, Risk Management and Value Creation in Financial Institutions, (New York: Wiley, 2002
66
Question 5: Primitive risk factors and tail risk

A big part of a risk manager's job is to identify her firm's risk factors. Each of the following
statements about risk factors is true EXCEPT which is false?
a) Two examples of primary (aka, primitive) risk factors include the return on a broad stock
market index and the risk-free spot (aka, zero) interest rate
b) For any risk factors that are represented by categorical or discrete variables, the risk
manager should seek to replace them with either interval, ratio, or continuous risk factor
variables
c) One of the risk manager's key activities is to deconstruct primitive risk factors into the
important loss drivers, the relationship of the loss drivers with each other, and the wider
business environment
d) Machine learning, as a subset of artificial intelligence, holds the potential to help risk
managers identify the "unknown unknowns" (aka, unk-unks)
Answer: B. FALSE. Instead, many risk factors are characterized by categorical or

discrete variables
Each of (A), (C) and (D) are TRUE.
About true (D), GARP writes, "Across the risk industries, massive computing power can now
help risk managers spot patterns and relationships in data more quickly. Unsupervised machine
learning [a subset of artificial intelligence] can help the risk manager identify the unknown
unknowns [aka, unk-unks] through identifying clusters and correlations without specifying the
area of interest in advance. Risk managers are about to enter an age of plenty in terms of data
volume and risk factor analysis."21
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-20-2-primitive-

risk-factors-and-tail-risk.23006/
21
67
Question 6: Regression diagnostics

Below are displayed 15 pairwise (X,Y) trials. The simple regression line based on all 15
observations is given by Y1 = 0.488 + 0.425*X. We consider the possibility that the 12th Trial,
given by point (X = 2.50, Y = -3.00) might be an outlier. If this point is removed, then the
regression based on the remaining 14 observations is given by Y2 = 0.761 + 0.574*X. These
results are displayed, including selected summary statistics.
According to Cook's distance, is the 12th Trial an

outlier?
a) No, because its Cook's distance is negative
b) No, because its Cook's distance is
3.341/(2*1.916) = 0.872
c) Yes, because its Cook's distance is +0.15 (as
given by the slope change)
d) Yes, because its Cook's distance is
1.916/(2*0.223) = +4.301
Answer: B. True: No because its Cook's distance is 3.341/(2*1.916) = 0.872
Cook's distance measures the sensitivity of the fitted values to dropping a single observation
and is given as follows by D(j):
( )
∑
=
In this case, the numerator is displayed on the given table (i.e., 3.341), and also displayed is the
estimate of the error variance, s^2 = 1.916. As this is univariate regression, k = 2 coefficients.
The Cook's distance is therefore given by 3.341/(1.916*2) = 0.872. Because this is less than
1.0, we do not view the 12th trial as an outlier.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-20-

regression-diagnostics-outliers-cooks-distance-m-fold-cross-validation-and-residual-
diagnostics.23497/
68
Question 7: Option spread strategies

Assume the current price of a stock is $30.00 and imagine that we can only trade the following
four options at two strike prices:
$3.98 and p(K=28.00) = $1.46
$2.05 and p(K=32.00) = $3.46
Each of these prices is approximately accurate for a six-month option when the volatility is
31.2% (but these details are not necessary to answering the question). If we want to implement
a bull spread, how could we do that?
a) We cannot create a bull spread with these options

b) Long the call with strike of 32.00 plus Short the put with strike of 28.00
c) Long the call with strike of 28.00 plus Short the call with strike of 32.00; or Long the put
with strike of 28.00 plus Short the put with strike of 32.00
d) Long the call with strike of 32.00 plus Short the call with strike of 28.00; or Short the put
with strike of 28.00 plus Long the put with strike of 32.00
Answer: C. True: Long the call with strike of 28.00 plus Short the call with strike of 32.00;
or Long the put with strike of 28.00 plus Short the put with strike of 32.00.
Working with the four options assumed, there are four possible spread treads (see below for
profit diagrams).
 A bull spread can be implemented with calls
or puts. A bull spread with calls requires an
upfront investment because the strike of the
purchased call is lower than the strike of the
written call (upper-left plot below). A bull
spread with puts generates up-front cash flow
because the strike of the purchased put is
lower than the strike of the written put (upper-
right plot below).
 A bear spread can be implemented with calls
or puts. A bear spread with puts requires an
upfront investment because the strike of the
purchased put is higher than the strike of the
written put (lower-left plot below). A bear
spread with calls generates up-front cash flow
because the strike of the purchased call is
higher than the strike of the written call (lower-
right plot below).
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-727-option-

spread-strategies-hull-chapter-12.10719/
69
Question 8: Linking internal rating systems to external credit ratings

Finlux International seeks to build an internal rating system for its considerable credit portfolio
and assigns the project to a team including Alice, Bob, Chris, and Denise. In order to cast a
wide net for ideas, each of the team members builds a mini prototype:
I. Alice (A) developed an internal migration matrix based on a sample taken during a
recession such that (related) her probabilities are not Markovian, yet to retrieve 5-year
cumulative default probabilities she raises the matrix to the fifth power (i.e.., 5-year
cumulative matrix = M^5) a calculation that might be valid if her probabilities were
Markovian
II. Bob (B), in order to maximum the universe of rated bonds, combines ratings for all of the
major agencies across industries, countries, asset classes
III. III Chris (C) uses a method of polling the salespeople who originate the loans on the
theory that these are the people with the best "on the ground" knowledge of credit risk
IV. Denise (D) mixed at-the-point-in-time and through-the-cycle ratings because she was
unaware of which methodological assumption applied to each sourced dataset
Which of the following accurately matches each team member to the bias that afflicts their
approach?
a) Country A is the most likely to default because debt above 100% is highly predictive of
default and overwhelms the other indicators
b) Country B is the most likely to default because it is the only country with three (out of
four) negative indicators
c) Country C is the most likely to default because it has an autocratic government
d) It is unclear: each has two negative (and two positive) indicators; further, quantification
of this scorecard is an insufficient predictor
Answer: A. TRUE: Alice (A) = Scale bias; Bob (B) = Homogeneity bias; Chris (C) =
Principal-Agent bias; Denise (D) = Time horizon bias
 Appendix 2C: "1. Time horizon bias. Mixing at-the-point-in-time and through-the-cycle
ratings; 2. Homogeneity bias. Not obtaining consistency of rating methodologies across
industries, countries, or asset classes; 3. Principal agent bias. Not managing the
potential conflict of interest between risk and salespeople within a bank; 4. Information
bias. Insufficiency of information to assign a rating; 5. Criteria bias. Having no clear-cut
and stable criteria for allocating ratings; 6. Scale bias. Not keeping a stable rating scale
through time; 7. Bias arising from lack of back testing. Bank analysts trusting blindly the
theoretical mapping between their rating classes and effective default rates without
validating it regularly on ex post default data; 8. Distribution bias. Bias in the outcome of
the PD model resulting from the choice of a specific distribution (often the normal
distribution) to model explanatory factors."22
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-919-linking-

internal-rating-systems-to-external-credit-ratings-de-servigny-ch-2.22404/
22
Arnaud de Servigny and Olivier Renault, Measuring and Managing Credit Risk (New York: McGraw-Hill, 2004)
70
Question 9: Risk management building blocks

One of the risk management building blocks is enterprise risk management (ERM). Which of the
following is TRUE as a feature or implication of ERM?
a) ERM encourages organizational silos to sharpen their self-identities
b) ERM supports a firm's 360-degree view of risk which requires multiple tools
c) ERM enables a complex firm to summarize its overall risk into a single number
d) ERM replaces instances of judgment with the application of statistical science
Answer: B. TRUE: ERM supports a firm's 360-degree view of risk which requires multiple
tools
Modern enterprise risk management (ERM) takes a holistic approach. To achieve this, GARP
says firms need to think bigger and this includes at least four aspects: Join Up Risk Silos;
Environment Matters; Culture Matters; and 360 Degree View of Risk (where such a 360 degree
view requires a full range of risk analysis tools looking at various time horizons). Source: Figure
1.7 in Chapter 1.23
In regard to (A), (C), and (D), each is FALSE.

 ERM does NOT encourage organizational silos to sharpen their self-identities. The
opposite! The mantra for ERM is something like breaking down organizational silos.
ERM is supposed to "join up" silos.
 ERM does NOT expect or want a complex firm to summarize its overall risk into a single
number: "Oftentimes, historic ERM efforts have over-focused on the need to express risk
as a single number such as economic capital or VaR. Expressing risk as a single
number was too simplistic an approach. Perhaps the biggest lesson of the 2007–2009
global financial crisis was that risk cannot be reduced to any single number: (i) It is multi-
dimensional, so it needs to be approached from many angles, using multiple
methodologies; (ii) It develops and crosses risk types, so even a wide view of risk
types—but at only one point in time—may miss the point; (iii) It demands expert
judgment that is combined with application of statistical science," explains GARP.23
 ERM does NOT intend to replace the VALUE of judgment. See the quote above.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-20-3-risk-

management-building-blocks.23018/
23
71
Question 10: Multiple regression

Sally is a portfolio manager at an investment management firm. She wants to test her primary
equity portfolio's reaction to the factors in the Fama-French three-factor model. She collected
excess returns (i.e., net of the risk-free rate) over the last eight years, so that the sample size, n
= 96 months. The response (aka, explained, dependent) variable is the portfolio's excess return.
The three explanatory variables are the market factor (MKT), the size factor (SMB), and the
value factor (HML). The size factor captures the excess return of small capitalization stocks
(SMB = "small minus big") and the value factor captures the excess returns of value stocks
(HML = "high book-to-market minus low book-to-market")'. Sally's regression results are
displayed below.
Which of the following descriptions of her portfolio is the most accurate?
a) Her small capitalization, value-oriented low-beta portfolio has not generated alpha
b) Her large capitalization, growth-oriented high-beta portfolio has not generated alpha
c) Her large capitalization, growth-oriented low-beta portfolio has generated significantly
positive alpha
d) Her small capitalization, value-oriented high-beta portfolio has generated significantly
positive alpha
Answer: C. True: Her large capitalization, growth-oriented low-beta portfolio has

generated significantly positive alpha
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-18-multiple-

regression.23464/
72

Consider an at-the-money (ATM) stock option with a strike price of $50.00 and six months’ time
to expiration; i.e., S(0) = K = $50.00 and T = 0.5 years. Now imagine the following four
variations (I., II., III. and IV) on this option:
I. It is a European CALL option on a non-dividend-paying stock while the risk-free rate is
3.0%
II. it is a European CALL option on a stock that pays 1.60% dividend yield (D = $0.40) while
III. It is a European PUT option on a stock that pays 1.60% dividend yield (D = $0.40) while
IV. It is a European PUT option on a stock that pays 1.60% dividend yield (D = $0.40) while
the risk-free rate is ZERO!
For the three variations where the stock pays a continuous 1.60% dividend, the equivalent
present value (over the life of the option) is given by the lump sum, D = $0.40. For those
interested, although it is beyond the scope of this question, this translation is given by the
following: the PV of dividend, D = -S(0)*[exp(-q*T)-1]; in this case, D = $50.00*[exp(-
0.0160*0.5)-1] = $0.3980.
Each of the above options has a different minimum value (aka, lower bound). However, among
the four, which has the LOWEST minimum value?
a) (I.) European call option on non-dividend stock and risk-free rate of 3.0%
b) (II.) European call option on 1.60% dividend stock and risk-free rate of 3.0%
c) (III.) European put option on 1.60% dividend stock and risk-free rate of 3.0%
d) (IV.) European put option on 1.60% dividend stock and risk-free rate of zero
Answer: C. True. The European put option on 1.60% dividend stock and risk-free rate of
3.0% has a lower bound of zero, but the other three variations have positive minimum
values. Specifically,
 European CALL option on a non-dividend-paying stock while the risk-free rate is 3.0%:
lower bound = $50.00 - 50.00*exp(-3.0%*0.5) = $0.74.
 European CALL option when the stock pays a 1.60% dividend, D = $0.40 (= 1.60%
continuous), and the risk-free rate is 3.0%: lower bound is $0.40 less and given by
$50.00 - $0.40 - 50.00*exp(-3.0%*0.5) = $0.34.
 European PUT option when the stock pays a dividend, D = $0.40 (= 1.60% continuous),
and the risk-free rate is 3.0%: lower bound = max[0, $0.40 + $50.00*exp(-3.0%*0.5) -
$50.00] = max[0, -0.34] = zero.
 European PUT option when the stock pays a dividend, D = $0.40 (= 1.60% continuous),
and risk-free rate is ZERO: lower bound = max[0, $0.40 + $50.00*exp(0%*0.5) - $50.00]
= max[0, $0.40]
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-725-properties-

of-stock-options-including-lower-bounds-hull-ch-11.10697/
73
Question 12: Predicting sovereign default

As of the twentieth century (i.e., beginning 1900 and afterward), each of the following is TRUE
about the consequences of sovereign default EXCEPT which is false?
a) Renders banking system more fragile: the probability of a banking crisis increases in
countries that have defaulted
b) Increased probability of military occupation: subsequent to default, the probability of a
military show of force increases by 25.0%
c) Negative impact on economy: real GDP tends to drop between 0.5% and 2.0% albeit the
decline is short-lived and mostly in the first year subsequent to default
d) Negative impact on trade: export industries tend to be particularly hurt by sovereign
default; one study indicates a drop of 8.0% in bilateral trade subsequent to default
Answer: B. This is FALSE as of the 20th century: Increased probability of military
occupation: subsequent to default, the probability of a military show of force increases
by 25.0%.
In regard to (A), (C), and (D), each is TRUE. Damodaran:

 "Default has a negative impact on the economy, with real GDP dropping between 0.5%
and 2%, but the bulk of the decline is in the first year after the default and seems to be
short lived.
 Default does affect a country’s long-term sovereign rating and borrowing costs. One
study of credit ratings in 1995 found that the ratings for countries that had defaulted at
least once since 1970 were one to two notches lower than otherwise similar countries
that had not defaulted. In the same vein, defaulting countries have borrowing costs that
are about 0.5 to 1% higher than countries that have not defaulted. Here again, though,
the effects of default dissipate over time.
 Sovereign default can cause trade retaliation. One study indicates a drop of 8% in
bilateral trade after default, with the effects lasting for up to 15 years, and another one
that uses industry level data finds that export-oriented industries are particularly hurt by
sovereign default.
 Sovereign default can make banking systems more fragile. A study of 149 countries
between 1975 and 2000 indicates that the probability of a banking crisis is 14% in
countries that have defaulted, an eleven percentage-point increase over non-defaulting
countries.”Error! Bookmark not defined.
 Sovereign default also increases the likelihood of political change. While none of the
studies focus on defaults per se, there are several that have examined the aftereffects of
sharp devaluations, which often accompany default. A study of devaluations between
1971 and 2003 finds a 45% increase in the probability of change in the top leader (prime
minister or president) in the country and a 64% increase in the probability of change in
the finance executive (minister of finance or head of central bank)."24
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-916-predicting-

sovereign-default-damodaran.22330/
24
Aswath Damodaran, Country Risk: Determinants, Measures and Implications - The 2018 Edition” (July 23, 2018).
(Pages 1-49 only)
74
Question 13: Risk appetite and hedging

According to GARP, "a recent trend among corporations is to use a board-approved risk
appetite to guide management and (potentially) to inform investors." Which of the following
statements is TRUE about the firm's risk appetite?
a) Risk appetite is the total amount of risk a firm can bear without becoming insolvent
b) In practice, the risk appetite should be focused on a single thing: one broad, durable
philosophical statement that avoids linkages to the firm's day-to-day risk management
operations because these are bound to change
c) Although risk appetite has an upper bound (an upper trigger), it is similar to a one-sided
confidence interval: there is no such thing as a lower bound (a lower trigger) on risk
appetite given that less risk is better
d) A risk appetite includes the mechanisms (e.g., detailed policy, business-specific risk
statements, and a framework for risk limits) that link a top-level statement to the firm’s
day-to-day risk management operations
Answer: D. TRUE: A risk appetite includes the mechanisms (e.g., detailed policy,
business-specific risk statements, and a framework for risk limits) that link a top-level
statement to the firm’s day-to-day risk management operations
In regard to (A), (B) and (C), each is FALSE.

 Risk capacity is the total amount of risk a firm can bear without becoming insolvent
 In practice, the risk appetite is two things, a top-level statement and the sum of the
mechanisms linking this statement to the firm's day-to-day operations. Explains GARP:
"In truth, forging a robust link between top-of-house risk appetite statements and the
operational metrics of risk appetite in a particular risk type or business line is a
challenging task. As seen in Chapter 1, there is no single measure of risk, even within a
single risk type, that allows us to monitor risk at the business level and then easily
aggregate this to the enterprise level. The result is that firms operationalize their risk
appetite using a multiplicity of measures. For financial firms, this can include business
and risk-specific notional limits, estimates of unexpected loss, versions of value-at-risk
(VaR), and stress testing. The level of detail needs to reflect the nature of the risk and
the sophistication of the risk management strategy."25
 Risk appetite is bounded on the upside (below risk capacity) but also has a lower bound:
the firm does not aspire to be risk-free

appetite-and-hedging-chapter-2.23034/
25
75

Shown below is the autocorrelation function (ACF) for a time series object that contains the total
quarterly beer production in Australia (in megalitres) from 1956:Q1 to 2010:Q2 (source:
https://cran.r-project.org/web/packages/fpp2/index.html).
About this ACF and its implications, each of the following statements is true EXCEPT which
statement is false?
a) ρ(1) and ρ(3) are insignificant

b) This time series is a white noise process
c) This ACF is compatible with a seasonal time series
d) This time series is a non-stationary process because it violates a property of covariance-
stationarity
Answer: B. False. This time series is NOT a white noise process

Notice that the series with deterministic seasonality is non-stationary; because any white noise
is covariance-stationary, a seasonally deterministic process cannot be covariance-stationary.
The specific feature, as GARP explains (in the answer to EOC 10.2), "Deterministic seasonality:
The mean of the process depends on the time observation due to a seasonal, repeating
pattern." (Source -- 2020 FRM Part I: Quantitative Analysis, 10th Edition.)
In regard to (A), (C) and (D), each is TRUE.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-21-stationary-

time-series-covariance-stationary-autocorrelation-function-acf-and-white-noise.23508/
76
Question 15: Chooser and barrier (exotic) options

A non-dividend paying stock is currently trading at a price $35.00 when its volatility is 30.0% and
the risk-free rate is 3.0%. Consider a chooser option with a strike price of $30.00 that gives the
holder the right to choose (a call or put option) in three months and the chosen option, at that
point in time, will have a remaining time to maturity of nine months; i.e., T1 = +0.25 years and
T2 = +1.0 years. The price of this chooser is $7.710. Which of the following changes, ceteris
paribus, will INCREASE the value of this chooser?
a) Dividend increase to 4%
b) Volatility decrease to 20%
c) Stock drops to $30.00
d) Increase T1 to six months
Answer: D. TRUE: Increase T1 to six months. This increases the chooser value to $8.175,
although intuitively it makes sense that deferring the choice, with the same strike price and
expiration date (i.e., +1.0 year from inception), ought to make the chooser more valuable.
Each of the other alterations will decrease the value of the chooser. Specifically,
 A dividend increase to 4% lowers the chooser price to 6.837
 A volatility decrease to 20% lowers the chooser price to $6.543
 A stock drop to $30.00 lowers the chooser price to $5.344
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-730-chooser-

and-barrier-exotic-options-chapter-26-cont.10739/
77
Question 16: Key rates versus partial-01s vs forward-buckets

The exhibit below combines Tuckman's Tables 5.6 and 5.7. The situation starts with the
underlying trade: a 5×10 payer swaption struck at 4.044% (which gives the buyer the right to
buy a fixed rate of 4.044% on a 10-year EUR swap in five years such that the underlying
security in this option is a 10-year swap). This initial swaption trade is highlighted in light blue
below. Additionally, the forward-bucket exposures of
four swaps are shown in the upper panel. The lower
panel highlights three different hedges (discussed in
Tuckman) and their respective implied net positions:
About these hedges, which of the following

statements is TRUE?
a) - Hedge #1 is exposed to the risk of a

steepening
b) Hedge #2 is exposed to the risk of a
steepening
c) Hedge #3 is the best hedge
d) As rates increase, the value of the initial
swaption (i.e., by itself without hedges)
decreases
Answer: C. True: Hedge #3 is the best hedge. While each of the hedges neutralizes the ~
DV01 (per zero in the final column which is analogous to DV01), the first two are exposed to a
curve flattening.
In regard to (A), (B), and (D), each is FALSE.

