FRM Part 1│ Test ID – 0016│Topic- Book 1 │ Que – 55

Answer Sheet
1. Perceptions of counterparty credit risk drive the price of lots of asset classes: LIBOR, credit
default swap (CDS), credit insurance, and so on. Which of the following describes how a change in
counterparty credit risk can create a “loss loop” and a spillover systemic risk?

A. As counterparty default credit risk increases, the increase in CDS prices triggers additional
margin calls and could force banks to obtain funding to meet those calls.
B. An increase in counterparty credit risk decreases CDS prices in general and shadow banks
that have large holdings of a declining asset will need to raise funding to meet those margin calls.
C. An increase in counterparty risk reduces the trust between banks that any institution could
survive without a bailout. As the Fed intervenes in the market with liquidity injections, reduced
collateral standards, and lower discount window rates, all of these create huge demand for the
excess liquidity and create a loss loop where institutional trust deteriorates even further.
D. The duration mismatch in modern banking is built on trusting that short-term funding could be
obtained to pay for the balance sheet of long-term assets. A decrease in counterparty risk will
reduce the cost of short-term funding and balance sheet financing costs.
A - Increases in counterparty credit risk increase, not decrease, counterparty credit risks.

2. The size of the financial crisis relative to the subprime mortgage market meant there were
triggers of the crisis but also vulnerabilities and amplifiers that led to a much wider crisis. Which of
the following is correctly paired with its proper description as a trigger or a vulnerability (amplifier)
of the crisis?

A. The growth of shadow banking and the use of securitized products to provide liquidity to the
market were triggers of the financial crisis.
B. The decline of housing prices was a trigger of the crisis.
C. The use of short-term debt such as repo agreements to fund balance sheet assets was a
trigger of the crisis.
D. The growth in the use of securitized products by investors and the losses on those
investments were triggers of the crisis.
B- Once housing prices started to decline and the prospect of further losses on subprime mortgages
increased, the crisis was triggered, and the growth of shadow banking was an amplifier for the crisis.

3. As the financial crisis spread beyond just asset prices, the Main Street economy was obviously
hit very hard and arguably still has not recovered. Which of the following was not an impact on the
real economy?

A. As confidence in the banking and financial sector fell, institutions began hoarding cash,
limiting the cash available to Main Street normally expected to finance continuing
operations, abruptly forcing many small businesses and even larger companies into layoffs.
B. Almost all firms cut back on dividend payments and expenditures and cut
contractors' expenses by statistically significant amounts.
C. As the credit crisis deepened, firms sought to roll over existing repo transactions or rely on the
short-term commercial paper market instead of maxing out credit lines just in case they needed
them.
 D. Despite the obvious need for cash, there was an overall decrease in the demand for consumer
loans.
C - As the credit crisis deepened, firms sought to roll over existing repo transactions or rely on the short-
term commercial paper market instead of maxing out credit lines just in case they needed them.

4. In the event of large losses by a firm, the first culprit to blame is the risk management function.
In what circumstances can large losses actually be a failure of risk management?

A. The risks were properly calculated but the risks should not have been taken.
B. Traders made assumptions about correlation that weren't captured by an overly simplistic
VaR model.
C. The firm chose to meet a trading target and exceeded a VaR limit.
D. VaR calculations made assumptions about correlations that were overly simplistic.
D - The issue here is that risk managers don't manage risk. Traders manage risk. Risk management
should really be called “risk measurement.” A large loss is a failure of risk management only if it
was a failure of risk measurement. The first, second, and third answer choices are all decisions the
firm or traders make and only the last choice is a failure of risk measurement that could lead to a
large financial loss.

5. If a failure of risk management is really a failure of risk measurement, then which of the following
is least likely to be an example of a risk management failure?

A. Using the wrong distribution of returns

B. Using the wrong correlation assumption among positions
C. A risk that is known but is ignored
D. Using risk-adjusted returns
D - This is fairly straightforward and the point here again is just to understand that risk managers
don't manage risk—they measure it. Traders manage risk and so a risk management failure is a failure
in measurement. Large losses due to ignored losses or losses that were known but chosen to ignore
are also risk management failures.

6. Under the assumption that risk managers don't manage risks—traders do—which of the
following is not a type of a risk management failure?