In regard to false (D), the swaption's total exposure is -0.0380 such that an increase in rates
implies an increase in its value..
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-913-key-rates-

versus-partial-01s-versus-forward-buckets-tuckman-ch-5.22275/
78
Question 17: Risk management governance

The global financial crisis (GFC) of 2007 to 2009 engendered regulatory responses to corporate
risk governance. Below are summarized ten key developments. The first Sarbanes-Oxley (SOX)
occurred prior to the GFC but is listed for context. The others are grouped naturally into three
responses: Basel III and BCBS, Dodd-Frank, and the European response.
I. Prior to the GFC, Sarbanes-Oxley (SOX) required that the CEO and CFO affirm the
accuracy of financial disclosures.
Basel III and BCBS:
II. Basel III (BIII) was a direct response to the GFC. BIII limited core Tier 1 capital to
common equity and retained earnings. BIII also imposed new ratios for short-term
liquidity (i.e., LCR) and long-term liquidity (i.e., NSFR).
III. Basel III designed a macroprudential overlay that included a 3.0% leverage ratio;
countercyclical capital buffer (CCCB; aka, CCyB); and total loss-absorbing capital
(TLAC) standards applicable to G-SIBs.
IV. The Basel III framework was revised again in 2016 with the Fundamental Review of the
Trading Book (FRTB; aka, part of Basel IV) which included enhanced disclosure
requirements.
V. The Basel Committee on Banking Supervision (BCBS) issued Corporate Governance
Principles for Banks which--in addition to identifying the importance of an independent
risk management function--defines roles for the board, board risk committees, senior
management, CROs and internal auditors
Dodd-Frank:
VI. The 2010 Dodd-Frank Act strengthened the regulatory reach of the Fed; ended too-big-
too-fail (TBTF); launched overhaul of derivatives markets; introduced the Volcker Rule;
created the Consumer Financial Protection Bureau (CFPB).
VII. The Dodd-Frank Act also instituted a new approach to scenario analysis and stress
testing that included: a top-down approach with macroeconomic scenarios unfolding
over several quarters; a focus on the effects of macroeconomic downturns on a series of
risk types, including credit risk, liquidity risk, market risk, and operational risk; an
approach that is computationally demanding, because risk drivers are not stationary, as
well as realistic, allowing for active management of the portfolios; a stress testing
framework that is fully incorporated into a bank’s business, capital, and liquidity planning
processes; and an approach that not only looks at each bank in isolation but across all
institutions. This allows for the collection of systemic information showing how a major
common scenario would affect the largest banks collectively.
The European response:
VIII. For banks in Europe, the Supervisory Review and Evaluation Process (SREP)
introduced three new principles to banking supervision: (i) A forward-looking emphasis
on the sustainability of each bank’s business model, including during conditions of
stress; (ii) An assessment methodology based on best practices within the banking
industry, and (iii) An expectation that every bank will ultimately operate under the same
standards.
IX. The two key components of SREP are (i) the internal capital adequacy assessment
process (ICAAP) and (ii) the internal liquidity adequacy assessment process (ILAAP).
79
The ICAAP incorporates scenario analysis and stress testing; it outlines how stress
testing supports capital planning. The ILAAP incorporates potential losses from asset
liquidations and increased funding costs during stressful periods.
X. European banks with assets of EUR 30 billion and above must run European Banking
Authority (EBA) stress tests. These stress tests are run at the consolidated banking
group level (insurance activities are excluded). Two supervisory macroeconomic
scenarios covering a three-year period are provided by the regulator: a baseline
scenario and an adverse scenario
In regard to the above list of regulatory responses to the GFC, which of the following statements
is TRUE?
a) The Basel III events (i.e., II to IV) are incorrectly summarized

b) The Dodd-Frank Act is (i.e., VI and VI) is incorrectly summarize
c) The European regulatory response to the GFC (i.e., VIII to X) is incorrectly summarized
d) All three responses (Basel III, the Dodd-Frank Act, and the European regulatory
response) are correctly summarized
Answer: D. TRUE: All three regulatory responses (Basel III, the Dodd-Frank Act, and the
European regulatory response) are correctly summarized.

management-governance-regulatory-responses-and-best-practices.23058/
80
Question 18: Linear regression models

Debra is an analyst at a governmental agency. Her boss asked her to investigate whether the
Phillips curve applies during high-inflation regimes. To answer the question, Debra collected
data from the FRED database at the St. Louis Fed (https://fred.stlouisfed.org/). The Phillips
curve describes an inverse relationship between unemployment rates and inflation rates;
https://en.wikipedia.org/wiki/Phillips_curve. Debra collected monthly data and she regressed the
inflation rate against the unemployment rate
(conditional on high-inflation regimes simply
for narrative purposes). Her independent
variable is the unemployment rate (FRED
code: UNRATE) and here, the dependent
variable is the Inflation rate (CPIAUCSL).
The units are percentages not decimals; e.g.,
the dataset includes the month of January in
1982 when the unemployment rate was 8.90
and the inflation rate was 6.38. Her
regression results are presented here.
Debra wants to know if an inverse relationship is observed. Which of the following statements
about the regression is TRUE?
a) The regression is not useful because the intercept is too far away from (different than)
zero
b) The pattern of the standard errors, t-statistics, and p-values suggest there is a violation
in some assumption(s) of the classical linear regression model (CLRM)
c) There is an inverse relationship because, for each unit increase in the unemployment
rate (i.e., +1.0%), the inflation rate is expected to decrease on average by 1.10%
d) There is not an inverse relationship because, for each unit increase in the
unemployment rate (i.e., +1.0%), the inflation rate is expected to increase on average by
5.60%
Answer: C. True: There is an inverse relationship because, for each unit increase in the
unemployment rate (i.e., +1.0%), the inflation rate is expected to decrease on average by
1.10% (note this would be true even if misinterpreted the units as decimals rather than
percentages; i.e., the slope implies an almost 1:1 inverse relationship).
In regard to (A), (B) and (D), each is false:

 The non-zero intercept is a viable alpha (due to luck or skill)
 There are no obvious, apparent violations although please note that regression
diagnostics are not shown.
 The slope is negative and highly significant (i.e., the t-stat is -19.843 and the associated
p-value is infinitesimal: the slope coefficient is twenty standard deviations away from
zero) such that we can conclude an inverse relationship between the unemployment rate
and the inflation rate.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-16-linear-
regression-models.23437/
81
Question 19: US Treasury bonds

[This is tedious and difficult. Inspired by the final LO above and Hull's26 EOC Question 6.11]
Today it is December 31, 2018. The cheapest-to-deliver bond in an August 2019 Treasury bond
futures contract is a 9.0% coupon bond, and delivery is expected to be made on August 28,
2019. Coupon payments on the bond are made on April 2 and October 2 each year. In this
case, therefore, as of settlement today (December 31, 2018) there were 90 days since the last
coupon and there will be 92 days until the next coupon. Delivery will be in 240 days (and
subsequent coupon date 35 days after delivery, or 275 days from today). The term structure is
flat, and the rate of interest with continuous compounding is 3.0% per annum. The conversion
factor for the bond is 1.380. The current quoted bond price (for this bond which is assumed to
be the cheapest to deliver) is $115.00. What is the quoted futures price for the contract?
a) $73.59
b) $80.70
c) $94.75
d) $106.44
Answer: B. $80.70 See exhibit below.26
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-720-us-treasury-

bonds-conversion-factors-cheapest-to-deliver-theoretical-futures-price.10636/
26
John C. Hull, Options, Futures, and Other Derivatives, 10th Edition (New York: Pearson Prentice Hall, 2017).
Example 6.2 from Hull, but spreadsheets handcrafted by David Harper.
82
Question 20: Multi-factor interest rate risk models

Suzanne the Risk Analyst is building an interest rate term structure and she is evaluating
various candidate models. Her first candidate is Tuckman's Model 127 (aka, normally distributed
rates and no drift) which has the advantage of extreme simplicity and is specified by (Tuckman
9.1)27: dr σ*dw. Her colleague Peter observes this is a single-factor model: the model's only
factor is the short-term interest rate. Among the following, which is probably the strongest
criticism against this model as a single-factor model?
a) It compels us to assume yield to maturity (YTM) as the interest rate
b) A single-factor model incorporates yield volatility but cannot capture the convexity effect
c) It implies a parallel shift: if we shock the short rate by X basis points, it assumes all rates
shock by X basis points
d) It necessarily must assume a perfectly flat term structure; aka, the flat yield curve
assumption that is common for exams but unrealistic
Answer: C. True: It implies a parallel shift: if we shock the short rate by X basis points, it
assumes all rates shock by X basis points
 In regard to false (A): Model 1 specifically does not assume yield to maturity, but rather
a short-term rate. More generally, single-factor interest rate models tend to assume
yield-to-maturity (aka, yield) as is the typical assumption for duration and DV01; i.e., our
typical usage of duration and DV01 is implicitly yield-based duration and yield-based
DV01. However, as Tuckman explains, this is not necessarily the case.
 In regard to false (B), the convexity effect illustrated in Tuckman's Chapter 8 assumes
a single=factor model
 In regard to false (D), this is a tempting answer because this is the typical assumption;
i.e., assume a flat yield curve or flat term structure. However, even under a single factor
model, the risk premium and convexity effect introduce non-flat features. Tuckman's
Chapter 9 (even at least one in Chapter 10, according to Tuckman) illustrates single-
factor models with non-flat term structures. The most important criticism of the single-
factor models is that they imply a parallel shift. It is true that the flaw of yield-based
metrics is that they assume parallel shifts, but yield-based metrics are an instance of a
single-factor model.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-911-multi-factor-

interest-rate-risk-models-tuckman-ch-5.22246/
27
Bruce Tuckman's Fixed Income Securities, 3rd Edition (Hoboken, NJ: John Wiley & Sons, 2011)
83
Question 21: Credit risk transfer mechanisms

The Acme Investment Trading Company perceives the credit risk of a certain public retailer is
mispriced by the market. Acme is considering buying or selling a credit default swap (CDS) for
the purpose of speculating on this view with respect to the retailer's credit profile. In comparison
to buying or shorting the retailer's cash bond, Acme has already identified an advantage to the
CDS: it has better liquidity. On the other hand, which of the following is a disadvantage of the
CDS?
a) The CDS will introduce a new counterparty risk and legal risk
b) The CDS will introduce basis risk because Acme, who cannot be naked, will need to also
purchase the retailer's bond(s) that are referenced by the CDS
c) Although the CDS is a good vehicle for expressing Acme's view on the retailer's default
risk, it will not adjust for mere credit deterioration
d) Unlike credit ratings which are frequently updated, Acme will need to wait until it sells the
CDS in order to obtain price discovery with respect to a change in retailer's credit risk
Answer: A. TRUE: The CDS will introduce a new counterparty risk and legal risk
In regard to (B), (C) and (D), each is FALSE. Instead:

 Acme does NOT need to own the (underlying) referenced bond. Importantly, credit
default swaps (CDS) are technically NOT insurance because they do not require an
"insurable interest" in the reference instrument.
 The CDS does not hedge market risk, but it DOES hedges credit risk including
deterioration.
 As long as the CDS is marked-to-market, its spread will dynamically re-price credit risk.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-20-7-credit-risk-

transfer-mechanisms.23105/
84
Question 22: P-value and confidence intervals

Mary belies that the average net promoter score (NPS) in financial services, as a population, is
at least 50. Her one-sided null hypothesis is H0: μ(NPS) ≤ 50 and her alternative hypothesis is
HA: μ(NPS) > 50. Among a collected sample of 40 firms, her staff observes a sample average
NPS of 53.60 with a standard deviation of 9.0. Her staff informs her that the test statistic is 2.53
and the two-sided p-value is 1.556% per the Excel function T.DIST.2T(2.530, 39) = 0.015563.
Their report also includes these 95.0% critical t-values: T.INV(0.95, 39) = 1.685 and
T.INV.2T(0.050, 39) = 2.023; as expected, these values are slightly higher than, respectively,
the critical Z-values of 1.645 and 2.33. Each of the following is true EXCEPT which is false?
a) The power of Mary's one-sided test is 99.22%
b) The one-sided 95.0% confidence interval is [51.2, ∞)
c) Mary can reject a one-sided null hypothesis, H0: μ(NPS) ≤ 50, with 95.0% confidence
d) Mary can reject a one-sided null hypothesis, H0: μ(NPS) ≤ 50, with 99.0% confidence
Answer: A. False. The power of a test is not (1 - p), the power is (1 - Prob of a Type II
Error).
In regard to (B), (C) and (D), each is TRUE.
 The one-sided 95.0% confidence interval is given by 53.6 - 1.4230 × 1.685 = [51.2, ∞)
 Mary can reject a one-sided null hypothesis, H0: μ(NPS) ≤ 50 with either 95.0%
confidence or 99.0% confidence because both 5.0% and 1.0% are greater than the one-
sided p-value of 0.77817% which is one-half the given two-sided p-value of 1.556%
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-15-p-value-

and-confidence-intervals.23423/
85
Question 23: Eurodollar futures contracts and duration-based hedging

It is August and Sally is a fund manager with $50.0 million invested in government bonds who is
worried that interest rates are expected to be volatile over the next quarter (note: this question is
inspired by Hull's EOC Problem 6.18). She decides to use the December Treasury bond ("T-
bond") futures contract to hedge the value of the portfolio. The current futures price is 108-00 or
$108.00. Because each contract is for the delivery of $100,000 face value of bonds, the futures
contract price is therefore $108,000.00. Suppose the modified duration of the bond portfolio in
three months will be 13.0 years. The cheapest-to-deliver (CTD) in the T-bond contract is
anticipated to be a bond with 18.0 years to maturity that pays a 5.0% semi-annual coupon; at
maturity, the duration of this CTD bond is expected to be about 12.0 years.
However, the manager does not want to completely neutralize duration. Rather, she wants to
REDUCE the portfolio's duration by 7.0 years, from 13.0 years to 6.0 years. About how many T-
bond futures contracts should she trade to achieve this reduction in duration of the net portfolio?
a) 15 contracts
b) 270 contracts
c) 333 contracts
d) 502 contracts
Answer: B. 270 contracts
If she wanted to neutralize the duration, then she would trade N* = P*D(P)/[V(F)*D(F)] =
($50,000,000*13.0)/(108,000*12.0) = 501.54. However, to reduce the duration from 13.0 years
to 6.0 years, she should trade 501.54 * 7/13 = 270.06 or about 270 contracts. (Please note that
the following sentence is a red herring given that we only require the expected duration of the
CTD bond at maturity: "The cheapest-to-deliver (CTD) in the T-bond contract is anticipated to be
an bond with 18.0 years to maturity that pays a 5.0% semi-annual coupon.")
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-721-eurodollar-

futures-contracts-and-duration-based-hedging-hull-chapter-6.10646/
86
Question 24: Effective duration and convexity

The exhibit below modifies Tuckman's Table 4.228 and shows the prices on May 28, 2019 for
two instruments: 10-year U.S. note futures contracts, TYU0, and call options with a strike of 120
on the same futures contracts, TYU0C 120.
What is the effective duration of, respectively, the futures, TYU0, and the options, TYU0C 120?
a) 4.2 and 106.3 years
b) 8.4 and 212.5 years
c) 33.5 and 850.1 years
d) 41.8 and 1,062.6 years
Answer: B. 8.4 and 212.5 years
 In regard to the futures contract, TYU0, effective duration = -1/$119.50*($118.90 -

$120.10)/(3.810% - 3.690%) = 8.368 years.
 In regard to the options, TYU0C 120, effective duration = -1/$1.490*($1.300 -
$1.680)/(3.810% - 3.690%) = 212.5 years,
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-909-effective-

duration-and-convexity-tuckman-ch-4.22209/
28
Bruce Tuckman, Fixed Income Securities, 3rd Edition (Hoboken, NJ: John Wiley & Sons, 2011. Modified table from
Tuckman; spreadsheet handcrafted by David Harper.
87
Question 25: Modern Portfolio Theory

Consider the market portfolio plus three other portfolios (A, B, C) with the following features
while the risk-free rate is 3.0%:
Please note the returns are expected gross returns;

e.g., the market's expected return is 9.0% so that its
expected excess return is 6.0%. If we assume the
capital asset pricing model (CAPM) is valid then which
of the following statements is TRUE?
a) Portfolio A is mispriced, or it cannot exist in equilibrium due to both its beta and standard
deviation
b) Portfolio B is mispriced, or it cannot exist in equilibrium due to its standard deviation
c) Portfolio C is mispriced, or it cannot exist in equilibrium due to its beta
d) All three portfolios can exist in equilibrium under the CAPM
Answer: C. TRUE: Portfolio C is mispriced, or it cannot exist in equilibrium due to its beta
The market's Treynor ratio is (9.0% - 3.0%) / 1.0 = 0.060. But Portfolio C has a Treynor ratio of
(13.0% - 3.0%)/1.4 = 0.0714; it is above the SML, with a Jensen's alpha of α = 13.0% - 3.0% -
1.4 × (9.0% - 3.0%) = +0.40%. As these are expected returns, this is not possible under CAPM
equilibrium. In regard to (A), (B) and (D), each is FALSE:
 Portfolio A has a Treynor of 0.060 (i.e., on the SML) and Sharpe ratio of (7.8% - 3.0%) /
30.0% = 0.160
 Portfolio B has a Treynor of 0.060 (i.e., on the SML) and Sharpe ratio of (10.2% - 3.0%) /
26.0% = 0.277. It is true that Portfolio B, when compared to Portfolio A, has higher return
and lower standard deviation (as evidenced by its higher Sharpe ratio). Portfolio B is
clearly more efficient than Portfolio A. This is not a violation of CAPM unless a portfolio
has a higher Sharpe than the market portfolio: the market portfolio, being the most
efficient, must have the highest Sharpe ratio. Indeed, the market portfolio's Sharpe ratio
of (9.0% - 3.0%) / 20.0% = 0.30 is the highest.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-20-8-modern-

portfolio-theory-mpt.23118/
88
Question 26: Coskewness and cokurtosis

Below is the probability mass function (pmf) of a binomial random variable where the probability
of success over 15 trials is 10.0%; i.e., p = 0.10 and n = 15. What is the interquartile range
(IQR) of this probability distribution?
a) Zero
b) 1.0
c) 2.5
d) 4.0
Answer: B. True: 1.0
The interquartile range (IQR) is the difference between the 25th and 75th percentile. In this
binomial, where p = 0.10 and n = 15, most of the probability is "consumed" by the first three
outcomes as follows:
Prob(X = 0) = 20.6%
Prob(X = 1) = 34.3%, cumulatively that's 54.9%;
Prob(X = 2) = 26.7%, cumulatively that's 81.6%
... we can observe the 25th percentile is 1.0 and the 75th percentile is 2.0, such that the IQR =
2.0 - 1.0 = 1.0.

coskewness-and-cokurtosis.23394/
89
Question 27: Gap, forward start & compound exotic options

Consider an asset with a current price of $120.00 and volatility of 16.0% while the risk-free rate
is 3.0%. A regular (aka, vanilla) but deeply out-of-the-money (OTM) one-year European put
option on the stock with a strike price of $100.00 has a price of $0.740; i.e., p(S = $120.00, K =
$100.00, σ = 0.160, Rf = 0.030, T = 1.0 year) = $0.740.
Now consider the modification of this regular put option into a gap put option with the addition of
a trigger price, denoted K2. In this case, the price of the gap put option is given by p(S =
$120.00, K1 = $100.00, K2 = trigger price, σ = 0.160, Rf = 0.030, T = 1.0 year). Each of the
following statements about this gap option is true EXCEPT which is false?
a) If K1 = K2 = $100.00, then the gap option also has a price of $0.740

b) If the strike price, K1= $100.00 and the trigger price, K2 = $110.00, then the gap option
has a negative price
c) If the strike price, K1 = $100.00 and the trigger price, K2 = $90.00, then the gap option
price is greater than $0.740
d) Given a strike price, K1 = 100.00, among various trigger prices, the gap option has its
highest price when the trigger, K2 = $100.00
Answer: C. False. Instead, the true statement is "If the strike price, K1 = $100.00 and the
trigger price, K2 = $90.00, then the gap option price is less than $0.740" because in this case
the actual gap option price is equal to $0.419.
In regard to (A), (B) and (C), each is TRUE. In regard to true (B), if the trigger K2 = $110.00,
then the gap put price = -$0.050.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-729-gap-forward-

start-and-compound-exotic-options-hull-chapter-26.10733/
90
Question 28: Coupon effect and carry roll-down scenarios

As shown in the exhibit below in a format similar to Tuckman's table 3.229, the price of a bond as
of 5/28/2019 is $113.335. This bond pays a semi-annual 10.0% coupon and has maturity of 1.5
years; that is, it matures on 11/30/2020. Currently, the six-month forward rates are 0.60%,
1.00% and 1.50% (see green row).
If we make a scenario assumption of

UNCHANGED TERM STRUCTURE, which
of the following is nearest to the carry roll-
down over the next six months?
a) -$4.185
b) -$1.090
c) +$3.270
d) +$5.990
Answer: A. True: -$4.185
The unchanged term structure assumes that, in six months, the term structure will be the same
such that the six-month zero rate will be 0.60% and the six-rate forward rate will be 1.00%.
Consequently, the bond price under this assumption, in six months will be $5.00/1.0030 +
$105.00/(1.0030 * 1.0050) = 109.1501615 and the carry-roll-down equals 109.1501615 -
$113.335 = -$4.18484; or if the original bond is exactly priced, then the carry-roll-down equals -
$4.184821. In contrast, if we assume "realized forwards," the bond price will be $108.675, and
the carry-down-roll will be -$4.659995.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-907-the-coupon-

effect-and-carry-roll-down-scenarios-tuckman-ch-3.22162/
29
Bruce Tuckman, Fixed Income Securities, 3rd Edition (Hoboken, NJ: John Wiley & Sons, 2011. Spreadsheet
handcrafted by David Harper.
91
Question 29: Performance measures

Let Rm(P) denote the monthly return of the portfolio and Rm(B) denote the monthly return of its
benchmark. Over a three-year measurement period, the following statistics are calculated:
 The average monthly return for, respectively, the portfolio and the benchmark was
Rm(P) = 8.50% and Rm(B) = 6.90%; therefore, on average, the portfolio outperformed
its benchmark by +1.60%.
 The monthly standard deviation of the difference between the portfolio's and
benchmark's return, σ[Rm(P) - Rm(B)] = 11.80%
 A regression of the portfolio's excess return against the benchmark's excess return
produced the sample regression function, ERm(P) = -0.0140 + 1.35 * ERm(B); therefore,
the regression intercept (aka, alpha) is -1.40%
 The standard error of the regression (SER), which approximates the volatility of alpha,
σ(α), is 11.0%
Although the periodicity is monthly, an information ratio is generally annualized. In regard to

annualized information ratios, which of the following statements is accurate?
a) The (both annualized) active information ratio is +0.136 and the residual information ratio
is +1.426
b) The (both annualized) active information ratio is +0.470 and the residual information ratio
is -0.441
c) The (both annualized) active information ratio is +0.636 and the residual information ratio
is -0.127
d) The (both annualized) active information ratio is -0.250 and the residual information ratio
is +0.889
Answer: B. True: The (both annualized) active information ratio is +0.470 and the residual
information ratio is -0.441
The active IR = (active return) / (active risk; aka, tracking error) = +1.60% / 11.80% per month,
when annualized is (+1.60% * 12) / [11.80% * sqrt (12)] = +1.60% / 11.80% * sqrt (12) = +0.470
The residual IR = alpha / σ(alpha) = -1.40% / 11.0%, which annualized is given by -1.40% /
11.0% * sqrt(12) = -0.441

performance-measures.23129/
92
Question 30: Conditional expectations and the i.i.d. property
Below is the joint distribution of analyst ratings (i.e., negative, neutral, or positive) and stock
returns (-5, zero, or +5 in percentage terms).
We are interested in the conditional distribution of stock returns given a negative analyst rating.
For example, the expected stock return conditional on a negative analyst rating is [-5.0 *
(20.0%/25.0%)] + [0 * (5.0%/25.0%)] + [+5 * (0%/25.0%)]= -4.0. The variance of the stock return
conditional on a negative analyst rating is [-5.0 - (-4.0)]^2 * 80% + [0 - (-4.0)]^2 * 20% + [+5.0 - (-
4.0)]^2 * 0% = 4.0. What is the skew of the stock return conditional on a negative analyst rating?
a) -6.00
b) -3.50
c) +1.50
d) +12.00
Answer: C. True: conditional skew is +1.50
The conditional distribution (i.e., conditional on a negative analyst rating) is given by the
following:
The third central moment = [-5 - (-4)]^3 * 80% + [0 - (-4)]^3 * 20% + 0 = 12.0. Skew = 12.0 /
[4^(3/2)] = 1.50.

conditional-expectations-and-the-i-i-d-property.23360/
93
Question 31: Foreign exchange (FX) forwards

You are trying to model the theoretical forward price of silver using the cost of carry model. Your
model is informed by the following four propositions. Each is correct except which is FALSE?
a) Storage costs can be treated as negative income in the cost of carry model
b) Investment assets have a positive convenience yield in futures markets due to the
optionality of liquid markets
c) A positive (negative) lease rate tends to contribute to backwardation (contango) in the
gold futures curve, ceteris paribus
d) Normal backwardation in a consumption commodity could be explained by some
combination of non-zero convenience yield and/or systematic risk (i.e., positive beta) of
the commodity
Answer: B. FALSE. Instead, Hull says that "for investment assets the convenience yield must
be zero; otherwise, there are arbitrage opportunities."30 In fact, a convenience yield is the
primary differentiator in the cost of carry model between a consumption and an investment
commodity; i.e., an investment commodity does not confer convenience, which allows to model
to enforce a price via the no-arbitrage condition. Consumption commodities, on the other hand,
confer convenience which precludes exact, inductive pricing per the theoretical model; i.e.,
convenience yield is the "plug variable" that equalizes the forward price.
In regard to (A), (C) and (D), each is TRUE.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-717-foreign-

exchange-fx-forwards-and-more-cost-of-carry-theory-hull-chapter-5.10611/
30
94
Question 32: Gross versus net bond returns

Let the two-year term structure of zero rates include the following four spot rates: 1.0% @ 0.5
years, 2.0% @ 1.0, 3.0% @ 1.5, and 4.0% @ 2.0 years. Using these discount rates, the price of
a two-year $100.00 face value bond with 4.0% coupon rate is $100.10 (see blue cell) as shown
in the exhibit below, where $100.10 is the sum of four discounted cash flows:
Assume the term structure above (i.e., 1.0% @ 0.5 years,

2.0% @ 1.0, 3.0% @ 1.5, and 4.0% @ 2.0 years) remains
valid, but a different bond trades at a price of only $95.12.
Which of the following is nearest to this bond's spread?
a) 30 basis points
b) 90 basis points
c) 140 basis points
d) 270 basis points
Answer: D. 270 basis points
See below: adding a spread of 2.70% to the term structure returns a present value of $95.12.
However, the quicker method is simply to compute the yields of the two bonds and use the
difference as an approximation! Especially for a short-term bond, the approximation will be good
as most of the difference concerns the 2.0-year cash flow. The yield of the original bond =
RATE(4, 2, -100.10, 100) * 2 = 3.95% and the yield of the second bond = RATE(4, 2, -95.12,
100) * 2 = 6.65%, for a difference of 2.69615%. Although please be mindful of the difference
between yield and spread and why this is an approximation: the yields are single factors that
incorporate the entire (multi-factor) spot rate curve; this approximately works in large part
because each bond's yield is near to the final spot rate at 2.0 year where the final cash flow
dominates the price.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-905-gross-

versus-net-bond-returns-bond-spread-and-bond-yield-tuckman-ch-3.22128/
95

Each of the following statements is true about the arbitrage pricing theory (APT) model EXCEPT
which is false?
a) APT says that systemic factors explain asset returns and that diversification both
b) If the return process for 30 firms is a five-factor market model, then the number of
c) As a special case of the capital asset pricing model, a key advantage of the APT is that
matrix transformation identifies via deductive guidance the model's relevant
macroeconomic factors and their risk premiums
d) The extended 2015 Fama-French model includes five factors, the market's price of risk,
redundant
Answer: C. False. Instead, a famous disadvantage of the multifactor APT is that it provides
ZERO guidance concerning the risk factors and their premiums; also, CAPM might be viewed
as a single-factor special case of the multi-factor APT (which even ignores key theoretical
differences), but not the other way around.
Each of (A), (B) and (D) is TRUE.

 APT says that systemic factors explain asset returns and that diversification both
 If the return process for 30 firms is a five-factor market model, then the number of
 The extended 2015 Fama-French model includes five factors, the market's price of risk,
redundant
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-20-10-multifactor-

models-of-risk-adjusted-asset-returns.23142/
96
Question 34: Common univariate random variables

Let X = µ + σ*T be the generalized student's t distribution where X is a linear transformation of
the classic student's t distribution, as represented by T ~ t(df) or sometimes T ~ t(v).
Consequently, X is a generalized random variable denoted by X ~ Gen. t(v)(µ, σ^2). If the
generalized student's t distribution happens to be standardized, then it could be represented as
X ~ Gen. t(v)(0, 1). If X is a generalized student's t distribution with µ = 2.0 and σ = 3.0 with
degrees of freedom, v = 8, then each of the following is true EXCEPT which is false?
a) The mean of X is 2.0

b) The variance of X is 12.0
c) The skew of X is 1.5; i.e., positive or right-skew
d) The kurtosis of X is 4.5; i.e., excess kurtosis is 1.5
Answer: C. False. The skew is zero. The student's t and generalized student's t are
symmetrical distributions.
In regard to (A), (B) and (D), each is TRUE. See https://trtl.bz/wiki-generalized-students-t.

Specifically:
 If the parameters are µ = 2.0 and σ = 3.0 with v = 8 degrees of freedom, then the mean
of X is 2.0; i.e., the mu parameter re-locates the center from zero to +2.0.
 As the variance of the student's t is given by df/(df-2), the generalizes student's t has a
variance given by σ^2*[df/(df-2)]; in this case, 3^2*[8/(8-2)] = 12.0
 The excess kurtosis of X is given by 6/(df - 4) as long as df is greater than 4; in this case
6/(8-4) = 1.5, and therefore kurtosis is 3.0 + 1.5 = 4.5. The generalization of the student's
t via location and scale does not change its kurtosis.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-7-common-

univariate-random-variables-students-t-f-distribution-mixture.23327/
97
Question 35: Par yield, convexity, and term structure theories

Consider the following upward-sloping but smooth zero rate curve:
There are various theories that attempt to explain the factors that determine the shape of the
zero rate curve. If the above zero curve is observed, each of the following theories is plausible
EXCEPT which of the following theories is the LEAST LIKELY to be true, if only because it does
not comport with the observed zero curve?
a) Under pure expectations, the expected future six-month spot rate, E[S(2.0, 2.5)], is
3.00%
b) Under liquidity preference, the expected future six-month spot rate, E[S(2.0, 2.5)], is
3.00%
c) Under liquidity preference, the expected future six-month spot rate, E[S(2.0, 2.5)], is
2.40%
d) Under preferred habitat (market segmentation), the expected future six-month spot rate,
E[S(2.0, 2.5)], could be 3.15%
Answer: B. False. Under liquidity preference, the expected future six-month spot rate is LESS
THAN the implied forward rate because of the mis-match in preferences: investors (lenders)
prefer to shorter durations in order to preserve their liquidity, but borrowers prefer longer
durations. In short, less supply (by lenders) and greater demand (by borrows) at longer periods
implies higher rates at longer periods. As the implied F(2.0, 2.5) = 3.0%, choice (C) is true. And
choice (A) is true because "pure expectations" implies that E[S(2.0, 2.5)] = F(2.0, 2.5). Below
are the implied forward rates.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-715-par-yield-

convexity-and-term-structure-theories-hull-chapter-4.10596/
98
Question 36: Flattening and steepening of rate curves

Below is a graph of swap rates (represented by the solid green line) and the corresponding,
implied six-month forward rates (represented by the dotted orange line). Specifically, the six-
month, 1.0-year, 1.5-year, 2.0-year and 2.5-year swap rates are, respectively, 0.70%, 1.20%,
1.50%, 1.50% and 2.0%. The six-month forward rates implied by this swap rate curve are: f(0,
0.5) = s(0.5) = 0.7000%; f(0.5, 1.0) = 1.7043%; f(1.0, 1.5) = 2.1089%; f(1.5, 2.0) = 1.5000%;
f(2.0, 2.5) = 4.0674%.
Consider the fixed side of a 2.5-year swap which pays

the swap rate of 2.0%. Because 2.0% is the 2.5-year
par rate, the present value of 100 face amount of the
fixed side of the 2.5-year swap is 100. Consider the
price of the swap over the following year, in two six-
month steps:
 After six months, as the swap ages (toward
maturity) from 2.5-year to a 2.0-year swap (but
with the same fixed rate, of course)
 After another six months, as the swap ages
from a 2.0-year swap to a 1.5-year swap
If we assume an unchanged term structure as the swap matures from a 2.5-year swap to a 1.5-
year swap, what happens to the price of the fixed side?
a) The price decreases during both six-month periods
b) The price increases during both six-month periods
c) The price increases (during first six months), then decreases (during next six months)
d) The price decreases (during first six months), then increases (during next six months)
Answer: C. True: The price increases (during first six months), then decreases (during
next six months). Specifically, after six months the price increases to $100.98, then after
another six months the price decreases to $100.74.
This question is modeled on Tuckman's example in Chapter 2's Maturity and Price or Present
Value.31 We can ascertain the price movement by comparing the swap rate (in this case, 2.0%)
to the associated forward rate:
 During the first six months, the comparable forward rate, f(2.0, 2.5) = 4.0674%; this is
higher than the 2.0% swap rate. Therefore, the price of the fixed side will increase: the
present value of the 2.5-year swap is lower than the 2.0-year swap because the 2.5-year
swap pays 2.0% for an additional six months but the forward rate is 4.0674%.
 During the subsequent six months, the comparable forward rate, f(1.5, 2.0) = 1.50%; this
is lower than the 2.0% swap rate. Therefore, the price of the fixed side will decrease: the
present value of the 2.0-year swap is higher than the 1.5-year swap because the 2.0-
year swap pays 2.0% for an additional six months but the forward rate is 1.50%.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-904-flattening-

and-steepening-of-rate-curves-tuckman-ch-2.22118/
31
Bruce Tuckman, Fixed Income Securities, 3rd Edition (Hoboken, NJ: John Wiley & Sons, 2011.
99
Question 37: Risk Data Aggregation and Reporting Principles

Relative to the other principles, compliance rates have been stronger for the Risk Reporting
Practices outlined in BCBS 239. In regard to effective risk reporting, each of the following is true
a) Aggregated data should be Material, Conservative, Elastic, and Cost-based (Principles 3
to 6)
b) The four primary types of data models include: semantic data, conceptual data, logical
data, and physical data.
c) Compliance rates are generally poor, or at least lagging, for Principle 2 (Data
architecture and IT infrastructure)
d) Adaptability (Principle 6) matters because a bank should be able to generate a range of
on-demand, ad hoc requests including, for example, integrated stress scenarios or
upcoming regulations
Answer: A. FALSE. Instead, aggregated data should exhibit Accuracy and Integrity (Principle
3), Completeness (Principle 4), Timeliness (Principle 5), and Adaptability (Principle 6)
In regard to (B), (C) and (D), each is TRUE.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-20-11-risk-data-

aggregation-and-reporting-principles.23151/
Question 38: Random variables

Let Z be a random variable that is a linear function of random variables X and Y, where Z = 3*X
+ 7*Y? If the standard deviation of X and Y, respectively, are σ(X) = 4.0 and σ(Y) = 5.0 and the
correlation between X and Y is ρ(X,Y) = 0.50, then what is the standard deviation of Z, σ(Z)?
a) 6.40
b) 7.81
c) 37.00
d) 42.30
Answer: D. True: 42.30
σ(Z) = sqrt[σ^2(Z)], and σ^2(Z) = σ^2(3*X + 7*Y) = 3^2*σ^2(X) + 7^2*σ^2(Y) + 2*3*7*cov(X,Y) =

9*4^2 + 49*5^2 + 2*3*7*(4 * 5 * 0.5) = 1,789.0 and σ(Z) = sqrt(1,789.0) = 42.30.
This applies the basic variance properties that we need to know; see
https://en.wikipedia.org/wiki/Variance#Properties
In this case, σ^2(a*X + b*Y) = a^2*σ^2(X) + b^2*σ^2(Y) + 2*a*b*Cov(X,Y), where (a) and (b) are
constants.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-4-random-

variables-2nd-of-2.23281/
100
Question 39: Duration, modified duration, and dollar duration

A three-year bond $1,000.00 face value bond pays a 10.0% semi-annual coupon and has a
semi-annual (aka, bond equivalent) yield of 14.0%. Its price is therefore $904.67. The chart
below also shows cash flows as proportional weights:
We can use modified duration to estimate the price impact of a small change in yield. Which of
the following is NEAREST to a duration-based (i.e., linearly approximate) estimate of the bond's
price change given a 26 basis point (0.26%) drop (shock down) to the yield?
a) $5.81
b) $6.00
c) $6.18
d) $7.25
Answer: A. $5.81.
Because the Macaulay duration is 2.6448 years, the modified duration is given by
2.6448/(1+0.140/2) = 2.47178 years and the (linearly) estimated price impact of a -26 basis
point shock is equal to $904.67*(-2.47178)*-0.00260 = $5.8140.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-714-duration-

modified-duration-and-dollar-duration-hull-chapter-4.10585/
101
Question 40: Spot, forward and par rates

Assume the following discount function (note that a discount function is a series of discount
factors):
Which of the following is nearest to the implied six-month forward rate starting in two years,
f(2.0, 2.5)? Assume rates are expressed as per annum with semi-annual compounding.
a) 4.30%
b) 5.83%
c) 7.95%
d) 10.72%
Answer: D. True: 10.72%. The f(2.0, 2.5) = [d(2.0)/d(2.5) - 1]*2; in this case,
[0.94720/0.89900 - 1]*2 = 10.72303%
The (much!) longer way is to translate the discount factors into their equivalent spot rates: s(2.0)
= [(1/0.94720)^(1/[2*2.0]) - 1]*2 = 2.73072%, and s(2.5) = [(1/0.89900)^(1/[2*2.5]) - 1]*2 =
4.3046%; and then infer the forward rate as a function of the spot rates: f(2.0, 2.5) = [(1 +
4.3046%/2)^(2*2.5) / (1 +2.73072%/2)^(2*2.0) - 1] * 2 = 10.72303%.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-903-spot-

forward-and-par-rates-tuckman-ch-2.22107/
102

According to GARP, each of the following is one of the top ten benefits of enterprise risk
management (ERM) EXCEPT which is NOT a benefit of ERM?
a) Hedges risks using derivative instruments

b) Focuses oversight on the most threatening risks
c) Optimizes risk transfer expenses in line with risk scale and total cost
d) Manages emerging enterprise risks such as cyber risk, anti-money laundering (AML)
risk, and reputation risk
Answer: A. False: Hedge risk using derivative instruments is one of GARP's example of
an application when we are "looking at [i.e., analyzing] risk within risk types" rather than
a natural benefit of ERM
The top ten benefits of ERM are the following:32

1. Helps define the firm’s risk appetite
2. Trains oversight on more threatening risks
3. Identifies risks created at the business line level
4. Manages risk concentrations
5. Manages emerging risks
6. Supports regulatory compliance
7. Helps understand intra-firm risks and their correlations
8. Optimizes the expense of risk transfer
9. Includes stressed capital costs into pricing decisions
10. Includes risk in the firm’s strategy and potentially even the firm’s business model
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-20-12-enterprise-

risk-management-erm-benefits-reasons-and-risk-culture.23162/
32
103
Question 42: Probabilities and Bayes rule

Among a set of filtered stocks, a stock screener assigns stocks to one of three style categories:
value, quality, or momentum. At the end of each month, the stock's performance is compared to
the S&P such that it either beats or does not beat the index The prior beliefs (aka, unconditional
probabilities) are the following: Pr(Style = Value) = 15.0%, Pr(Style = Quality) = 30.0%, and
Pr(Style = Momentum) = 55.0%. The stock screener also knows that a Moment stock is more
likely than a Quality stock, and much more likely than a Value stock, to beat the index;
specifically, the screener knows the following conditional probabilities:
 Pr(Beat | Value) = 40.0%
 Pr(Beat | Quality) = 60.0%
 Pr(Beat | Momentum ) = 80.0%
If we observe that a stock beats the index, what is the probability it is a momentum stock; i.e..,
what is Pr(Momentum | Beat)?
Bonus question: if we observe the stock beats the index two months in a row, what is the
probability it is a momentum stock; i.e., what is Pr(Momentum | Two consecutive Beats)?
a) 39.6%
b) 55.0%
c) 64.7%
d) 83.3%
Answer: C. True: 64.7%
Per Bayes, Pr(M|B) = Pr(B∩M)/Pr(B) = Pr(B|M)*Pr(M) / Pr(B) = 80.0% * 55.0% / (15.0%*40.0%