A. Mismeasurement of known risks

B. Failure to communicate known risks to top management
C. Failure in the implementation of risk limits
D. Failure to use the right risk metrics
C - The six types of risk management failures you should know are:

1. Mismeasurement of known risks

2. Failure to take risks into account
3. Failure in communicating the risks to top management
 4. Failure in monitoring risks
5. Failure in managing risks
6. Failure to use appropriate risk metrics

So notice that all of these are failures of measurement or communication. Only in the third answer
choice do we have a failure caused by an action, violating a risk limit that could lead to a failure.
Risk measurement is ultimately a very passive function within a bank; there typically is limited
enforcement capacity within risk management to force a trader out of a position. Always put yourself
in the mind-set that risk management is really risk measurement or risk communication, and you will
get these questions right.

7. Consider the following statements:

Statement 1: The risk-return characteristics of portfolios that combine the risk-free asset with a risky
asset or a portfolio of risky assets lie along a straight line.

Statement 2: All other things remaining the same, the greater the slope of the capital allocation
line, the better the risk-return characteristics of portfolios that lie on it.

Which of the following is most likely?

A. Only Statement 1 is correct.

B. Only Statement 2 is correct.
C. Both statements are correct.
D. Neither statement is correct.

C - The risk-return characteristics of portfolios that combine the risk-free asset with a risky asset or
a portfolio of risky assets lie along a straight line as the correlation between the risk-free asset and
any risky asset equals zero. All capital allocation lines have a constant gradient or slope.
Portfolios on capital allocation lines with a steeper positive slope dominate all portfolios that lie
on CALs with a lower slope (that lie below it).

8. Jane Boyd is an FRM candidate and has just registered for the last class required to complete her MBA
program. The class relates to investments and is taught by Professor John Stratton. Stratton uses a unique
teaching methodology, wherein portions of each session are actually taught by the students. Specifically,
every week, a student will prepare a presentation relating to their chosen area of study.

The student will present to the class and will face questions from the professor and students upon
completion. Boyd has chosen to do her presentation on portfolio theory.

Upon completion of the presentation, the students asked Boyd the following question: Which of
the following statements regarding beta is correct?

A. Beta is a measure of the covariance between the asset return and the market return.
B. Beta is a measure of diversification.
C. Beta is a measure of systematic risk.
 D. Beta is a measure of unsystematic risk.
C - Beta is a measure of the systematic risk of a security relative to the market. Beta is calculated as:
Covariance between asset J and the market / Variance of the market return.

9. Darren Peters, FRM, has gathered information on all the monthly returns of actively managed
portfolios and passive indices. He is using multifactor models, of which he has examined many.
Darren determines the optimal number of factors using the R-squares for different models.

He selects a model that has a reasonable but small number of factors. He uses the difference in
monthly returns between the managed portfolios and the market index represented by the S&P 500,
represented as RTN, as the dependent variable. The independent variables are the S&P 500 return
less the 90-day T-bill rate represented as MKT, the monthly returns to a passive portfolio of high EPS
stocks less the returns of a passive portfolio of low EPS stocks represented by EPSS, and the monthly
returns to a passive portfolio of small cap stocks less the returns of a passive portfolio of large cap
stocks, represented by LCSC.

The following results were derived for the historical data:

RTN = –.0025 + .15MKT – .08EPSS – .07LCSC

Which of the following is not a reason to support the case for active portfolio management?

A. Failure of the CAPM beta to explain returns

B. Excess volatility in market prices
C. The existence of market anomalies
D. Efficient frontier theory
D - All are valid reasons to support the case for active portfolio management except for the
efficient frontier theory. The efficient frontier theory is the theory that all investors allocate their
money between the risk-free asset and the tangency efficient portfolio.

10. According to the efficient frontier theory, an asset is considered efficient if:

A. It has a higher rate of return than other assets in its portfolio class.
B. No other asset with equal payment characteristics offers a higher return, or no other asset
with an equal return offers more favorable payment characteristics.
C. No other asset with an equal expected return offers lower risk, or no other asset with equal risk
offers a higher expected return.
D. It has a higher risk-adjusted rate of return than other assets in its portfolio class.
C - No other asset with an equal expected return offers lower risk, or no other asset with equal
risk offers a higher expected return. Any risk averse investor should invest in an asset considered
to be efficient, since it offers better risk characteristics than inefficient assets.