+ 30.0%*60.0% + 55.0%*80.0%) = 80.0% * 55.0% / 68.0% = 64.71%.
The bonus question is: If we observe the stock beats the index two months in a row, what is
the probability it is a momentum stock; i.e., what is Pr(Momentum | Two consecutive Beats)?
The answer is 72.73%. Per Bayes, P(M | 2B) = P(2B | M) * P(M) / P(2B) = 64.0% * 55.00% /
48.40% = 72.73%;
where P(2B) = (6%/15%)^2*15% + (18%/30%)^2*30% + (44%/55%)^2*55% = 48.40%,
and where P(2B | M) = P(B | M)^2 = (44%/55%)^2 = 64.0%
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-2-more-

probabilities-and-bayes-rule.23259/
104
Question 43: Spot and forward rates

Consider the steep spot (aka, zero) rate curve illustrated
below: 3.0% at 0.5 years, 4.0% at 1.0 year, 4.6% at 1.5 years
and 5.0% at 2.0 years. Each of these zero rates is per annum
with continuous compounding.
Which of the following is nearest to the theoretical price of a

two-year $100.00 face value bond that pays an 8.0% semi-
annual coupon (4.0% coupon every six months)?
a) $97.31
b) $99.47
c) $102.38
d) $105.62
Answer: D. $105.62
The theoretical price is equal to $105.60 = $4.00*exp(-0.030*0.5) + $4.00*exp(-0.040*1.0) +
$4.00*exp(-0.0460*1.5) + $104.00*exp(-0.050*2.0).
In the final column we show the theoretical price if, instead, we assume the zero rates are
expressed with semi-annual compounding.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-713-spot-and-

forward-rates-in-bond-pricing-hull-chapter-4.10578/
105
Question 44: Discount function and the Law of One Price

In regard to Tuckman's discussion of the components and structure of U.S. Treasury STRIPS,
which of the following statements is TRUE?
a) The holder of a U.S. Treasury STRIP is immunized against inflation risk but exposed to
significant liquidity risk and call risk
b) The Law of One Price says an arbitrage profit is necessarily available when two
securities offer identical cash flows but sell at different market prices
c) If we apply the discount function implied only by C-STRIPS (i.e., without P-STRIPS) to
infer the price of a U.S. Treasury bond, we are likely to undervalue the security relative
to its actual market price
d) Because C-STRIPS and P-STRIPS are perfect commodities, arbitrage enforces the law
of one price to ensure that, with respect to U.S. Treasury bonds, theoretical (aka, model)
prices equal market prices
Answer: C. True: If we apply the discount function implied only by C-STRIPS (i.e., without
P-STRIPS) to infer the price of a U.S. Treasury bond, we are likely to undervalue the
security relative to its actual market price.
In regard to true (C), a key point raised by Tuckman33 is that individual Treasury bonds have
idiosyncratic features that are reflected in their market prices. In particular, P-STRIPS are not
fungible and therefore their prices inherit the idiosyncratic features of their associated bond
issues (emphasis ours): "If U.S. Treasury bonds were commodities, with each regarded solely
as a particular collection of cash flows, then the price of each would be well approximated by
discounting its cash flows with the C-STRIPS discount factors [of Figure 1.1]. If however
individual bonds have unique characteristics that are reflected in pricing, the law of one price
would not be as accurate an approximation. Furthermore, since C-STRIPS are fungible while P-
STRIPS are not, any such pricing idiosyncrasies would manifest themselves as differences
between the prices of P-STRIPS and C-STRIPS of the same maturity.
... Inspection [of Figure 1.2] shows that there are indeed significant pricing differences between
P-STRIPS and C-STRIPS that mature on the same date. This does not necessarily imply the
existence of arbitrage opportunities, as discussed at the end of the previous section. However,
the results do suggest that bonds have idiosyncratic pricing differences and that these
differences are inherited by their respective P-STRIPS." About the idea that P-STRIPS are not
fungible, Tuckman explains: "C-STRIPS are fungible while P-STRIPS are not. When
reconstituting a bond, any C-STRIPS maturing on a particular date may be applied toward the
coupon payment of that bond on that date. By contrast, only P-STRIPS that were stripped from
a particular bond may be used to reconstitute the principal payment of that bond. This feature of
the STRIPS program implies that P-STRIPS, and not C-STRIPS, inherit the cheapness or
richness of the bonds from which they came ..."33
- continued -
33
106
In regard to (A), (B) and (D), each is FALSE:

 In regard to false (A), STRIPS (Separate Trading of Registered Interest and Principal of
Securities) are different than TIPS (Treasury Inflation Protected Securities). TIPS protect
against inflation risk, but STRIPS are exposed to inflation risk. Further, STRIPS have no
call risk and virtually no liquidity risk.
 In regard to false (B), a key idea explained by Tuckman is that violation of the Law of
One Price creates an arbitrage opportunity but not all arbitrage opportunities can be
exploited for profit. If the securities are indeed commodities, there exist at least two
complications: "First, there are transaction costs in doing arbitrage trades which could
significantly lower or wipe out any arbitrage profit... Second, bid-ask spreads in the
financing markets (see Chapter 12), incurred when shorting securities, might also
overwhelm any arbitrage profit."34
 In regard to false (D), as explained in the quote above, U.S. Treasury bonds are
commodities (i.e., fungible cash flow collections) only in theory. Maybe the most obvious
example of this lack of fungibility is the observation that on-the-run U.S. Treasury bonds
trade at a premium due to the superior liquidity features.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-900-discount-

function-and-the-law-of-one-price-tuckman-ch-1.22065/
34
107

Scenario analysis is an ascendant tool. After the global financial crisis (GFC), regulators insisted
that systemically important banks demonstrate their ability to withstand adverse and severely
adverse scenarios. Meanwhile, GARP explains, "Scenario analysis, along with stress and
sensitivity testing, have risen to become the preeminent risk identification tools for many
enterprise risk management (ERM) programs. This is a result of the weaknesses in probabilistic
risk metrics (e.g., VaR) that were revealed by the global financial crisis of 2007–2008."35
Which of the following statements is TRUE about scenario analysis?

a) An advantage of scenario analysis is that data science enables the bank to generate a
virtually infinite number of scenarios
b) Scenario analysis involves changing one parameter or variable in a risk model to see
how sensitive the model result is to the analysis
c) A disadvantage of scenario analysis is its necessary dependence on referencing actual
historical events such as the global financial crisis (GFC)
d) An advantage of scenario analysis is that it does not need to consider risk frequency
beyond plausibility; i.e.., scenario analysis may be entirely qualitative
Answer: D. TRUE: An advantage of scenario analysis is that it does not need to consider
risk frequency beyond plausibility; i.e.., scenario analysis may be entirely qualitative.
In regard to (A) and (C), each is FALSE; choice (B) is inaccurate because it refers sensitivity
testing. According to GARP35, the following are advantages of scenario analysis (emphasis
ours per the Q&A):
 "No need to consider risk frequency beyond 'plausibility'
 Scenarios can take the form of transparent and intuitive narratives.
 Challenges firms to imagine the worst and gauge the effects
 Can allow firms to focus on their key exposures, key risk types, and the ways in which
risk develops over time
 Allows firms to identify warning signals and build contingency plans
 Does not depend on historical data; can be based around either historical events
or forward-looking hypothetical events
 Firms can make scenario analysis as sophisticated or straightforward as they like,
outside regulator defined programs.
 Stress test results can influence risk appetite, risk limits, and capital adequacy.
Disadvantages include:
 Difficult to gauge probability of events; does not lead to the quantification of risk
 Unfolding scenarios can become complex with many choices.
 Firms may not stretch their imaginations (e.g., scenarios might underestimate the impact
of an extreme loss event or omit important risk exposures).
35
2020 FRM Part I: Foundations of Risk Management, 10th Ed. Pearson Learning Solutions, 10/2019. VitalBook file.
108
 Only a limited number of scenarios can be fully developed—are they the right
ones?
 Are they the right warnings and plans, given the scenario selection challenge?
 The scenarios chosen are often prompted by the last major crisis; imaginative future
scenarios may be dismissed as improbable.
 Scenario analyses vary in terms of quality and sophistication. Their credibility and
assumptions can be difficult to assess.
 Usefulness depends on accuracy, comprehensiveness, and the forward-looking qualities
of the firm’s stress test program."36
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-20-13-enterprise-
risk-management-erm-scenario-analysis-and-behavioral-concepts.23179/
36
109
Question 46: One- versus two-tailed hypothesis tests

Barbara observes a sample with the following statistics: mean of X and standard deviation of Y.
She thinks the true (aka, population) mean is Z. She does NOT know the population's variance,
nor does she even know the population's distribution, including she cannot assume it is normal.
If she wants to conduct a hypothesis test of the observed sample mean, each of the following
statements is true EXCEPT which is incorrect?
a) If the sample is small (i.e., n < 30), there is no valid test statistic
b) If the sample is large, she is justified in conducting a hypothesis test of the mean with a
student's t distribution (and she may even approximate the student's t with a normal
distribution)
c) A one-tailed test is more appropriate if (i) the sample mean is either greater than, or less
than, the null hypothesized value or (ii) the metric is financial such as in this case of a
mutual fund's mean return
d) If the sample is large, there is a valid test statistic and for a given observed X either (i) a
switch from two-tailed to one-sided confidence and/or (ii) an increase in the sample size
will increase the likelihood of rejecting the null
Answer: C. False, neither is true.
In regard to (A), (B) and (D), each is TRUE.

 In regard to true (A), while in practice some do continue to use the student's t
distribution for all small samples, strictly speaking, if the sample is small then we require
an assumption that the population is normal in order to utilize the student's t (when
population variance is unknown) or the normal Z (when population variance is known)
 In regard to true (B), this is the essential magic of the central limit theorem (CLT): if the
sample is large, we do not require knowledge of the population distribution (including it
may well be non-normal) in order to test the sample mean with student's t or normal Z. If
we know the population variance, then the normal Z is appropriate; if we do not know the
population variance, then the student's t is appropriate because we are consuming a
degree of freedom by using the sample variance as a proxy (however, it is okay to use
the normal Z to approximate this student's t, because they are close in a large sample).
 In regard to true (D), ceteris paribus a switch from two-tailed to one-tailed will increase
the rejection region; and an increase in the sample size will decrease the standard error
by increasing its denominator: SE = (observed sample mean - hypothesized population
mean)/sqrt(sample size).
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-719-one-versus-

two-tailed-hypothesis-tests-miller-ch-7.13420/
110
Question 47: Optimal cross-hedge & reducing portfolio beta

Sally the portfolio manager oversees a $9.0 million large-cap equities portfolio with a beta of
1.30. She has decided the portfolio's beta is too high and calibrates a new target beta of 0.70. If
she employs S&P 500 index futures contracts to reduce the beta when the index futures price is
2,400 (the contract size is $250 * S&P 500 index per the specification), then which is nearest to
the trade?
a) Short 9.0 contracts
b) Short 27.0 contracts
c) Short 54.0 contracts
d) Long 13.0 contracts
Answer: A. Short 9.0 contracts
The value of the portfolio, V(A), is $9,000,000 and the value of one futures contract, V(F), is
2,400 * $250 = $600,000 such that number of contracts is given by N(*) = (β - β*)*V(A)/V(F) =
(1.30 - 0.70) * $9.0/$0.60 = 9.0 contracts. To reduce the beta, she should SHORT the futures
contracts.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-711-optimal-

cross-hedge-and-reducing-portfolio-beta-hull-chapter-3-continued.10566/
111
Question 48: Delta hedging, scenario analysis and portfolio insurance

On Monday, a bank's position (the underlying portfolio) on the dollar-euro exchange rate has an
initial position delta of 11,300 and a position gamma of -25,000. The exchange rate is EURUSD
$0.860; i.e., per the currency priority convention, Euro is the base currency. By the end of the
week, on Friday, the exchange rate had jumped by +$0.050 to $0.910. The bank entered two
trades:
 On Monday, while the exchange rate is EURUSD $0.860, the bank's first trade
neutralized delta; aka, makes the net position "delta neutral"
 On Friday, after the exchange rate had increased to EURUSD $0.910, the bank's
second trade re-established the net position's delta neutrality
Which of the following were the bank's trades? Please note: this question is inspired by Hull's
EOC Problem 19.2237.
a) Long 11,300 Euros on Monday, then short an additional 565 Euros on Friday
b) Long 11,300 Euros on Monday, then unwind (purchase) 565 Euros on Friday
c) Short 25,000 Euros on Monday, then short an additional 2,250 Euros on Friday
d) Short 25,000 Euros on Monday, then unwind (purchase) 1,250 Euros on Friday
Answer: D. Short 11,300 Euros on Monday, then unwind (purchase) 1,250 Euros on
Friday
The positive delta of 11,300 signifies that, for example, if the exchange rate increases by
$0.010, then the value of the portfolio increases by $0.01 * 11,300 = +$113.00. An increase in
the EURUSD exchange rate reflects appreciation in the Euro (the base currency) and
depreciation in the US dollar (the quote currency). Therefore, the position experiences a loss in
value when the exchange rate decreases (per positive delta) which represents a depreciation of
the Euro (i.e., an appreciation in the USD). To neutralize this delta requires a SHORT position in
11,300 Euros.
The gamma of -25,000 signifies that delta changed by ($0.91 - $0.86) * (-25,000) = -1,250.0
when the exchange rate changed from $0.860 to $0.910. Consequently, as of Friday, the
portfolio's new position delta = 11,300 - 1,250 = 10,050. To maintain delta neutrality, the second
trade unwind 1,250 so that it's short Euro position is 10,500.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-821-delta-

hedging-scenario-analysis-and-portfolio-insurance-hull-ch-19.21029/
37
112

Three famous financial disasters are Continental Illinois (whose failure in 1984 was the largest
bank failure in US history prior the global financial crisis), Lehman Brothers (who was the fourth-
largest U.S. investment bank before filing for bankruptcy in 2008), and Northern Rock (who was
a fast-growing British mortgage bank, who in 2008 was forced into public ownership as an
alternative to insolvency). What did Continental Illinois, Lehman Brothers, and Northern Rock
have in common?
a) Excessive reliance on certain short-term liabilities
b) Insufficient geographical diversification of funding sources
c) Asset-to-equity ratios were too low for banks to be profitable
d) Improper application of Federal Reserve stress testing programs
Answer: A. TRUE: Excessive reliance on certain short-term liabilities; i.e., they are each
examples of funding liquidity risk. Each of Continental Illinois, Lehman Brothers, and
Northern Rock are discussed in 9.2 as examples of Funding Liquidity risk.
 About Continental Illinois, GARP explains (emphasis ours): "When Penn Square
failed [note: Penn Square was a smaller bank that sold loans to Continental], Continental
found itself increasingly unable to fund its operations from the U.S. markets. As a result,
it began to raise money at much higher rates in foreign wholesale money markets (e.g.,
Japan). But when rumors about Continental’s worsening financial condition
spooked the international markets in May 1984, the bank’s foreign investors
quickly began to withdraw their deposited funds. Continental Illinois was confronted
with a full-blown liquidity crisis as depositors withdrew USD 6 billion in only ten days.
Regulatory authorities eventually stepped in to prevent a domino effect on other banks,
which they feared might put the entire U.S. banking system at risk."38
 About Lehman, GARP explains, "Banks are naturally highly leveraged entities (i.e., they
take on a large amount of debt rather than issue equity to fund their activities). In the
run-up to the crisis, however, Lehman (like other investment banks in the boom years)
pursued leverage to excess. By 2007, the bank had an assets-to-equity ratio of
approximately 31:1. Meanwhile, the bank’s funding strategy (i.e., the way it borrowed
money to grow its operations) introduced a fatal element of fragility. Specifically, Lehman
began borrowing huge amounts of money on a short-term basis (e.g., borrowing daily
from the repo markets) to fund relatively illiquid long-term real estate assets. This meant
that the firm had to depend heavily on the confidence of its funders and counterparties if
it was to continue to borrow the funds necessary to stay in business."38
 Finally, about Northern Rock, GARP explains, "The bank’s rate of growth was
supported by a business model and funding strategy that was unusual among U.K.
banks. Specifically, the bank relied on an originate-to-distribute approach, by which it
raised money through securitizing mortgages, selling covered bonds, and making use of
the wholesale funding markets. As a result, Northern Rock relied much more heavily on
investors and wholesale markets and less on retail deposits for funding in comparison to
many of its U.K. peers ... When the interbank funding market froze in early August 2007,
all of Northern Rock’s global funding channels seized up simultaneously in a scenario
that the bank’s executives later claimed was unforeseeable."38
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-20-14-learning-
from-financial-disasters-first-of-three.23187/
38
113
Question 50: Bayes' Theorem

An analyst at your firm has developed a new trading strategy called AlphaGen. She claims there
is a 70.0% probability on any given day that the strategy offers true alpha and will generate a
profit. After observing ten (10) days of performance, in fact the strategy was profitable only four
days. Assume there are only two possible states of the world: either the analyst is correct and
the strategy offers true alpha; or the strategy does not offer true alpha and the profit/loss
outcome is equally likely to be a gain or loss on any given day. Your prior assumption was that
the two states of the world are equally likely: there is s 50.0% probability the strategy offers true
alpha, and a 50% probability it does not. These assumptions are illustrated below; e.g., if the
strategy does generate alpha, then P[Profit | Alpha] = 70.0%, but if the strategy does not
generate alpha, then P[Profit | No Alpha] = 50.0%.
We can also represent the prior probabilities as follows: P[p = 0.70]

= 50.0% and P[p = 0.50] = 50.0%. Additionally, because you are an
FRM candidate, you are already able to compute the following
binomial probabilities:
 Prob[Exactly 4 profits out of 10 days | True Alpha] =
binomial[4 successes, 10 trials, p = 0.70, false = p.m.f.] =
0.70^4*0.30^6*C(10,4) = 3.68%
 Prob[Exactly 4 profits out of 10 days | No Alpha] = binomial[4
successes, 10 trials, p = 0.50, false = p.m.f.] = 0.50^4*0.50^6*C(10,4) = 20.51%.
Given the evidence that the strategy was profitable on four days out of ten, which is nearest to
the (posterior) probability that the analyst is correct, and the strategy generates true alpha?
(note: this question is inspired by Miller's EOC question 6.4)39.
a) 15.20%
b) 25.00
c) 31.80%
d) 50.0%
Answer: A. 15.20%. Per Bayes, the P[Alpha | 4 Successes out of 10] = P [Alpha ∩ 4
Successes]/P[4 Successes] = 3.68% * 50.0% / [(3.68% * 50.0%) + (20.51% * 50.0%)] =
15.1992%; the sub-par performance lowers our belief that the strategy generates alpha,
from 50.0% to 15.20%.
Similarly, the posterior probability P[No Alpha | 4 Successes out of 10] = 20.51%*50%/12.09% =
84.80%. In this way, the prior (unconditional) probability of a true alpha strategy was 50.0%, but
the observed performance (i.e., only four profits in ten days) updates our beliefs to a probability
of 15.2% that the strategy really does generate alpha.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-717-bayes-

theorem-miller-ch-6.13378/
39
Michael Miller, Mathematics and Statistics for Financial Risk Management, 2nd Edition (Hoboken, NJ: John Wiley
& Sons, 2013)
114
Question 51: Futures contracts

Barbara is a value investor who bought 1,000 shares of Apple (ticker: AAPL) in 2014 when the
share price was $95.00 and she considered them under-valued. In hindsight, her view was
correct as the shares currently (as of mid-2017) trade at $140.00. She now thinks the shares
are slightly over-valued. However, she does not want to sell them unless there is a market
crash. This is because she believes the shares are likely to trade in a range and may even gain
modestly in the future. However, she also believes there is something like a 10.0% probability of
a technology sector crash (a possibility enabled by the low interest rate regime). If the
technology sector does crash, she fears the AAPL shares could plummet. If the AAPL shares
drop, Barbara does wants to sell, however she does not want to sell in a panic at fire-sale
prices.
Specifically, if the shares were to quickly lose more than 13.0% of their current value, Barbara
will be eager to sell them. However, she also wants to ensure that she realizes a minimum
holding period return (HPR) of 30.0%; and to this HPR dividends have already contributed
6.0%. Therefore, she only wants to sell if the price appreciation (from her $95.00 cost basis) is
at least +24.0%. She justifies this conditional view on a belief that if the shares plunge too far
such that she cannot realize her HPR threshold, the market will have overreacted. In this case
of an over-reaction, she believes it will be better to avoid selling in a panic and instead she will
be better off to await an eventual recovery. Which of the following orders is most consistent with
her strategy?
a) A market order
b) A limit order at $121.80 plus a market order at $135.57
c) A stop-limit order with stop at $121.80 and limit at $117.80
d) Two stop-loss orders: a soft-stop at $121.80 and a hard-stop at $105.00
Answer: C. True: A stop-limit with a stop at $121.80 and a limit at $117.80. The stop is set
13.0% below the current price and the limit ensures a 30.0% HPR as (117.8 - 95.0)/95.0 =
24.0%.
In regard to (A), (B) and (D) each is false

 In regard to (A), a market order is carried out immediately (but Barbara does not want
to sell unless there is a crash)
 In regard to (B), this choice doesn't make sense: the limit order (to sell) is so far below
the current price that it can be immediately executed
 In regard to (D), there is no such thing as a soft- versus hard-stop
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-709-futures-

contracts-hull-chapter-2-continued.10539/
115
Question 52: Futures delta and dynamic delta hedging

A market maker takes a short position in 1,000 European call options on copper futures. The
options mature in three months, and the futures contract underlying the option matures in four
months. The current four-month futures price is $3.30 per pound, the exercise price of the
options is $3.00, the risk-free interest rate is 4.0% per annum, and the volatility of silver futures
prices is 20.0% per annum. Which is nearest to the position delta? (note: this question is
inspired by Hull's EOC Question 19.10)40
a) -833.0
b) -525.0
c) -314.0
d) +267.0
Answer: A. -833.0
Position delta is given by the product of quantity and percentage delta: ΔP = Qty * %Δ. In this
case, we want the percentage delta of a call option on a copper futures contract. According to
Hull, the (percentage) delta of European futures call option is usually defined as the rate of
change of the option price with respect to the futures price (not the spot price) and is given by
exp(-rT)*N(d1) where d1 = ( ln[F(0)/K] + σ^2*T )/ [σ*sqrt(T)]. In this case:
d1 = [LN(3.30/3.00) + (0.20^2/2)*0.25] / 0.20*sqrt(0.250) = 1.003102 or approximately 1.0. Note

the maturity of the futures contract is not utilized.
Position Δ = 1,000 * N(d1)*exp(-rT) = 1,000*N(1)*exp(-0.040*.25) = -1,000 * 0.841345 * exp(-

0.040*.25) = -832.9; or with exact an exact N(d1) value, the answer is -833.715.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-818-futures-

delta-and-dynamic-delta-hedging-hull-ch-19.20406/
40
116

In early 2012, J.P. Morgan Chase (JPM) lost billions on trades executed by the London Whale,
the notorious nickname for Bruno Iksil, who assumed massive exposures (masquerading as
hedges) in a large credit derivative portfolio. Which of the following BEST summarizes the root
cause of the debacle?
a) Lack of formal risk limits
b) A poor risk culture enabled by failures in corporate governance
c) The chief investment officer (CIO) lacked the sophistication to correctly value certain
credit derivatives
d) The chief investment officer (CIO) used only one metric, value at risk (VaR), an over-
reliance owing to JPM's pioneering use of VaR
Answer: B. TRUE. A poor risk culture enabled by failures in corporate governance. As
GARP explains, "In contrast to JPMorgan Chase’s reputation for best-in-class risk management,
the whale trades exposed a bank culture in which risk limit breaches were routinely disregarded,
risk metrics were frequently criticized or downplayed, and risk evaluation models were targeted
by bank personnel seeking to produce artificially lower capital requirements."41

from-financial-disasters-second-of-three.23199/
Question 54: Central limit theorem and mixture distributions

Your colleague Peter is selecting probability distributions in order to perform several Monte
Carlo simulations. Each of the following choices appears to be logical or sensible, EXCEPT
which choice prima facie appears be a mistake?
a) To model recovery rates for high yield bonds, he selects a beta distribution
b) To model a continuous variable that is non-negative, right-skewed and tends toward the
normal distribution as the degrees of freedom (d.f.) increase, he selects either a chi-
square or F-distribution
c) To model a light-tailed distribution (aka, platykurtosis where kurtosis < 3) he selects
either a Poisson distribution or a student's t distribution whose degrees of freedom (df) is
less than 30
d) To model a continuous outcome within a finite range (a,b) using a distribution that is only
slightly more complex than a uniform distribution, but allows him to specify a unique
mode, he selects a triangular distribution with parameter (c) equal to the mode
Answer: C. False. The Poisson distribution has mean and variance equal to lambda, λ, and its
excess kurtosis is elegantly given 1/λ such that it always has (slightly) heavy tails; the student's t
also has slightly heavy tails with excess kurtosis given by df/(df-2) when df > 4.
In regard to (A), (B) and (D) each is TRUE.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-716-central-limit-

theorem-and-mixture-distributions-miller-ch-4.13371/
41
2020 FRM Part I: Foundations of Risk Management, 10th Edition. Pearson Learning Solutions, 10/2019.
117
Question 55: Hedging versus speculation

PlanetZim Financial Bank just entered a position in a derivatives contract. Which of the following
features of the derivative position is MOST likely to indicate the trade is a case of
SPECULATION, in contrast to a case of a hedge, arbitrage or market-making?
a) If a hedge has no basis risk, then the hedged outcome is always superior to the un-
hedged outcome
b) In distinguishing from an arbitrage or a hedge, the key feature of a speculation is the use
of high leverage
c) Although put options can be used as a hedge or insurance, a position in call options
implies the investor is speculating rather than hedging
d) In Hull, the theoretical price of futures contracts and stock options (per Black-Scholes
Merton) depend on an assumption that no riskless arbitrage opportunities exist
Answer: D. TRUE: In Hull, the theoretical price of futures contracts and stock options
(per Black-Scholes Merton) depend on an assumption that no riskless arbitrage
opportunities exist
In regard to (A), B) and (C), each is either false or at least NOT necessarily true:
 A hedged outcome is often worse than an un-hedged outcome; in fact, we expect it to be
worse if the underlying risk factor produces a gain
 Leverage tends to be a feature of all derivative contracts because they are not funded.
 Call options could hedge a short position
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-707-hedging-

versus-speculation-hull-chapter-1.10530/
118
Question 56: Black Scholes

Mark the Risk Analyst is evaluating an at-the-money (ATM) call option on a non-dividend-paying
stock when the stock's price is $30.00; i.e., S(0) = K = $30.00. For this option, he has the table
shown below. The table displays option prices generated by the Black-Scholes-Merton option
pricing model according to selected input variations of volatility and maturity. In other words, the
table displays different values of c = BSM[S(0) = $30.00, K = $30.00, σ, Rf = 0.030, T].
Mark's option actually expires in in eight months; T = 8/12. Further, he observes that the option's
traded price (aka, observed market price) is $3.00. In this case, which of the following is nearest
to the call option's implied volatility?
a) 24.5%
b) 28.0%
c) 31.5%
d) 35.0%
Answer: B. 28.0%. This is a simple but tedious matter of interpolating values in the table.
See below.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-815-black-

scholes-value-of-a-warrant-and-implied-volatility-hull.14084/
119

The Volkswagen emissions scandal concerned over ten million cars during the years 2009 to
2015. The scandal unfolded with significant financial repercussions and massive reputational
damage to the company. GARP writes that "the damage to Volkswagen, the world’s biggest
carmaker, was significant ... Its reputation, particularly in the important US market, took a severe
hit. The reputational effect extended beyond the company itself as German government officials
expressed concerns that the value of the imprimatur 'Made in Germany' would be diminished
because of Volkswagen’s actions." Which of the following most accurately summarizes the
Volkswagen emissions case study?
a) Volkswagen deliberately programmed emission controls to activate only during
regulatory testing but not during real-world driving
b) Volkswagen did not conduct adequate quality assurance (QA) on its emission controls
and consequently, a meaningful percentage of them failed during real-world driving
c) The Volkswagen case study illustrates how reputation risk can materialize despite the
good intentions of managers who disclose problems immediately and cooperate with
regulators
d) Volkswagen had effective emission control devices (i.e., hardware), however, the
software contained an undetected bug that caused the controls to inadvertently fail
during real-world driving
Answer: A. TRUE: Volkswagen deliberately programmed emission controls to activate
only during regulatory testing but not during real-world driving
In regard to (B), (C), and (D), each is FALSE.

from-financial-disasters-third-of-three.23211/
120
Question 58: Skew, kurtosis, coskew and cokurtosis

Portfolio manager Peter manages a large portfolio with 100 component positions. He is
interested in analyzing the non-trivial cross moments in the portfolio (trivial cross-moments are
the position's coskew/cokurtosis with itself, which is simply the position's standard skew or
kurtosis, so these are analogous to the diagonal of a covariance matrix which is mere variances.
Each of the following statements is true EXCEPT which is inaccurate?
a) Between any two (n = 2) positions in the portfolio, the number of non-trivial coskew
moments between them is two
b) Between any two (n = 2) positions in the portfolio, the number of non-trivial cokurtosis
moments between them is three
c) Given a sub-portfolio consisting of any two positions, lower coskew values (i.e., where
positives are gains and negatives are losses) imply greater risk for the sub-portfolio
d) Although it is easy to estimate this portfolio's set of higher-order cross moments,
standard skew and kurtosis are preferred because they are BLUE and the informational
utility of coskew and cokurtosis is negligible
Answer: D. False. This is actually not easy because for 100 positions there exist fully 171,600
coskew cross moments and 4,421,175 cokurtosis cross moments! Also, according to Miller,
there is indeed often information utility in coskew and cokurtosis (alas there is a formidable
curse of dimensionality in accessing them). The reference to BLUE is a red herring; BLUE
refers to estimator properties.
In regard to (A), (B) and (C), each is TRUE.
In regard to true (A) and (B), the number of non-trivial cross moments is given by k = (m+n-
1)!/[m!(n-1)!] - n. But in the case of only two variables, say (X) and (Y), the total number of
coskew cross moments is four, which includes two trivial: S(XXX), S(XXY), S(XYY), S(YYY).
The total number of cokurtosis cross moments is five, which includes two trivial: K(XXXX),
K(XXXY), K(XXYY), K(XYYY), K(YYYY).
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-712-skew-

kurtosis-coskew-and-cokurtosis-miller-chapter-3.12190/
121
Question 59: Mutual funds

The Investment Committee at your endowment just analyzed the historical performance of its
asset allocation to hedge funds, which was 20.0% of the fund. It has determined that net of fees
these hedge funds did not outperform the S&P 500 on a risk-adjusted basis. Consequently, the
Committee wants to re-allocate this portion to a fund that tracks the S&P 500 index; and the
Committee is comfortable mirroring the index with minimum tracking error. An outside
consultant proposes an exchange-traded fund (ETF) such as the "Spider" (ticker SPY), but
some members want to compare the ETF to an open-ended or closed-ended mutual fund that
tracks the S&P 500.
In addition to highlighting the fact that the expense ratios tend to be lower for ETFs than mutual
funds, the consultant offers the following arguments in favor of an ETF:
I. In contrast to an open-ended mutual fund, advantage of the SPDR ETF can be traded at
any time, can be shorted, and does not have to be partially liquidated to accommodate
redemptions
II. In contrast to a closed-ended mutual fund whose price tends to trade at a discount to its
fair market value, there is never any appreciable difference between the traded price of
the SPDR EFT and its fair market value.
Which of the consultant's argument(s) is (are) TRUE?
a) Neither is true
b) Only I. is true, but II. is false
c) Only II. is true, but I. is false
d) Both are true.
Answer: D. Both [statements] are true.
Exchange-traded funds (ETFs) offer several advantages over open-ended and closed-ended
mutual funds:
 Because institutional investors exchange their ETF shares for the underlying assets,
unlike closed-end funds, there is never a material difference between the ETF share
price and its fair market value.
 ETFs can be bought or sold at any time of the day. ETFs can be shorted just like stock
can be shorted. ETF holdings are disclosed twice a day.
 ETF expense ratios tend to be lower than mutual fund expense ratios.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-705-mutual-

funds-hull.10282/
122
Question 60: Lognormal property of stock prices and Black-Scholes-Merton

A stock has a current price of $71.00 and follows geometric Brownian motion. It offers an
expected return of 14.0% with volatility of 23.0% per annum. Which is nearest to the probability
that a deeply out-of-the-money (OTM) European call option on the stock with a maturity of one
year (T = 1.0 year) and an exercise price of $100.00 will be exercised?
a) 16.0%
b) 23.5%
c) 31.8%
d) 40.0%
Answer: A. 16.0%
ln[S(t)] = Φ[LN($71.00) + (0.140 - 0.230^2/2)*1.0, 0.230^2*1.0) = Φ[$4.3, 0.230^2*1.0) =

Φ[4.37623, 0.230^2].
Because LN(100) = 4.60517, the probability [S(t) > 100] = 1 - N[(4.60517 - 4.37623)/0.230] = 1 -
N(0.995393), which is nearly 1- N(1.0) = ~ 16.0%.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-814-the-

lognormal-property-of-stock-prices-and-the-assumptions-of-black-scholes-merton-bsm.14071/
Question 61: Anatomy of the Great Financial Crisis

According to GARP, "a wave of uncertainty over the valuation of asset-backed structured
products exacerbated the [global financial] crisis" as counterparty risk suddenly became priced
expensively by counterparties. Consequently, the valuation of these illiquid assets became
problematic due to their inherent opacity (until mid-2007 counterparty risk was a factor that
effectively had NOT even been priced by the market!). Coincidentally, with these VALUATION
and TRANSPARENCY issues, which of the following is TRUE about the ensuing liquidity
crunch?
a) A solvency crisis led to a liquidity crisis
b) The OIS-swap spread narrowed to almost zero
c) Short-term wholesale funding markets started to freeze
d) Systemic reduction in collateral haircuts led to a liquidity crunch
Answer: C. TRUE: Short-term wholesale funding markets started to freeze
A key theme of the history (see 10.6 The Liquidity Crunch Hits) is banks' dangerous reliance on
short-term wholesale funding, in particular repurchase agreements (repos), commercial paper
(CP) and asset-backed commercial paper (ABCP). The valuation and transparency issued
caused investors to increase collateral haircuts and/or balk at rolling over short-term funds. In
regard to (A), (B) and (D), each is FALSE.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-20-17-anatomy-

of-the-great-financial-crisis-gfc-of-2007-2009.23224/
123
Question 62: Gaussian Copula

Below are the joint probabilities for a cumulative bivariate normal distribution with a correlation
parameter, ρ, of 0.30.
If V(1) and V(2) are each variables characterized by a uniform distribution, which is nearest to
the joint probability Pr[V(1) < 0.050, V(2) < 0.050] under a Gaussian copula model?
a) 0.25%
b) 0.71%
c) 1.36%
d) 1.82%
Answer: B. 0.71%. It's a simple lookup, if we know to map the uniform 0.05 probability to
the associated -1.645 normal quantile! This question is mostly to illustrate the concept of
the Gaussian copula.
To examine this closer, here is the working spreadsheet (enable macro) at http://trtl.bz/t2-707-1-
bivar-normal
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-707-gaussian-

copula-hull.10198/
124
Question 63: Insurance company regulations and pension funds

A defined benefit pension fund is 50.0% invested in equities and 50.0% invested in bonds. If we
assume the simplest possible balance sheet, which is MOST LIKELY to be the net effect of a
scenario where equities are approximately flat, but interest increase by 100 basis points?
Please note this is inspired by Hull's EOC Question 3.1842, so it makes simplifying assumptions
such as (i) the rate increase is a parallel shift of both short- and long-term interest rates, (ii)
durations are not managed, and (iii) the fund is not hedged.
a) Improvement in funded status because present value of liabilities decreases more than
assets decrease
b) Improvement in funded status because present value of assets increases more than
liabilities increase
c) Deterioration in funded status because present value of liabilities increases more than
assets increase
d) Deterioration in funded status because present value of liabilities decreases more than
assets decrease
Answer: A. TRUE. Improvement in funded status because present value of liabilities

decreases more than assets decrease
An increase in the interest rate implies an increase in the discount rate used to value the
liabilities; this decreases the present value of the liabilities. An increase in the interest should
affect a decrease in the value of the bonds (on the asset site) per the typical inverse relationship
between bond prices and yields. However, bonds are only 50% of the asset mix so that the
liability impact should be greater than the asset impact, for a net positive effect on the pension's
funded status.
And for further reference, this question is based on Hull's end-of-chapter (EOC) question 3.18:
 Hull's EOC Question 3.18 Question:42 During a certain year, interest rates fall by 200
basis points (2%) and equity prices are flat. Discuss the effect of this on a defined
benefit pension plan that is 60% invested in equities and 40% invested in bonds.
 Answer: "The value of a bond increases when interest rates fall. The value of the bond
portfolio should therefore increase. However, a lower discount rate will be used in
determining the value of the pension fund liabilities. This will increase the value of the
liabilities. The net effect on the pension plan is likely to be negative. This is because the
interest rate decrease affects 100% of the liabilities and only 40% of the assets."42
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-704-insurance-

company-regulations-and-pension-funds-hull.10277/
42
Source for Hull's 3.18: John C. Hull, Risk Management and Financial Institutions, 5th edition (Hoboken, New
Jersey: John Wiley & Sons, 2018).
125
Question 64: Binomial model

Peter initially values a one-year European put option on a non-dividend-paying (q = 0%) stock
with the following assumptions:
 One-year put option maturity with twelve steps in the binomial model (one for each
month): Δt = 1/12
 The strike price is equal to the stock's current price of $40.00; i.e., at-the-money
 Volatility of stock, σ = 25.0% per annum
 Riskfree rate is 3.0% per annum with continuous compounding, r = 3.0%
Once he performs the twelve-step valuation, he decides to re-price the same option but with
only one difference: he will increase the number of steps in the binomial tree to 50 (one for each
week) so that each time step Δt = 1/50. In regard to the switch from twelve steps to 50 steps
(i.e., Δt = 1/12 → Δt = 1/50), each of the following statements is true EXCEPT which is false?
a) In switching from monthly to weekly steps, the number of terminal stock prices increases
from 13 to 51
b) In switching from monthly to weekly steps, the SMALLEST terminal stock price (in the
binomial tree) decreases from $16.82 (when Δt = 1/12) to $6.83 (when Δt = 1/50)
c) In switching from monthly to weekly steps, the LARGEST terminal stock price (in the
binomial tree) increases from $95.10 (when Δt = 1/12) to $234.31 (when Δt = 1/50)
d) In switching from monthly to weekly steps, the probability that the terminal stock price
equals EXACTLY $40.00 (i.e., same as the initial price) approximately doubles because
SQRT(50/12) ≈ 2.0
Answer: D. False. As the steps increase from 12 to 50, the exactly prob[S(1.0 year) =
$40.00] decreases from 22.56% to 11.23%.
The exact probability is given by the binomial probability mass function (pmf). In order to reach
the node that equals the initial value, we need the number of up movements to equal the
number of down movements. In the case of 12 steps, six up (and six down) returns to the initial
value; in the case of 50 steps, 25 up (and 25 down) returns to the initial value. In this way:
 The binomial Pr(X = 6 | T = 12, p = 0.49929) = 22.56%, and
 The binomial Pr(X = 25 | T = 50, p = 0.49965) = 11.23%.
In regard to (A), (B) and (C), each is TRUE.