11. ssume that security J has a beta of 1.3 and that the risk-free rate of return in the market is 6%.
Additionally, the equity risk premium is 8%. What is the expected return on security J?

A. 15.8%
 B. 16.4%
C. 8.6%
D. 14.8%
B - The expected return according to the CAPM is given by:
Expected return on asset J = Risk-free rate + (BetaJ)(Equity risk premium).
In our case, we have: 6% + (1.3)(8%) = 16.4%.

12. The slope of the SML in an economy is 8.9%. The risk-free rate prevailing in the economy is
4.9%. A security has a correlation coefficient of 0.23 with the market. The market's standard deviation is
15% while that of the security is 19%. The expected return on the portfolio equals _______.

A. 7.49%
B. 12.39%
C.13.66%
D.14.19%
A - The Security Market Line (SML) is a plot of the expected returns on securities against their betas. The
CAPM implies that the slope of the SML equals the market risk premium and the intercept equals the risk-
free rate. Hence, the data given in the problem implies that the market premium is 8.9%.
To calculate the expected return on the security using the CAPM, we must first find its beta. The
beta of the security equals the covariance between the security and the market divided by the market
variance. Also, the covariance equals the product of the correlation coefficient and the individual
standard deviations. Hence, the covariance between the security and the market equals 0.23 × 0.15 ×
0.19 = 0.0066. Therefore:
The beta of the security equals 0.0066 / 0.152 = 0.29.
The CAPM expected return on the security equals 4.9% + 0.29 × 8.9% = 7.49%.

13. Consider the following statements:

Statement 1: All the portfolios on the capital market line are perfectly positively correlated.

Statement 2: A risk-free asset has zero correlation with all other risky assets. Which of the following
is most likely?

A. Both statements are incorrect.

B. Both statements are correct.
C. Only one statement is correct.
B - Both statements are correct.

14. An analyst gathered the following information regarding three portfolios. Which portfolio is
most likely to plot below the Markowitz efficient frontier?

Portfolio Expected Return Standard Deviation

A. 8% 13%
B. 15% 16%
 Portfolio Expected Return Standard Deviation
C. 11% 20%
A. Row A
B. Row B
C. Row C
C - Portfolio C lies below the Markowitz efficient frontier because Portfolio B offers a higher
return at lower risk.

15. The dependent and independent variable in the capital allocation line equation are most likely:

Dependent Variable Independent Variable

A. Expected return Total risk
B. Total risk Market risk premium
C. Expected return Market risk premium
D. Market risk Expected return
A. Row A
B. Row B
C. Row C
D. Row D
A - The CAL has expected return on the y-axis and portfolio risk on the x-axis.

16. Jennifer invests 30% of her funds in the risk-free asset, 45% in the market portfolio, and the rest in
Beta Corp, a U.S. stock that has a beta of 0.9. Given that the risk-free rate and the expected return on
the market are 7% and 16% respectively, the portfolio's expected return is closest to:

A. 13.08%
B. 16.00%
C. 15.10%
D. 12.50%
A - Beta of the portfolio = w1R1 + w2 R2 + w3 R3
Beta of the portfolio = (0.3 × 0) + (0.45 × 1) + (0.25 × 0.9) =
0.675 Expected return of the portfolio = Rf + R (Rm – Rf)
Expected return of the portfolio = 0.07 + 0.675 (0.16 – 0.07) = 0.1308 or 13.08%

17. The correlation coefficient between the market and stock A is 0.33. The market has an
expected return of 12% and a coefficient of variation of 1.4. The security has a variance of 0.03. Its
beta with respect to the market equals ________.

A. 0.24
B. 0.34
 C. 0.19
D. 0.46
B - The coefficient of variation equals the standard deviation divided by the mean. This gives the
standard deviation of the return on the market equal to 1.4 × 12% = 16.8%. The standard deviation of
the security equals square root (0.03) = 17.32%. Now, the beta of the security equals the covariance
between the security and the market divided by the market variance. Also, the covariance equals the
product of the correlation coefficient and the individual standard deviations. Hence, the covariance
between the security and the market equals 0.33 × 0.1732 × 0.168 = 0.0096. Therefore, the beta of the
security equals 0.0096 / (0.16822) = 0.34.