 In regard to true (A), the binomial tree with N steps has (N+1) terminal values
 In regard to true (B) and (C), under Δt = 1/12, the smallest terminal price is given by
$40.00*exp[-0.250 * sqrt(1/12)]^12 = $16.82, and the largest terminal price is given by
$40.00*exp[0.250 * sqrt(1/12)]^12 = $95.10. Under Δt = 1/50, the smallest terminal price
is given by $40.00*exp[-0.250 * sqrt(1/50)]^50 = $6.83, and the largest terminal price is
given by $40.00*exp[0.250 * sqrt(1/50)]^50 = $234.31. Notice the more granular tree has
much more dispersion, however the tail probabilities are extremely small.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-812-binomial-

model-for-options-on-stock-indices-and-stocks-with-dividends-hull-ch-13.14011/
126
Question 65: GARP Code of Conduct

Peter is a Risk Analyst (and certified FRM) tasked by his firm to evaluate a half dozen vendors
and make a recommendation to purchase one of their risk management software packages.
The firm has a specific need, and the Risk Committee of the board has given the list of six
vendors to Peter because they are each reputable vendors in the software category. Upon
seeing the list, Peter realizes that he is friends with one of the CEOs (among the six vendors)
because they both volunteer their time to a local charity and, due to this shared interest, they
frequently socialize together.
According to GARP's Code of Conduct, should Peter take any action with respect to a potential
conflict of interest?
a) No action is necessary because the Code is silent with respect to conflicts of interest
b) Peter must withdraw from the task because an FRM must avoid actual, perceived, or
potential conflicts of interest
c) Peter should disclose his potential conflict to his superior(s), but he should be able to
retain the task
d) Peter should cease contact with the CEO (and hiatus the volunteering) because an FRM
must avoid all actual conflicts of interest
Answer: C. TRUE: Peter should disclose his potential conflict to his superior(s), but he
should be able to retain the task
The key is full disclosure. In regard to false (B) and (D), it is unrealistic to avoid all potential
conflicts of interest; full disclosure ensures they can be managed.
The relevant code(s) include:
"II. Code of Conduct: 1.2. Conflicts of Interest: GARP Members have a responsibility to promote
the interests of all relevant constituencies and will not knowingly perform risk management
services directly or indirectly involving an actual or potential conflict of interest unless full
disclosure has been provided to all affected parties of any actual or apparent conflict of interest.
Where conflicts are unavoidable GARP Members commit to their full disclosure and
management"
... and "III. Rules of Conduct: 2. Conflict of Interest: GARP Members:
2.1 Shall act fairly in all situations and must fully disclose any actual or potential conflict to all
affected parties.
2.2 Shall make full and fair disclosure of all matters that could reasonably be expected to impair
their independence and objectivity or interfere with their respective duties to their employer,
clients, and prospective clients."43
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-20-18-garp-code-

of-conduct.23235/
43
127
Question 66: Bivariate normal distribution

The data and plot below show a bivariate normal sample distribution. The first two columns, z(1)
and z(2), display random standard normal variables, N(0,1). Because X(1) is a (non-standard)
random normal variable with mean, µ, of 2.0 and standard deviation, σ, of 4.0, it is given by X(1)
= 2.0 + 4.0 * z(1). On the other hand, X(2) is correlated with X(1) according to the selected
correlation parameter, ρ(X1, X2), of 0.80.
What is the missing third realization ("???") of X(2)?

a) -1.27
b) +3.03
c) +8.50
d) +13.12
Answer: D. +13.12
e(2) = ρ*z(1) + z(2)*sqrt(1-ρ^2) = 0.80*0.340+1.050*sqrt(1-0.80^2) = 0.9020, is the random
correlated standard normal variable.
The realized X(2) = µ+σ*e(2) = 5.0+9.0*0.9020 = $13.1180.
In order to generate random but correlated standard normal variables, we can use:
= + 1−
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-706-bivariate-

normal-distribution-hull.10189/
128
Question 67: Life insurance products and mortality tables

Below is an extract (selected rows) from a mortality table:
Which is nearest to the probability of a man aged 80 years old dying in the second year
(between ages 81 and 82)?
a) 0.39%
b) 1.76%
c) 6.20%
d) 7.31%
Answer: C. 6.20%. This is the probability that he does not die in the first year multiplied by the
probability that he does die in the second year, which is given by (1 - 0.0594030) * 0.0658730 =
0.0619599 = 6.19599%
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-702-life-

insurance-products-and-mortality-tables-hull.10259/
129
Question 68: Spectral risk measures

In the event of certain operational loss, the severity of the loss ranges from three to 18. As luck
would have it, the loss distribution is similar to the roll of three dice.
For example, in the event of a loss occurrence, the probability of a loss of either three (the
minimum loss) or 18 (the maximum loss) is given by approximately (1/6)^3 = 0.4630%; the
probability of a loss of four or 17 is 3/6^3 = 1.389%. Which are nearest, respectively, to the
95.0% value at risk (VaR) and 95.0% expected shortfall (ES) for the severity of this loss?
a) 14.5 (95.0% VaR) and 15.5 (95.0% ES)

b) 15.0 (95.0% VaR) and 16.4 (95.0% ES)
c) 15.5 (95.0% VaR) and 17.1 (95.0% ES)
d) 16.0 (95.0% VaR) and 18.0 (95.0% ES)
Answer: B. 15.0 (95.0% VaR) and 16.4 (95.0% ES). See below.
In regard to the 95.0% VaR, the 0.050 quantile falls within X = 15: The cumulative probability of
16 or worse is given by 0.463% + 1.389% + 2.778% = 4.630% (i.e., not quite reaching the 5.0%
threshold) and 0.463% + 1.389% + 2.778% + 4.630% = 9.259%. In regard to the 95.0%
expected shortfall (ES), the 5.0% probability tail is identified by including a TRUNCATED Pr(X =
15) = 0.370% such that 0.463% + 1.389% + 0.370 = 5.0%. Given this tail, the conditional
average is equal to (0.0833 + 0.2361 + 0.4444 + 0.0556)/0.050 = 16.389.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-810-spectral-risk-

measures-especially-expected-shortfall-es-dowd-ch-2.13970/
130
Question 69: Policy responses and real effects of global financial crisis
Gorton says, “The recent crisis is often described as being the worst global crisis since the
Great Depression, and the evidence supports this label.”44 The financial crisis included two main
panic periods: August 2007 and September‐October 2008. Gorton’s literature review compares
the crisis to the long history of previous and numerous financial crises. This comparison
produced two interesting features: on the one hand, the authors found a crucial SIMILARITY to
historical predicates but, on the other hand, they found a novel DIFFERENCE from previous
crises. Which of the following best summarizes, respectively, the feature common (aka,
similarity) to previous crises and the novel difference observed in the recent crisis?
a) Dependence on fiat money (similarity or feature in common) and Innovation in financial
instruments (the novel difference)
b) Growth in notional derivatives outstanding (similarity) and Acceleration in leverage (the
novel difference)
c) Central banking support and intervention (similarity) and Erosion of lending standards
(the novel difference)
d) Acceleration in leverage prior to the crisis (similarity) and Shadow banking system as the
location of bank runs (the novel difference)
Answer: D. TRUE: Acceleration in leverage prior to the crisis (similarity) and Shadow
banking system as the location of bank runs (the novel difference)
According to Gorton, the global financial crisis (GFC) of 2007-09 shared both important
similarities with, and novel differences from, recent historical crisis. One of the strongest
similarities, according to Gorton, was the buildup (aka, acceleration) of leverage in the system
prior to the crisis. A related similarity to prior crisis was the runup in home prices.
Although a feature of historical crises was runs on short-term debt, the difference (aka, novelty)
was the location of the runs during the GFC: the shadow banking system, which including
commercial paper (CP), repurchase agreements (repos), and money-market mutual funds.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-703-policy-

responses-and-real-effects-of-global-financial-crisis-gorton.10098/
44
Gary Gorton and Andrew Metrick, 2012. “Getting Up to Speed on the Financial Crisis: A One-Weekend-Reader’s
Guide”, Journal of Economic Literature 50:1, 128—150.
131
Question 70: Correlation

You have assumed a single-index model and regressed the returns for two stocks, stock (A)
and stock (B), against the index in separate univariate regressions. This produced the following
two linear functions, such that β(A) is 0.80 and β(B) is 1.40:
, = + , + ,
= 0.020 + 0.80 +
= 0.050 + 1.40 +
Additionally, the volatility of the index, σ(M), is 20.0%, the volatility of stock A, σ(A), is 32.0%
and the volatility of stock B, σ(B), is 40.0%. Which of the following is the implied correlation
between the two stocks?
a) 0.2240
b) 0.3500
c) 0.4900
d) 1.1200
Answer: B. 0.3500. Covariance(A,B) = β(A)*β(B)*σ(M)^2 = 0.80*1.40*0.20^2 = 0.04480 and

correlation = 0.04480/(0.32*0.40) = 0.350.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-705-correlation-

hull.10172/
132
Question 71: Long and short hedges

You are meeting with your FRM study group when one of the members of the group says they
are a bit unclear on the definition of the term "short hedge." The following conversation ensues:
I. Albert says, "It's simple, if a company owns an asset but wants to hedge its plan to
sell the asset at the future spot price, a short hedge is appropriate"
II. Barbara says, "Yes, Albert that is true, but if the company plans to sell the
commodity in the future at a predetermined price, then a long hedge is appropriate!"
III. Chris says, "Barbara is correct because a short hedge is simply a hedge where a
short futures position is taken."
IV. Donald says, "Exactly true, Chris. And that means that a short hedge can also be a
cross-hedge; i.e., these terms are not mutually exclusive."
V. Erin says, "And I would like to add that the company does not need to own the asset
in order to conduct a short hedge."
VI. Fred says, "And I would like to add that a short hedge implies negative basis, just as
a long hedge implies positive basis."
Which of the statements is (are) accurate?
a) Only Donald and Erin are accurate
b) Only Albert, Chris, and Fred are accurate
c) All of the statements are accurate, except Barbara's
d) All of the statements are accurate, except Fred's
Answer: D. All of the statements are accurate, except Fred's, whose statement is false
because a short hedge is a hedge with a short position, per TRUE choice (C), such that
the basis could be either negative or positive.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-710-long-and-

short-hedges-hull-chapter-3.10546/
133
Question 72: Putting value at risk (VaR) to work

Patricia the Portfolio Manager owns an option portfolio that contains both long and short
positions in European call and put options. The position gamma of the portfolio is negative,
specifically it is -19,500. Recall that position gamma is the product of option quantity and each
option's percentage gamma. For example, a long position in 10,000 call options that each have
a percentage (per option) gamma of 0.050 has a position gamma of +500; on the other hand, a
short position in the same number of options has a position gamma of -500. Position gamma
can be summed across the option portfolio.
Patricia initially estimates her option portfolio's value at risk (VaR) based on a delta
approximation. Her analysis quotes VaR in Loss(+)/Profit(-) format; aka, L/P units. In this way,
losses and VaR are expressed as positive values. However, she realizes that such an estimate
omits the portfolio's negative position gamma, so she re-computes the portfolio's VaR by using
a DELTA-GAMMA approximation. How does the revised estimate compare to the first delta-only
estimate?
a) The delta-gamma L/P VaR is higher
b) The delta-gamma L/P VaR is lower
c) If the position delta is positive, the L/P VaR is lower; but if the position delta is negative,
the L/P VaR is higher.
d) We need more information
Answer: A. True: The delta-gamma L/P VaR is higher. Negative position gamma
exacerbates the VaR relative to the linear delta approximation, so the re-computed L/P VaR is
higher. Percentage (per option) gamma is always positive, so that negative position gamma
implies a net short option position, which is exposed to gamma risk. On the other hand, a
positive position gamma would imply a net long option position such that re-computed L/P VaR
would less than the linear duration-only approximation.
In regard to (A), (C) and (D), each is false.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-806-putting-

value-at-risk-var-to-work-allen-ch-3.13766/
134

Suppose that three factors have been identified for the U.S. economy:
 Expected inflation rate (IR) is +2.00%
 Expected 10-year Treasury yield (T-NOTE) is 2.40%
 Expected growth in productivity (PROD) is +3.00%
A stock with an expected return of 9.0% has the following betas with respect to these factors:
β(IR) = +1.50, β(T-NOTE) = -1.20 and β(PROD) = 0.70. In turns out that that economy's actual
factor performance is the given by the following set of results:
 Actual inflation rate (IR) is + 2.60%
 Actual 10-year Treasury yield (T-NOTE) is 3.00%
 Actual growth in productivity (PROD) +2.00%
What is the revised estimate of the stock's expected rate of return (note: this is a variation on
Bodie's Problem 10.145)?
a) 8.480%
b) 9.000%
c) 9.250%
d) 10.375%
Answer: A. 8.480%. Revised estimate = 9.0% + [1.5 * (2.6% - 2.0%)] + [-1.20 * (3.0% - 2.4%)]
+ [0.70 * (2.0% - 3.0%)] = 8.480%
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-704-bodies-

multifactor-models.10108/
45
Zvi Bodie, Alex Kane, and Alan J. Marcus, Investments, 10th Edition (New York: McGraw-Hill, 2013)
135
Question 74: Linear and nonlinear trends

You would like to describe an account that begins at TIME(0) = $100.00 and compounds
continuously at 9.0% per annum. What is a function that characterizes the value of this account,
A(t), over time according to such a continuous and constant growth trend?
a) A(t) = $100*exp[0.090*TIME(t)]
b) ln[A(t)] = ln($100) + 0.09*TIME(t)
c) Neither (A) nor (B)
d) Both (A) and (B)
Answer: D. TRUE: Both (A) and (B).
A(t) = β(0)*exp[β(1)*TIME(t)] describes an exponential (aka, log-linear) trend that is growing at a

continuous rate of β(1); in this case, β(0) is the initial value of $100.00 and β(1) is the growth
rate of 9.0%. Then we can also take the natural log of both sides and observe that LN[A(t)] is a
linear function of time:
LN[A(t)] = LN(β(0)*exp[β(1)*TIME(t)]) = LN[β(0)] + LN(exp[β(1)*TIME(t)]) = LN[β(0)] +
β(1)*TIME(t).
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-699-linear-and-

nonlinear-trends-diebold.10149/
Question 75: Cost of carry and normal backwardation

The current price of a technology index is 3,000 and its yield, q, is 2.0% per annum with
continuous compounding; i.e., about 2.010% per annum with semi-annual compounding. The
risk-free rate is 3.0% per annum with continuous compounding. The discount rate for the index
can be determined by the capital asset pricing model (CAPM) where its beta is 1.80 and the
market's expected return is 9.0%; i.e., the market's expected excess return is 6.0%. Which is
nearest to the index's expected future spot price in 10 months, E[S(+0.833)]?
a) $3,025.10
b) $3,127.64
c) $3,309.99
d) $4,005.05
Answer: C. $3,309.99 The discount rate (per CAPM) is given by k = Rf + β*ERP = 3.0% +
1.80*(9.0% - 3.0%) = 13.8% and because the dividend yield is 2.0%, the expected growth
rate in the price is 13.8% - 2.0% = 11.8%. Therefore, the E[S(+10/12)] =
$3,000*exp(0.1180*10/12) = $3,309.99.
In regard to false choice (A), note that $3,025.10 is the theoretical forward price which is given,
per cost of carry, by F(+10/12) = S(0)*exp[(r-q)*T] = $3,000*exp[(0.030 - 0.020)*10/12] =
$3,025.10. Please also note that F(0) = E[S(T)]*exp[(r-k)*T) holds true as $3,025.10 =
$3,309.99*exp[(0.030 - 0.1380)*10/12); and further, because F(0) < E[S(T)] this is an instance
of normal backwardation, which is anticipated by the relationship (k>r).
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-718-cost-of-

carry-with-cash-flow-and-normal-backwardation-hull-chapter-5.10619/
136
Question 76: Stress testing validation and internal audit

Which of the following statements is TRUE about the role of validation in stress testing
governance?
a) Stress that cannot be fully validated should not be used
b) Stress-test estimates should be continuously backtested against realized outcomes
because quantitative backtest results are a common, critical validation metric
c) Expert-based judgement should be applied to ensure that test results are intuitive and
logical, and to add additional perspective on stress-test performance
d) If a model fails to perform strongly in the data-rich environment of a baseline (e.g., good
times) setting, then it cannot be trusted to estimate stressed outcomes
Answer: C. TRUE: Expert-based judgement should be applied to ensure that test results
are intuitive and logical, and to add additional perspective on stress-test performance. In
regard to (A), (B) and (D), each is false, or at least not necessarily accurate.
Siddique and Hasan (selected, emphasis ours): "... because stress tests by definition aim to
estimate the potential impact of rare events and circumstances, conducting more traditional
outcomes analysis used in a more data-rich environment may not be possible. For
instance, statistical backtesting of stress-test estimates against realised outcomes may
not be feasible.
To address challenges associated with validating stress tests, some institutions may try to test
their models using data from nonstress periods, i.e., during good times or in a baseline setting.
Such testing can be beneficial to determine whether the stress test generally functions as a
predictive model under those conditions. If the stress test does not perform well in a more data-
rich environment, that would certainly raise questions about its usefulness. However, while
baseline outcomes showing good test performance can provide some additional
confidence in the stress test, those outcomes should not be interpreted as sufficient for
the designated task of estimating stress outcomes. For instance, markets and market actors
can behave quite differently in stress environments and assumed interactions among variables
can change markedly (such as higher incidence of nonlinearities). Thus, the model used in a
baseline situation may actually require a different specification to properly estimate stress
outcomes (or an entirely new model may be needed for stress periods)
... As an additional response to these validation issues, given the limitations of relying on
outcomes analysis, an institution may need to rely on other aspects of validation and
independent review of stress tests – such as a greater emphasis on conceptual soundness of
the stress test, additional sensitivity testing, and simulation techniques. Or an institution may
choose to create holdout sample portfolios and run them through its stress-test model.
Benchmarking to internal or external models, tools or results can also be beneficial, but
institutions should be careful that the benchmarks appropriately fit the institution’s risks,
exposures, and activities. Finally, expert-based judgement should be applied to ensure that
test results are intuitive and logical, and to add additional perspective on stress-test
performance.46
- continued -
46
2013)
137
Despite these additional efforts, institutions may continue to be challenged in trying to fully
validate their stress tests to the same extent as other models, given the limitations in conducting
performance testing. Such limitations do not mean that those stress tests cannot be used, but
there should be transparency about validation status, and information about the lack of full
validation should be communicated to users of stress-test results. For cases in which validation
and independent review have identified material deficiencies or limitations in a stress test, there
should be a remediation plan to explain how the stress test will be enhanced or its use limited,
or both. Identified deficiencies in stress tests should be communicated to all stress-test users."47
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-801-stress-

testing-validation-and-the-role-of-internal-audit-siddique.13458/
Question 77: Fama-French three factor model

Assume a sock's returns are accurately characterized by the Fama-French three-factor model.
The stock's own factor betas and the risk model's risk premiums are given below:
What is the firm's size/value style characteristics and what is the firm's required rate of return?
a) Small-cap, growth-oriented with a required return of 5.50%
b) Small-cap, value-oriented with a required return of 6.00%
c) Large-cap, growth-oriented with a required return of 3.50%
d) Large-cap, value-oriented with a required return of 8.00%
Answer: A. Small-cap, growth-oriented with a required return of 5.50%.
The positive factor beta (+0.70) given as a sensitivity to the size factor, SMB, indicates small
cap due to implied positive contribution to return. The negative factor beta (-0.40) given as a
sensitivity to the value factor, SML, indicates a growth-oriented (i.e., as opposed to value-
orientation) due to implied negative contribution to return. The required return is given by, E(r) =
Rf + β(M)*[R(M)-Rf] + β(SMB)*[R(SMB)-Rf] + β(HML)*[R(HML)-Rf] = 2.0% + 1.0*4.0% +
0.70*1.0% - 0.40*3.0% = 5.50%.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-705-fama-french-

three-factor-model-bodies-multifactor-models-continued.10115/
47
2013)
138
Question 78: Bootstrapping