18. Which of the following is most likely based on systematic risk?

A. Sharpe ratio
B. Treynor ratio

C. M2
D. Information ratio

B - The Sharpe ratio and M2 are based on total risk. The Treynor ratio is based on beta risk only
19. Which of the following portfolio performance measures equals the slope of the capital
allocation line?

A. Sharpe ratio
B. Jensen's alpha
C. Treynor ratio
D. Sortino Ratio
A - The slope of the CAL equals the difference between the asset/portfolio's return and the risk-free
rate divided by the standard deviation of the asset/portfolio.

20. You have the following information on a portfolio in your bank. You have no other

information. Risk-free rate = 1%

Portfolio return = 12%

Benchmark return = 7%

Standard deviation = 8 %

Tracking error = 2%

Which of the following is correct?

A. The information ratio is 0.67.

B. The information ratio is 1.60.
 C. The Sharpe ratio is 1.375.
D. The Sharpe ratio is 2.67.
C - The information ratio is calculated as: (12% – 7%) / 2% = 2.5. The Sharpe ratio is calculated as:
(12% – 1%) / 8% = 1.375.

21. Assume that you are concerned only with systematic risk. Which of the following would be
the best measure to use to rank order funds with different betas based on their risk-return
relationship with the market portfolio?

A. Treynor ratio
B. Sharpe ratio
C. Jensen's alpha
D. Sortino ratio
A - Systematic risk is the risk that can't be diversified away and the beta of our portfolio is:
βP = (ρPM * σP * σM) / σ2where ρPM is the correlation coefficient between the portfolio and
the market, σp is the risk of the portfolio, and σM is the risk of the market.
In either case, beta explains the volatility of the portfolio compared to the volatility of the market,
which captures only systematic risk.The Sharpe ratio is standardized by sigma, not beta, so the
Treynor ratio is the correct ratio to use in this case. The Treynor formula is Tρ = [E(Rρ) – Rf] / βρ,
which describes the difference between excess return over systematic risk—the beta—which is
what the question asks.

22. You are an analyst comparing manager performance. You expect the portfolio to return 12% and
expect a standard deviation (risk) of 18%. The beta of this portfolio you know to be 0.90. The
expected return of the market is 11% with a standard deviation of 14%. You expect the 2016 risk-free
rate to be 1%.

What is the Treynor measure?

A. 0.060
B. 0.122
C. 0.36
D. 0.090
B - = (12 –1) / .90 = .1222
The second answer is the correct answer to complete the formula of the Treynor measure: the
expected return of the portfolio minus the risk-free rate divided by the beta of the portfolio.

23. Which of the following most likely indicates the maximum fee an investor should pay a
portfolio manager?

A. Sharpe ratio
B. Jensen's alpha
C. Treynor ratio
D. Sortino ratio
B - Jensen's alpha equals the difference between the portfolio's actual return and the required
return (as predicted by the CAPM) based on the asset's systematic risk. An investor should not pay
the portfolio manager a fee greater than the portfolio's Jensen's alpha, as such a fee would take the
portfolio's net return lower than the risk of a passively managed portfolio.

24. A regression of ABC Stock's historical monthly returns against the return on the S&P 500 gives
an alpha of 0.003 and a beta of 0.95. Given that ABC Stock rises by 4% during a month in which the
market rose 2.25%, calculate the unexpected return on ABC Stock.

A. 1.75%
B. 1.56%
C. 2.44%
D. 1.88%
B - ABC Stock's expected return for the month = 0.003 + 0.95 × 0.0225 = 0.0244 or 2.44%
ABC's company-specific return (abnormal return) = 0.04 – 0.0244 = 0.0156 or 1.56%

25. An analyst gathered the following

information: Risk-free rate: 5%

Market risk premium: 6%

Beta: 0.8

The required rate of return for the stock is closest to:

A. 6%
B. 5.8%
C. 3.5%
D. 9.8%
D - Required rate of return = 5% + 0.8 (6%) = 9.8%
26. Which of the following statements is true of the arbitrage pricing theory (APT)?

A. There may be numerous factors influencing the return on an asset.

B. Covariance with the market is the only relevant factor influencing the return on an asset.
C. Standard deviation and inflation are the two factors influencing the return on an asset.
D. There are only three factors influencing the return on an asset.
A - Unlike the CAPM (which assumes that the only relevant factor influencing the return on an asset
is its covariance with the market), the APT model allows for numerous factors to influence the
return on all assets, including, for example, inflation, GDP, and changes in the interest rate.
27. The important factor to consider when adding an asset to a diversified portfolio is:
 A. The standard deviation of the asset
B. The range of returns of the asset
C. The risk of the asset
D. The covariance of the asset returns with the other asset returns in the portfolio
D - The covariance of the asset returns with the other asset returns in the portfolio.
The standard deviation and the covariances with other assets of a new asset affect the standard
deviation of the portfolio. When that portfolio already consists of a large, diversified number of
assets, the effect of an additional asset is felt primarily through its covariance with the other assets
in the portfolio.

28. Which of the following is not an example of a multifactor model?

A. Statistical factor models

B. Macroeconomic factor models
C. Fundamental factor models
D. Systematic factor models
D - There are three types of multifactor models. These are fundamental factor
models, macroeconomic factor models, and statistical factor models.
29. Which of the following statements is most accurate?

A. A security whose required rate of return is greater than the expected rate of return
is considered overvalued and plots above the security market line.
B. If the stock's alpha is positive, it is considered undervalued and plots above the
security market line. A security whose estimated rate of return is greater than the required
rate of return is considered overvalued and plots below the security market line.
B - A security whose required rate of return is greater than the expected rate of return is
considered overvalued and plots below the security market line.
A security whose expected rate of return is greater than the required rate of return is
considered undervalued and plots above the security market line.

30. John Quentin is a graduate student in mathematics currently applying for a job as a quantitative
portfolio analyst with CMB Partnership. However, while Quentin is well versed in mathematics, his
knowledge of portfolio theory is cursory. He would like to learn more about mean-variance
analysis and general portfolio theory concepts before he interviews with CMB's managing director.

Which of the following is the primary determinant of portfolio standard deviation?

A. The expected return of the individual assets

B. The standard deviation of the individual assets
C. The number of securities in the portfolio
D. The average covariance between the assets
D - The average covariance between the assets in a portfolio is the primary determinant of portfolio
standard deviation. As the number of securities in the portfolio increases, and the portfolio becomes
more diversified, the relative importance of the average covariance between assets increases.

31. Which of the following is most likely?

A. The lower the diversification ratio, the greater the risk reduction benefits of diversification
and the greater the portfolio effect.
B. The higher the diversification ratio, the greater the risk reduction benefits of
diversification and the greater the portfolio effect.
C. The lower the diversification ratio, the lower the risk reduction benefits of diversification
and the greater the portfolio effect.
D. The lower the diversification ratio, the higher the risk reduction benefits of diversification
and the lower the portfolio effect.
A - The diversification ratio is the ratio of the standard deviation of an equal-weighted portfolio to the
standard deviation of a randomly selected component of the portfolio. The lower the diversification
ratio, the greater the risk reduction benefits of diversification and the greater the portfolio effect.

32. An analyst gathered the following information regarding two stocks:

Stock A Stock B
Beta 0.7 1.1
Current market price $20 $35
Expected dividend $1 $1
Expected price at year end $23 $37

Assuming a risk-free rate of 5% and the expected market return of 12%, which of the
following statements is most accurate?

A. Stock A is overpriced and therefore the analyst should sell it.

B. Stock B is underpriced and therefore the analyst should buy it.
C. Stock A is underpriced and therefore the analyst should buy it.
C - Required return of Stock A = 5% + 0.7 (12% − 5%) = 9.9%
Expected return of Stock A = (23 – 20 + 1) / 20 = 20%
Since the expected return of Stock A is greater than its required return, it is underpriced and
therefore the analyst should buy it.
Required return of Stock B = 5% + 1.1 (12% − 5%) = 12.7%
Expected return of Stock B = (37 – 35 + 1) / 35 = 8.57%
Since the expected return of Stock B is less than its required return, it is overpriced and therefore
the analyst should sell it.