What is the crucial difference between bootstrapping and Monte Carlo simulation?
a) One uses artificial data but the other requires actual data
b) One requires random number generation, but the other does not rely on randomness
c) One requires a distributional assumption, but the other does not permit a distributional
assumption
d) There is no crucial difference between bootstrapping and Monte Carlo simulation
Answer: A. One uses artificial data but the other requires actual data.
Brooks: "13.4 Bootstrapping is related to simulation, but with one crucial difference. With
simulation, the data are constructed completely artificially. Bootstrapping, on the other hand, is
used to obtain a description of the properties of empirical estimators by using the sample data
points themselves, and it involves sampling repeatedly with replacement from the actual data.
Many econometricians were initially highly sceptical of the usefulness of the technique, which
appears at first sight to be some kind of magic trick – creating useful additional information from
a given sample. Indeed, Davison and Hinkley (1997, p. 3), state that the term ‘bootstrap’ in this
context comes from an analogy with the fictional character Baron Munchhausen, who got out
from the bottom of a lake by pulling himself up by his bootstraps."48
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-602-

bootstrapping-brooks.9244/
Question 79: Quoted versus cash bond prices

The price of a 72-day Treasury bill is quoted as 7.00. Which is nearest to the continuously
compounded return (on an actual/365 basis) that an investor will earn on the Treasury bill for
the 72-day period? (note: inspired by Hull's EOC Problem 6.8)49
a) 1.40000% per annum with continuous compounding
b) 5.60000% per annum with continuous compounding
c) 5.71790% per annum with continuous compounding
d) 7.14737% per annum with continuous compounding
Answer: D. 7.14737% per annum with continuous compounding. The cash price, Y = 100 -
72/360*7 = 98.60 such that the continuously compounded return = 365/72*LN(1 +
1.40/98.60) = 0.0714737 = 7.14737%.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-719-quoted-

versus-cash-bond-prices-hull-chapter-6.10627/
48
Chris Brooks, Introductory Econometrics for Finance, 3rd Ed. (Cambridge, UK: Cambridge University Press, 2014)
49
139
Question 80: Value at risk (VaR) estimation approaches

Linda Allen50 introduces the following value at risk (VaR) estimation approaches:
 Historical simulation (HS)
 GARCH (1,1)
 Hybrid
 Multivariate density estimation (MDE)
 Historical standard deviation (STDEV)
 Adaptive volatility (AV)
Consider these six summary descriptions:
I. The simplest parametric approach whose weakness is sensitivity to window
length and extreme observations
II. The most convenient and prominent non-parametric approach whose weakness
is inefficient use of data
III. An interpretation of the exponentially weighted moving average (EWMA) that
gives the risk manger a rule that can used to adapt prior beliefs about volatility in
the face of news
IV. A parametric approach that assumes conditional returns are normal but
unconditional tails are heavy; and that returns are not correlated but conditional
variance is mean-reverting
V. An approach that weights past squared returns not by time but instead according
to the difference between current and past states of the world
VI. An approach that modifies historical simulation by assigning exponentially
declining weights to past data such that recent (distant) returns are assigned
more (less) weight
Which sequence below correctly matches the VaR estimation approach with its summary
description?
a) I = HS, II = AV, III = GARCH, IV = MDE, V = Hybrid, VI = STDEV
b) I = GARCH, II = MDE, III = Hybrid, IV = STDEV, V = HS, VI = AV
c) I = STDEV, II = HS, III = AV, IV = GARCH, V = MDE, VI = Hybrid
d) I = AV, II = Hybrid, III = STDEV, IV = HS, V = GARCH, VI = MDE
Answer: C. TRUE: I = STDEV, II = HS, III = AV, IV = GARCH, V = MDE, VI = Hybrid. These
terms are matched with their summary explanation below, but grouped by
parametric/non-parametric and sub-sorted in the order of Linda Allen's presentation.50
Parametric approaches (please note that Allen occasionally blurs the distinction between
volatility and VaR, but these parametric VaR approaches generally produce a volatility that can
be scaled by a confidence deviate to retrieve VaR):
 Historical standard deviation (STDEV): The simplest parametric approach whose
weakness is sensitivity to window length and extreme observations.
 Adaptive volatility (AV): An interpretation of the exponentially weighted moving average
(EWMA) that gives the risk manger a rule that can used to adapt prior beliefs about
volatility in the face of news
50
Linda Allen, Jacob Boudoukh and Anthony Saunders, Understanding Market, Credit and Operational Risk: The
Value at Risk Approach (Oxford: Blackwell Publishing, 2004)
140
 GARCH (1,1): A parametric approach that assumes conditional returns are normal but
unconditional tails are heavy; and that returns are not correlated but conditional variance
is mean-reverting
Non-parametric approaches
 Historical simulation (HS): The most convenient and prominent non-parametric approach
whose weakness is inefficient use of data
 Multivariate density estimation (MDE): An approach that weights past squared returns
not by time but instead according to the difference between current and past states of
the world
 Hybrid (aka, age-weighted which Dowd has dubbed "semi-parametric"): An approach
that modifies historical simulation by assigning exponentially declining weights to past
data such that recent (distant) returns are assigned more (less) weight
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-804-value-at-risk-

var-estimation-approaches-allen-ch-2.13700/
141
Question 81: Getting up to Speed on the Financial Crisis

According to Ben Bernanke, among the following trigger/vulnerability pairs, which were the
primary TRIGGER and (among) the primary VULNERABILITIES, respectively, that led to the
financial crisis?
a) Derivatives (trigger); and Monetary policy (vulnerability)
b) Deficiencies in Risk Management (trigger); and The prospect of losses on subprime
mortgage loans (vulnerability)
c) Leverage (trigger); and Sudden stop in syndicated lending to large, relatively risky
corporate borrowers (vulnerability)
d) The prospect of losses on subprime mortgage loans (trigger); and Dependence on
unstable short-term funding (vulnerability)
Answer: D. TRUE: The prospect of losses on subprime mortgage loans (trigger); and
Dependence on unstable short-term funding (vulnerability). Selected (emphasis ours,
although the entire document is worth reading) from Testimony by Chairman Ben S. Bernanke
(Causes of the Recent Financial and Economic Crisis) Before the Financial Crisis Inquiry
Commission:51
"Triggers of the Crisis > In discussing the causes of the crisis, it is essential to distinguish
between triggers (the particular events or factors that touched off the crisis) and
vulnerabilities (the structural weaknesses in the financial system and in regulation and
supervision that propagated and amplified the initial shocks). Although a number of
developments helped trigger the crisis, the most prominent one was the prospect of
significant losses on residential mortgage loans to subprime borrowers that became
apparent shortly after house prices began to decline. With more than $1 trillion in subprime
mortgages outstanding, the potential for losses on these loans was large in absolute terms;
however, judged in relation to the size of global financial markets, prospective subprime losses
were clearly not large enough on their own to account for the magnitude of the crisis. (Indeed,
daily movements in global equity markets not infrequently impose aggregate gains or losses
equal to or greater than all the subprime mortgage losses incurred thus far.) Rather, the
system's vulnerabilities, together with gaps in the government's crisis-response toolkit, were the
principal explanations of why the crisis was so severe and had such devastating effects on the
broader economy…..
Vulnerabilities > Dependence on Unstable Short-Term Funding > Shadow banks are
financial entities other than regulated depository institutions (commercial banks, thrifts, and
credit unions) that serve as intermediaries to channel savings into investment. Securitization
vehicles, ABCP vehicles, money market funds, investment banks, mortgage companies, and a
variety of other entities are part of the shadow banking system. Before the crisis, the shadow
banking system had come to play a major role in global finance; with hindsight, we can see that
shadow banking was also the source of some key vulnerabilities."51
Bernanke itemizes several vulnerabilities. In the Private Sector, they are
 Deficiencies in Risk Management

 Leverage
 Derivatives
51
September 2, 2010; see FRB- Testimony--Chairman Ben S. Bernanke--September 2, 2010
142
In the Public Sector vulnerabilities include:
 Statutory Gaps and Conflicts

 Ineffective Use of Existing Authorities
 Crisis-Management Capabilities
 Too Big to Fail
 Monetary Policy (unclear, according to Bernanke's view albeit he is biased)
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-702-getting-up-

to-speed-on-the-financial-crisis-gorton.10091/
Question 82: Sample moments and bias

During a recent workweek, Peter recorded the number of dropped calls to the company's
support line. For the tiny sample of five days (n = 5), the average number of dropped calls was
9.60 per day. Peter used Excel's VAR.P() to retrieve the variance and the result was 1.840.
However, his colleague Mary pointed out that this is a biased estimate of the unknown
population variance. What is the unbiased estimate of the variance?
a) 1.472
b) 1.840
c) 2.300
d) Needs more information
Answer: C. True: 2.300. If n = 5 and 1.840 is the biased variance estimate, then 1.840 * 5/4 =
2.300 is the unbiased estimate.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-11-sample-

moments-and-bias.23372/
143
Question 83: Swaps

A $100.0 million interest rate swap has a remaining life of 15 months. Under the terms of the
swap, six-month LIBOR is exchanged for 3.60% per annum (compounded semiannually). Six-
month LIBOR forward rates for all maturities are 3.00% (with semiannual compounding). Two
Three months ago, the six-month LIBOR rate was
2.90% (this assumption is shown in purple cell
below). OIS rates for all maturities are 2.80% with
continuous compounding.
Which is nearest to the current value of the swap

to the counterparty who is paying the floating rate?
(Inspired by Hull's EOC Problem 7.2, 10th
Edition)52
a) -$295,850
b) +$931,000
c) +$1.80 million
d) +$2.14 million
Answer: B. $931,000. See below. Spreadsheet here
https://www.dropbox.com/s/1wwn4xn7h4h95m7/t3-723-1-swap-valuation.xlsx?dl=0
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-723-swaps-

valuation-with-ois-and-libor-comparative-advantage-and-currency-swap-valuation.10675/
52
Hull, Options, Futures, and Other Derivatives, 10th Edition (New York: Pearson, 2017).
144
Question 84: Classical value at risk (VaR)

Rebecca has determined that her equity portfolio's 25-day 95.0% confident absolute value at
risk (aVaR) is given by -µ*Δt + σ*α*sqrt(Δt) = -12,000 + 208,000 = $196,000. She subsequently
decides that she wants to translate this into a 10-day 99.0% confident aVaR. If the returns are
i.i.d. and normally distributed, which of the following is nearest to the translated VaR?
a) 133,300
b) 150,000
c) 181,530
d) 195,400
Answer: C. 181,530. The drift translates linearly: 12,000 * 10/25 = 4,800. The volatility
translation includes two components:
 The time scales per the square root rule, sqrt(10/25), and further
 The confidence changes the deviate from ~1.645 to ~2.33, proportionally per 2.33/1.645
Consequently, the volatility shock translates to 208,000*sqrt(10/25)*2.33/1.645 = $186,330.
Therefore the new 10-day 99.0% confident aVaR is given by -4,800 + 186,330 = 181,530.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-807-classical-

value-at-risk-var-dowd-ch-2.13916/#post-60228
Question 85: Principles for risk data aggregation

Among the Basel Committee's Principles for effective risk data aggregation and risk reporting,
Principle 2 is "Data architecture and IT infrastructure: A bank should design, build and maintain
data architecture and IT infrastructure which fully supports its risk data aggregation capabilities
and risk reporting practices not only in normal times but also during times of stress or crisis,
while still meeting the other Principles."53 The principle includes paragraph 33, where two terms
have been replaced with "[keyword #1]" and "[keyword #2]":
"A bank should establish integrated data [keyword #1 here] and architecture across the banking
group, which includes information on the characteristics of the data--i.e., [keyword#2 inserts
here]--as well as use of single identifiers and/or unified naming conventions for data including
legal entities, counterparties, customers and accounts." The first keyword, [keyword #1], refers
to the categorization or classifications of data; for example, market risk and credit risk are
categories of risk. The second keyword, [keyword #2], refers to information about the data."53
Which terms correctly replace, respectively, [keyword #1] and [keyword #2]?
a) Aggregation and principles
b) Capabilities and architecture
c) Taxonomies and metadata
d) Timeliness and accuracy
Answer: C. Taxonomies and metadata
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-511-principles-

for-risk-data-aggregation-governance.8294/
53
“Principles for Sound Stress Testing Practices and Supervision” (Basel Committee on Banking Supervision
Publication, May 2009)
145
Question 86: Hypothesis testing

Peter Parker at Betalab Bank emailed a survey to the bank's customers. The survey included a
question that asked them to rank their customer satisfaction on a scale from one to 10. She
received 51 responses, and she considers that a random sample (n = 51). Among this sample,
the average satisfaction score (on a scale of one to 10) is 8.50 with a sample standard deviation
of 1.90. Betalab's CEO is Mary-Jane, FRM, and she hopes that the bank's average customer
satisfaction is at least 9.0. Mary-Jane holds the FRM designation, so she understands that
acceptance of the null is more accurately a failure to reject the null, but she is a practical
person. Her null hypothesis is that the population's average customer satisfaction is at least 9.0
(i.e., H0: μ ≥ 9.0 and H1: μ < 9.0). Peter shares his sample findings with five of his colleagues,
and each colleague gives different input, as follows:
I. Albert says the test statistic is (8.5 - 9.0) ÷ [1.90 / SQRT(51)] = -1.88, or |-1.88| =
1.88
II. Betty says that if the sample size were doubled, ceteris paribus (i.e., same sample
mean and sample standard deviation), the test statistic will increase about +41%
III. Chris says that (for n = 51) Mary should use a one-sided test, and with one-sided
95.0% confidence (aka, 5.0% significance) she should reject the null
IV. Derek says that (for n = 51) Mary can accept (aka, fail to reject) the CEO's null
hypothesis with 95.0% confidence but only if she artificially switches to a two-sided
hypothesis (i.e., H0: μ = 9.0 and H1: μ ≠ 9.0). Notice how this insincerely "games"
the test: the setup here calls for a one-sided test.
V. Erin agrees with Chris and says that Mary should use a one-sided test per the CEO's
one-sided hypothesis but notes that Peter can accept (aka, fail to reject) the null with
one-sided 99.0% confidence (aka, 1.0% significance)
Which of the five statements is (are) correct?
a) None of the statements are correct
b) Only I. and II. are correct
c) Only IV and V. are correct
d) All five of the statements are correct
Answer: D. All five of the statements are correct
 Albert is correct: the test statistic is (8.5 - 9.0) ÷ [1.90 / SQRT(51)] = -1.88, or |-1.88| =
1.88
 Betty is correct: if we double the sample from 51 to 102, the test statistic multiplies by
sqrt(2) = 141.4%, as it would become (8.5 - 9.0) ÷ [1.90 / SQRT(102)] = -2.658. In
general, multiplying the sample by X will multiply the test statistic by sqrt(X) because the
test statistic divides (÷) by the standard error which itself has a denominator of SQRT(n);
i.e., previous ÷1/SQRT(nX) is equivalent to ×SQRT(nX)
 Chris is correct: the CEO's test is one-sided and the one-sided critical-t at 95.0% =
T.INV(5.0%, 50) = -1.676, such that the null is rejected
 Derek is correct: the two-sided critical-t at 95.0% = T.INV.2T(5.0%, 50) = 2.009 such that
null is "accepted"
 Erin is correct: the one-sided critical-t at 99.0% = T.INV(1.0%, 50) = -2.403 such that the
null is "accepted"
- continued -
146
Notice that we don't really NEED the student's t lookup table, especially for the one-sided test.
As the sample size increases, the 95.0% and 99.0% critical-t values converge on the familiar
normal deviates, respectively, of 1.645 and 2.326. For a sample size of 50, we know the critical-
t values will be a little bit larger than these normal deviates (heavier tails but only slightly
heavier). In regard to a one-tailed 95.0% test, the test statistic of 1.88 isn't near enough to
1.645; it falls in the rejection region (p value of 3.30%). In regard to a one-tailed 99.0% test, the
test statistic of 1.88 must be below the critical-t which, in turn, must be slightly greater than
2.326; it falls in the acceptance region (again, p value of 3.30%).

hypothesis-testing.23405/
Question 87: Option combination strategies

As she analyzes a stock, Barbara contemplates a straddle because she wants to express her
view that there will be a big change in the stock price, either dramatically up or down, but she is
uncertain as to the direction. In this way, she wants an option combination strategy that is "long
volatility." However, the straddle is more expensive than she anticipated. Which of the following
will allow her to generally express her "long volatility" view (giving her the potential for a large, or
even uncapped, payoff in the event of a dramatic price move) but with a cost that is REDUCED
in comparison to the straddle?
a) Strip
b) Strap
c) Strangle
d) Reverse butterfly spread
Answer: C. TRUE: Strangle. The strangle is similar to the straddle but, as the call's strike
price is greater than the put's strike price, it has lower initial cost (although the price
needs to move further to generate a profit).
 In regard to false (A) and (B), these are generally more expensive as, in comparison to
the straddle, they require the purchase either an additional call (in the case of the strap
which consists of two calls plus one put) or an additional put (in the case of a strip which
consists of two puts plus one call).
 In regard to false (D), the butterfly spread is not a combination. A reverse butterfly
spread strategy is a "long volatility" trade, however, the gain is decidedly capped.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-728-option-

combination-strategies-hull-chapter-12.10724/
147
Question 88: Stress Testing and Risk Management Tools

Shown below is a bank's portfolio of wholesale exposures (this is Siddique and Hasan's Table
2.2):54
The bank needs to estimate the sensitivities of this portfolio's losses to changes in two macro
variables: gross domestic product (GDP) growth and unemployment. If the bank conducts a
stress test, each of the following is likely--or at least reasonable--to be included in the bank's
stress test assumptions EXCEPT which is the LEAST likely to be an assumption in the stress
test?
a) An abrupt increase in exposures (EAD); e.g., EADs increase by 30.0%
b) Transition to lower rating buckets; e.g., $500 million transitions to Rating 7
c) Stressed default probabilities (PDs); e.g., for Rating bucket 3 the PD spikes to 4.0%
d) Stressed loss given default (LGD); e.g., LGD increases by 10.0% for all rating buckets
Answer: A. An increase in EAD is the least likely; the other assumptions are included in
the illustrated stress test.
Siddique and Hasan: "Let us assume that the bank chooses to use a PD LGD approach.
Therefore, the bank needs to compute what the PD is in the stress scenario for each of the two
years. Additionally, the bank needs to model which of the exposures transition to a lower rating.
Finally, the bank needs to understand what new wholesale loans the bank will generate in the
two years and what rating buckets (and PD) the new loans will be in [Endnote: For the purposes
of this simplified example, we are aware that we are making very strong assumptions and
simplifications in this example and are ignoring many elements that banks take into account. For
example, banks can find that the underwriting of new loans can actually be stricter in a
recession, resulting in a lower PD for new business compared with the existing book.] Based on
historical experience, the bank establishes the following firstyear and second-year stressed
PDs. This may be based on the bank’s own historical experience or on industry data. The
exposures (EAD) are not expected to change. However, the LGD does change. Using the
experience of 2008, the bank finds that, according to Moody’s URD data, the LGD for senior
unsecured increases from 53% to 63%. The bank chooses to increase its LGD by 10% for all
rating buckets. Table 2.3 presents the balances and the stressed parameters for the bank’s
wholesale portfolio. We are assuming no new business and are not taking into account
migration between the two years."54
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-802-stress-

testing-and-other-risk-management-tools-siddique.13506/
54
2013)
148
Question 89: Credit Crisis of 2007

“Agency costs” is a term used to describe the costs in a situation where the interests of two
parties are not perfectly aligned. In the events leading up to the Global Financial Crisis (CFC;
aka, credit crisis), which of the following was a source of agency cost?
a) Home appraisers seeking loan-to-value ratios
b) Rating agencies paid by issuers
c) Annual (end-of-year) bonuses
d) All of the above
Answer: D. All of the above
Hull:55 "Economists use the term 'agency costs' to describe the situation where incentives are
such that the interests of two parties in a business relationship are not perfectly aligned. The
process by which mortgages were originated, securitized, and sold to investors was
unfortunately riddled with agency costs.
The incentive of the originators of mortgages was to make loans that would be acceptable to the
creators of the ABS and ABS CDO tranches. The incentive of the individuals who valued
houses on which the mortgages were written was to please the lender by providing as high a
valuation as possible so that the loan-to-value ratio was as low as possible. (Pleasing the lender
was likely to lead to more business from that lender.) The main concern of the creators of ABSs
and ABS CDOs was the profitability of the structures (i.e., the excess of the weighted average
inflows over the weighted average outflows). They wanted the volume of AAA-rated tranches
that they created to be as high as possible and found ways of using the published criteria of
rating agencies to achieve this. The rating agencies were paid by the issuers of the securities
they rated and about half their income came from structured products.
Another source of agency costs concerns financial institutions and their employees. Employee
compensation falls into three categories: regular salary, the end-of-year bonus, and stock or
stock options. Many employees at all levels of seniority in financial institutions, particularly
traders, receive much of their compensation in the form of end-of-year bonuses. This form of
compensation is focused on a short-term performance. If an employee generates huge profits
one year and is responsible for severe losses the next year, the employee will receive a big
bonus the first year and will not have to return it the following year. The employee might lose his
or her job as a result of the second-year losses, but even that is not a disaster. Financial
institutions seem to be surprisingly willing to recruit individuals with losses on their resumes.
Imagine you are an employee of a financial institution investing in ABS CDOs in 2006. Almost
certainly you would have recognized that there was a bubble in the U.S. housing market and
would expect that bubble to burst sooner or later. However, it is possible that you would decide
to continue with your ABS CDO investments. If the bubble did not burst until after December 31,
2006, you would still get a nice bonus at the end of 2006!"55
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-510-more-

factors-that-contributed-to-the-credit-crisis-of-2007-hull.8274/
55
John Hull, Risk Management and Financial Institutions, 3rd Edition (New York: John Wiley & Sons, 2012)
149
Question 90: BLUE estimators, Law of large numbers (LLN), and central limit
theorem (CLT)
Barbara just received a dataset. She runs the dataset through five different regression models,
where each regression model employs a different estimator for the slope. The properties of the
slope estimators include the following:
 Estimator A is biased but has the smallest variance (3.7)
 Estimator B is linear and biased but has a small variance (4.6)
 Estimator C is linear and unbiased but has a medium variance (9.5)
 Estimator D is nonlinear and biased but is consistent and has a large variance (11.8)
 Estimator E is nonlinear and unbiased but has the largest variance (14.1)
Which of these estimators is BLUE?
a) None of the estimators are BLUE
b) Estimators A and B are both BLUE, but none of the others are BLUE
c) Estimator C might be BLUE, but none of the others are BLUE
d) Estimators D and E might both be BLUE, but none of the others are BLUE
Answer: C. True: Estimator C might be BLUE, but none of the others are BLUE
Estimators have various properties including linear, unbiased, efficient, and consistent. The
Gauss-Markov theorem says that if we make the assumptions required of the classical linear
regression model (CLRM), then the estimators are the Best Linear Unbiased Estimators
(BLUE). To be blue, the estimator (by definition) must but linear and unbiased (for this reason,
nonlinear and/or biased estimators cannot be BLUE). Among the linear, unbiased estimators
whichever has the smallest variance is the "best" (aka, efficient). As there is an important and
somewhat inevitable trade-off between bias and variance, the "efficient" estimator is the
estimator with the smallest variance among the set of unbiased estimators. In this way, BEST
represents the "efficient [Best or smallest variance] Linear Unbiased Estimator."
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-12-blue-

estimators-law-of-large-numbers-lln-and-central-limit-theorem-clt.23382/
150
Question 91: Exchange option, volatility swap, and static option replication
Patricia wants to hedge her portfolio of exotic options. The portfolio consists mostly of barrier
options. She is comparing a classic delta-hedge to a static options replication; the static option
replication entails shorting a portfolio that replicates certain boundary conditions. Each of the
following is a good argument in favor of a static option replication, for the purpose of hedging
her portfolio, EXCEPT which is WEAKEST argument?
a) The delta of barrier options is discontinuous at the barrier and consequently difficult to
delta-hedge
b) The delta-hedged portfolio can still experience losses due to large moves in the
underlying asset price
c) Static options replication has a key advantage over delta-hedging in that it does not
require frequent rebalancing
d) Her underlying position is already options and static option replication is not designed to
hedge options, as it would add risk to hedge options with options
Answer: D. False. Static option replication is the use of options to hedge other options. In
regard to (A), (B), and (C), each is TRUE as an advantage of static option replication over
classic delta-hedging.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-732-exchange-

option-volatility-swap-and-static-option-replication-hull-ch-26-continued.10755/
151
Question 92: Key rate exposure technique in multi-factor hedging applications

Assume we follow Tuckman's56 illustration and estimate the key rate exposures (i.e., KR01s and
key rate durations) for a zero-coupon bond with 30 years to maturity; e.g., C-STRIP. The key
interest rate is a par yield. The analysis selects four key rates: 2-year, 5-year, 10-year, and 30-
year. Further, as Tuckman explains about the rule for rates between neighbors, "each of the
four shapes is called a key-rate shift. Each key rate affects par yields from the term of the
previous key rate (or zero) to the term of the next key rate (or the last term). For example, the
10-year key rate affects par yields of terms 5 to 30 years only. Furthermore, the impact of each
key rate is normalized to be one basis point at its own maturity and then assumed to decline
linearly, reaching zero at the terms of the adjacent key rates. For the two-year shift at terms of
less than 2 years and for the 30-year shift at terms greater than 30 years, however, the
assumed change is constant at one basis point."56
About this key rate exposure technique, each of the following statements is true EXCEPT which
is false?
a) It is possible for a 30-year zero coupon bond to have a non-zero key-rate with respect to
the 10-year shift
b) Due to the linear decline between neighbors, we need to double (i.e., multiply by 2) the
sum of the four KR01s to approximate the DV01 of the security
c) The shift in the 10-year par yield (as the key rate) implies a shift of greater than one
basis point in the 10-year spot rate and a negative shift in the 30-year spot rate
d) If the key-rate '01 with respect to the 5-year shift is -0.0035, KR01(5.0) = -0.0035, then
the security's price increases by $0.0035 per $100 face value amount for a positive one-
basis point shift in the five-year key rate
Answer: C. True: The Hedge Position is a portfolio that contains four bonds. See
Tuckman’s figure56
As explained by Tuckman, the Hedge Position

requires solving for the face amount (F2, F5,
F10, and F30) of each of the four hedging
securities in order to neutralize the residual
steepener represented by the key rate (KR01)
exposure.
Discuss here in the forum:

https://www.bionicturtle.com/forum/threads/p1-
t4-912-key-rate-exposure-technique-in-multi-
factor-hedging-applications-tuckman-ch-
5.22257/
56
152
Question 93: Mechanisms for transmitting risk governance

Each of the following is true about the re-empowered role of the Chief Risk Officer (CRO)
a) The CRO should report to line business management, but should be independent of
both the CEO and the board's risk committee
b) The CRO must evaluate all new financial products to verify that the expected return is
consistent with the risks undertaken
c) CROs should not just be after-the-fact risk managers but also risk strategists
d) The CRO they should play a significant role in determining the risks that the bank
assumes as well as helping to manage those risks.
Answer: A. False. To ensure there is a strategic focus on risk management at a high level, the
CRO in a bank or other financial institution should report to the chief executive officer (CEO)
and have a seat on the risk management committee of the board. In regard to (B), (C) and (D),
each is TRUE.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-505-
mechanisms-for-transmitting-risk-governance-crouhy-galai-mark.8225/
Question 94: Linear transformation of covariance and correlation

Over the previous six months, two assets generated the monthly returns displayed below under
columns X(i) and Y(i). The third and fourth columns display the squared difference-from-
average-returns that inform the univariate variance; the fifth column
shows the associated cross-product that informs their covariance.
Because this is a very small sample, we want to retrieve unbiased

sample moments. What are, respectively, the unbiased sample
variances of the two variables and their sample covariance?
a) The unbiased sample variances, σ^2(X) = 2.16 and σ^2(Y) =
2.50 and sample covariance σ(X,Y) = 3.67
b) The unbiased sample variances, σ^2(X) = 4.67 and σ^2(Y) =
6.25 and sample covariance σ(X,Y) = 3.67
c) The unbiased sample variances, σ^2(X) = 4.67 and σ^2(Y) = 6.25 and sample
d) The unbiased sample variances, σ^2(X) = 5.60 and σ^2(Y) = 7.50 and sample
Answer: D. True: The unbiased sample variances, σ^2(X) = 5.60 and σ^2(Y) = 7.50 and
sample covariance σ(X,Y) = 4.40.
The unbiased sample variance divides the sum of squared difference-from-average returns by
(n-1); in this case, σ^2(X) = 28.00 / (6 - 1) = 5.60 and σ^2(Y) = 37.50/ (6-1) = 7.50.
Similarly, the sample covariance is given by σ(X,Y) = 22.00 / (6 - 1) = 4.40.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-9-linear-

transformation-of-covariance-and-correlation.23352/
153

The price of a dividend-paying stock is $44.00 while the riskfree rate is 3.0%. Consider a
European call option and a European put option with identical strike prices, K = $40.00, and
identical times to expiration of nine months, T = 0.75 years. The call has a price of $8.95 and
the put has a price of $5.36. What is the present value of the dividends expected during the life
of the option?
a) Zero
b) $0.19
c) $1.30
d) $4.75
Answer: C. $1.30. Because c + D + K*exp(-r*T) = p + S(0), D = p + S(0) - c - K*exp(-rT) = $5.36
+ $44.00 - $8.95 - $40.00*exp(-0.030*0.75) = $1.300.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-726-more-

properties-of-stock-options-including-put-call-parity-hull.10705/
Question 96: External credit rating scales

Consider the following one-year rating transition (aka, migration) matrix illustrated below:
About this migration matrix, each of the followings

statements is true EXCEPT which is false?
a) Bonds rated either A, AA, or AAA will not default
within one year
b) Over a one-year period, the most likely outcome
for any rated bond is an unchanged rating
c) At the end of two years, a bond with an AAA-rating
will necessarily still be an investment-grade obligor
d) The probability that a bond with an AAA-rating will have the same rating at the end of
two years is greater than 0.940^2 = 88.360%
Answer: C. False: At the end of the first year, the AAA-rated bond can migrate to AA or A;
then in the second year, either an AA- or A-rated bond can migrate to BB or B which are
speculative (aka, non-investment grade). In regard to (A), (B) and (D), each is TRUE
 In regard to true (A), bonds rated either A, AA, or AAA will not default within one year
 In regard to true (B), each of the values in the diagonal is greater than 50.0% which is
typical.
 In regard to true (D), while it is true that the probability that a bond with an AAA-rating
does NOT migrate during two years (and therefore has the same AAA-rating at the end
of two years) is 88.360%, the bond can migrate to AA or A and then back to a AAA-
rating in the second year such that the probability the bond has a AAA rating at the end
of two years is GREATER THAN 0.940^2. Specifically, the probability of AAA > AA >
AAA equals 5.0% * 2.0% = 0.10% and the probability of AAA > A > AAA equals 1.0% *
0.90% = 0.0090% such that the probability the bond is AAA-rated at the end of two years
is given by 88.360% + 0.10% + 0.90% = 88.4690%.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-917-external-
credit-rating-scales-de-servigny-ch-2.22349/
154
Question 97: Types of risk

Crouhy writes that "understanding [the difference between expected loss and unexpected loss]
is the key to understanding modern risk management concepts such as economic capital
attribution and risk-adjusted pricing."57 Which of the following statements is TRUE about
unexpected loss (UL)?
a) Unexpected loss levels tend to be higher for a consumer credit card portfolio than a
corporate loan portfolio
b) In a credit portfolio, higher default correlation implies lower portfolio unexpected losses
c) Unexpected loss (UL) it typically priced into the products or services offered to
customers, while expected loss is the denominator of risk-adjusted return on capital
(RAROC)
d) Market risk value at risk (MVaR) can be expressed as either relative MVaR or absolute
MVaR but it is "relative MVaR" that matches (better captures) unexpected losses (UL)
Answer: D. Market risk value at risk (MVaR) can be expressed as either relative MVaR or
absolute MVaR but it is "relative MVaR" that matches (better captures) unexpected
losses (UL)
 In regard to (A), this is false: Crouhy distinguishes the lower unexpected loss of a
consumer credit card portfolio (due to lower default correlation, better diversification and
higher granularity) from the higher unexpected loss of a corporate loan portfolio (due to a
"lumpy" portfolio which is less diversified and exhibits higher correlation risk).
 In regard to (B), this is false: portfolio unexpected loss (UL) increases with correlation. If
correlation is less than a perfect 1.0, the portfolio UL is less than the sum of individual
ULs; as correlation tends toward 1.0, the portfolio UL increases and approaches the sum
of individual ULs.
 In regard to (C), this is false: expected loss (EL) is typically priced into products as an
ongoing "cost of doing business." Unexpected loss (UL) tends to refer to the
denominator of RAROC, which is economic capital.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t1-502-types-of-risk-
crouhy-galai-mark.8203/
57
Michel Crouhy, Dan Galai, and Robert Mark, The Essentials of Risk Management, 2nd Edition (New York:
McGraw-Hill, 2014)
155
Question 98: Probability matrix

A stock (X1) has three possible returns: -5%, 0, or +5%. The analyst rating (X2) can be negative
(denoted by X2= -1), neutral (X2 = 0), or positive (X2 = +1). The probability matrix is displayed
below (inside the square). Six joint probabilities are given, but three are missing; for example,
the joint probability of a negative analyst rating and a negative stock return, P(X1 = -5% ∩ X2 =
-1) = 14.0%.
The bottom row (outside the square) displays the unconditional (aka, marginal) probabilities for
the stock; for example, the unconditional Pr(X1 = -5%) = 20.0%. What is the unconditional (aka,
marginal) probability that the analyst rating is positive, Pr(X2 = +1)?
a) 28.0%
b) 39.0%
c) 46.0%
d) 60.9%
Answer: B. True: 39.0%. See below.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-20-8-probability-

matrix.23340/
156
Question 99: Arbitrage and the cost of carry model

The spot price of wheat is $5.00 per bushel while the risk-free rate is 3.0% per annum with
continuous compounding. The cost to store wheat is 12.00% per annum as a proportion of the
spot price. The traded (observed) price of a nine-month wheat futures contract, F(0, 0.75), is
$5.430. Among the following choices, which of the following scenarios is the most likely?
a) Arbitragers will immediately compel the futures contract price to increase by $0.165
b) Arbitragers will immediately compel the futures contract price to increase by $1.370
c) We can currently conduct a cash-and-carry arbitrage, borrowing to buy the asset at the
current spot price, for a future profit of about $0.316 per bushel
d) The market is concerned that a possible shortage (i.e., lack of supply) in wheat might
occur and this is reflected in a convenience yield of about 4.0% per annum as a
proportion of the spot price
Answer: D. The market is concerned that a possible shortage (i.e., lack of supply) in
wheat might occur and this is reflected in a convenience yield of about 4.0% per annum
as a proportion of the spot price.
According to Hull, a key difference between and investment commodity and a consumption
commodity is the convenience yield engendered by ownership of the consumption commodity.
According to Hull, "This argument [i.e., the two-sided no arbitrage argument] cannot be used for
a commodity that is a consumption asset rather than an investment asset. Individuals and
companies who own a consumption commodity usually plan to use it in some way. They are
reluctant to sell the commodity in the spot market and buy forward or futures contracts, because
forward and futures contracts cannot be used in a manufacturing process or consumed in some
other way. There is therefore nothing to stop equation (5.14) from holding, and all we can assert
for a consumption commodity is F(0) ≤ [S(0) + U]*exp(rT)."58 In the model, this is realized with
the convenience yield such that, F(0) = S(0)*exp[(r+u-y)*T], where (y) is the convenience yield
which "simply measures the extent to which the left-hand side is less than the right-hand side."
Further, says Hull: "For investment assets the convenience yield must be zero; otherwise, there
are arbitrage opportunities ... The convenience yield reflects the market’s expectations
concerning the future availability of the commodity. The greater the possibility that shortages will
occur, the higher the convenience yield. If users of the commodity have high inventories, there
is very little chance of shortages in the near future and the convenience yield tends to be low. If
inventories are low, shortages are more likely, and the convenience yield is usually higher."58
In regard to choice (A), this is actually a fine choice because $0.165 is the arbitrage profit if
there is no convenience yield. Specifically, if y = 0, then F(0) = $5.00*exp[(3.0% + 12%)*9/12] =
$5.595, which is about $0.165 higher than the observed $5.430. (if this were the case, the
arbitrage to exploit is a "reverse cash and carry" that shorts the expensive commodity and takes
a long position in the futures contract).
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t3-716-arbitrage-

and-the-cost-of-carry-model-hull-chapter-5.10601/
58
157
Question 100: Components of country risk

Peter works for an ESG fund that evaluates political risk. Among the components of political
risk, Peter's fund assigns the greatest weight to corruption. If corruption is the most important
criteria, into which of the following countries is Peter's firm MOST LIKELY to invest; i.e., which
is least corrupt?
a) Libya
b) Mexico
c) Venezuela
d) New Zealand
Answer: D. TRUE: New Zealand is consistently in the top ten (top three really)
Damodaran (2018): "b. Corruption and Side Costs: Investors and businesses have to make
decisions based upon rules or laws, which are then enforced by a bureaucracy. If those who
enforce the rules are capricious, inefficient, or corrupt in their judgments, there is a cost
imposed on all who operate under the system. Transparency International tracks perceptions of
corruption across the globe, using surveys of experts living and working in different countries,
and ranks countries from most to least corrupt. Based on the scores from these surveys,
Transparency International also provides a listing of the ten least and most corrupt countries in
the world [in table 1, with higher scores indicating less corruption for 2017. Ten Least Corrupt:
New Zealand (89), Denmark (88), Finland (85), Norway (85), Switzerland (85), Singapore (84),
Sweden (84), Canada (82), Luxembourg (82), Netherlands (82). Ten Most Corrupt: Somalia (9),
South Sudan (12), Syria (14), Afghanistan (15), Sudan (16), Yemen (16), North Korea (17),
Equatorial Guinea (17), Guinea Bissau (17), Libya (17).
In business terms, it can be argued that corruption is an implicit tax on income that does not
show up in conventional income statements as such. It reduces the profitability and returns on
investments for businesses in that country directly and for investors in these businesses
indirectly. Since the corruption tax is implicit, it is also likely to be more uncertain than an explicit
tax, especially if there are legal sanctions that can be faced as a consequence, and thus add to
total risk. Ng (2006) notes that increased corruption translates into higher borrowing costs for
companies and lower stock values."59
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t4-914-the-

components-of-country-risk-include-political-legal-and-economic-structure-damodaran.22292/
59
Aswath Damodaran, Country Risk: Determinants, Measures and Implications - The 2018 Edition” (July 23, 2018).
(Pages 1-49 only)
158

BT P1-Interactive-Full-Mock-2-v5

Uploaded by

Copyright:

Available Formats

BT P1-Interactive-Full-Mock-2-v5

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

BT P1-Interactive-Full-Mock-2-v5

Uploaded by

Copyright:

Available Formats

Licensed to Guru. Downloaded November 13, 2020.

By David Harper, CFA FRM CIPM

QUESTION 1: RISK TYPOLOGY .............................................................................................. 8

QUESTION 36: FLATTENING AND STEEPENING OF RATE CURVES .................................27

QUESTION 71: LONG AND SHORT HEDGES ........................................................................45

Candidate Answer Sheet: Mark an X under your answer of choice.

Question # Answer A Answer B Answer C Answer D

Question # Answer A Answer B Answer C Answer D

Question # Answer A Answer B Answer C Answer D

Question 1: Risk typology

a) To either avoid or transfer each risk

Question 2: Stationary Time Series

a) AR(1) = 1.7650 and MR(1) = 1.2100

Question 3: Lookback and Asian (exotic) options

Among the following choices, which lookback

a) Floating lookback call

Question 4: Credit loss distribution

In this situation, which of the following statements is TRUE?

Question 5: Primitive risk factors and tail risk

Question 6: Regression diagnostics

According to Cook's distance, is the

a) No, because its Cook's

Question 7: Option spread strategies

a) We cannot create a bull spread with these options

Question 8: Internal rating systems & external credit ratings

Question 9: Risk management building blocks

a) ERM encourages organizational silos to sharpen their self-identities

Question 10: Multiple regression

Which of the following descriptions of her portfolio is the most accurate?

Question 11: Properties of stock options

Question 12: Predicting sovereign default

Question 13: Risk appetite and hedging

Question 14: Stationary Time Series

a) ρ(1) and ρ(3) are insignificant

Question 15: Chooser and barrier (exotic) options

Question 16: Key rates versus partial-01s vs forward-buckets

About these hedges, which of the

a) Hedge #1 is exposed to the

Question 17: Risk management governance

a) The Basel III events (i.e., II to IV) are incorrectly summarized

Question 18: Linear regression models

Question 19: US Treasury bonds

What is the quoted futures price for the contract?

Question 20: Multi-factor interest rate risk models

a) It compels us to assume yield to maturity (YTM) as the interest rate

Question 21: Credit risk transfer mechanisms

Question 22: P-value and confidence intervals

a) The power of Mary's one-sided test is 99.22%

Question 23: Eurodollar futures contracts & duration-based

Question 24: Effective duration and convexity

What is the effective duration of,

a) 4.2 and 106.3 years

Question 25: Modern portfolio theory

Please note the returns are expected gross

a) Portfolio A is mispriced, or it cannot

Question 26: Coskewness and cokurtosis

What is the interquartile range (IQR) of this probability distribution?

Question 27: Gap, forward start & compound exotic options

a) If K1 = K2 = $100.00, then the gap option also has a price of $0.740