33. Susan has a portfolio whose standard deviation is estimated to be 11.68%. She is thinking of
adding another asset to her portfolio whose standard deviation of returns is the same as her existing
portfolio, but has a correlation coefficient with the existing portfolio of 0.65. If she adds the new
asset to her portfolio, the standard deviation of the new portfolio will be:

A. Equal to 11.68%
 B. Less than 11.68%
C. More than 12.68%
D. Between 11.68% and 12.68%
B - Whenever the correlation coefficient is less than +1, diversification benefits occur and reduce
the overall standard deviation of the portfolio.

34. Which of the following approaches to risk is most likely to be consistent with taking a
portfolio perspective?

A. Measuring risk based on the relative total risk of securities.

B. Measuring risk based on relative total risk multiplied by the correlation of a security with
other assets.
C. Measuring risk based on relative total value at risk of securities.
D. Measuring risk based on relative variance to a peer group of securities.
B - Taking a portfolio perspective considers the risk of an asset versus the risk of other assets at the
portfolio level, rather than risk in isolation. By considering the correlation of a security versus other
assets the investor will be focusing correctly on the risk impact on the total portfolio rather than the
stand alone risk of individual assets. The first and second choices consider the risk of a security in
isolation hence do not take a portfolio approach.
35. What remains in a market portfolio that cannot be diversified away?

A. Security market line

B. Unsystematic risk
C. A noncomplete diversified portfolio
D. Systematic risk
D - A market portfolio includes all risky assets such as non-U.S. securities, real estate, coins, stamps,
and so forth. Since the portfolio contains all risky assets, the risk unique to individual assets, called
unsystematic risk, is diversified away. But the variability in all the risky assets caused by
macroeconomic variables, called systematic risk, remains in the market portfolio.

36. A two-factor APT model and three assets that are consistent with this model are given below:

E(R) = 5% + 7% × S1 – 9% × S2

What is the expected return of a portfolio composed of these assets that has a sensitivity of 1.25
to factor 1 and 2.45 to factor 2?

A. 8.21%
B. –8.3%
C -7.45%
D 1.45%
B - The expected return of the portfolio can be determined simply from the given APT
equation. E(R) = 5% + 7% (1.25) – 9%(2.45) = –8.3%
37. Which of the following is an assumption of the arbitrage pricing theory (APT)?

A. Perfectly competitive capital markets

B. A market portfolio that contains all risky assets and is mean-variance efficient
C. Normally distributed security returns
D. Quadratic utility function
A-

Expected Return Standard Deviation Beta

Small Caps 17% 15% 1.32
S&P 500 11% 9%
Bonds 7% 6%
International Stocks 19%
T-bills 4%
One of the major assumptions of the APT is perfectly competitive capital markets. The other
answer choices are assumptions made by the CAPM, but not by the APT model. The APT model
makes considerably fewer assumptions than the CAPM, and is superior to it in this way.
The correlation between the small cap stocks and bonds is .30, and the composition of the
tangential portfolio (T) is 55% small cap and 45% bonds.

38. The arbitrage pricing theory assumes:

A. That capital markets are perfectly competitive, that investors always prefer more
wealth to less wealth with certainty, and the utility function is quadratic in nature. It does
not assume that the stochastic process generating asset returns can be represented as a K
factor model, or that security returns are normally distributed.
B. That capital markets are perfectly competitive, security returns are normally
distributed, and that the stochastic process generating asset returns can be represented as a
K factor model. It does not assume that the utility function is quadratic in nature, or that
there is a market portfolio that contains all risky assets and is mean-variance efficient.
C. That capital markets are perfectly competitive, that investors always prefer more
wealth to less wealth with certainty, and that there is a market portfolio that contains all
risky assets and is mean-variance efficient. It does not assume that the stochastic process
generating asset returns can be represented as a K factor model, or that security returns are
normally distributed.
D. That capital markets are perfectly competitive, investors always prefer more wealth to
less wealth with certainty, and that the stochastic process generating asset returns can be
represented as a K factor model. It does not assume that the utility function is quadratic in
nature, or that there is a market portfolio that contains all risky assets and is mean-
variance efficient.
A - The arbitrage pricing theory (APT), developed by Ross in the early 1970s, makes the three
assumptions that are offered in the answer. In contrast to the CAPM, it does not assume
quadratic utility functions, normally distributed security returns, or a market portfolio that
contains all risky assets and is mean-variance efficient.
39. Which of the following is not one of the principles outlined by the Basel Committee for
data aggregation and reporting?

A. Enterprise governance and infrastructure

B. Risk data aggregation capabilities
C. Risk reporting practices
D. Regulatory reporting
D - I've said before that the questions from the Basel Committee and the Bank of International
Settlements are very bland and, I think, low priority. In this case, regulatory reporting is not one of
the principles because this type of reporting is not focused on meeting regulatory requirements. This
type of data and reporting is for internal data and supervisory review.

40. Which of the following is least likely a benefit of an effective data aggregation strategy?

A. Operational efficiency
B. Reduced probability of losses
C. Enhanced strategic decision making
D. Reduced legal risks
D - Data aggregation is aimed at the management of financial risk and financial data. Legal risk
falls outside of that scope.

41. Which of the following is not a responsibility of each GARP member with respect to
professional integrity and ethical conduct?

A. GARP members shall act with integrity in all dealings.

B. GARP members shall accept no gifts greater than $500.
C. Members shall be mindful of cultural differences regarding ethical behavior.
D. Members shall exercise reasonable judgment.
B - Unlike the CFA exam, there are few opportunities for “gotcha” questions. The code of conduct is
only five pages, so make sure you read it. For this question, there is no dollar limit on gifts other than a
consideration that could be reasonably expected to compromise their independence or objective.

42. Which of the following is least likely to be a consequence of a GARP member violating the
GARP code of conduct?

A. Reporting of the member to the regulatory authority of that member's country.

B. Suspension of the member for five years.
C. Suspension of the member permanently.
D. Removal of the right to use the FRM designation.
A - What you should know here is that GARP has no regulatory authority and can really only
remove the designation from a member. The second answer is true because GARP can decide to
suspend a member while an investigation is underway, suspend a member for a defined number of
years, or permanently ban the member.

43. Within the context of enterprise risk management (ERM), what is the difference between a top-
down and bottom-up approach and why are both necessary within ERM?

A. In a bottom-up approach, risk limits are set at the business unit level and summed up
to the top. For economic capital this is advantageous since it calculates the potential
diversification among each of the business lines.
B. In a top-down approach the risk limits are set at the senior level and distributed down but
do not calculate the potential impact of diversification across each business line.
C. Both are necessary because of the need to make sure risk limits, when aggregated
across businesses, are consistent with the objectives of senior management.
D. In both the bottom-up and top-down approaches, the risk allocation is the
same regardless of where the analysis begins.
C - The first and second answers are both the opposite of the impact with respect to
correlation of risks across business lines. What GARP wants you to know is that when
risk is allocated starting at the bottom, there is no visibility to the potential diversification
impact so that potential information is lost. Only by performing both top down and bottom
up can there be any differences in total risk noticed, and the difference would be the
potential reduction in risk, not an increase in risk because of the subadditivity property of
VaR.

44. Which of the following is correctly paired with the way the product type served as a trigger or
an amplifier of the financial crisis?

A. Short-term commercial paper triggered a “run on the bank” type mentality as money market
funds “broke the buck.”
B. Short-term debt backed by longer-dated assets was a trigger of the crisis as the value of those
longer-dated assets was pushed lower in price as institutional investors had to meet margin calls.

C. Repo agreements are generally considered the most secure form of short-term borrowing
because these agreements are collateralized. As perceived credit risk traded higher, banks
not renewing these short-term obligations amplified the financial crisis.
D. The losses on securitized lending as home prices fell amplified the crisis because of the
widening credit spreads and higher prices on CDS contracts that might offer any protection.
C - Repo agreements are generally considered the most secure form of short-term borrowing
because these agreements are collateralized. As perceived credit risk traded higher, banks not
renewing these short-term obligations amplified the financial crisis.

45. Which of the following was not a consequence of the failure of Lehman Brothers?

A. A run on credit markets sparked a worsening credit crisis that forced banks to
decrease haircuts on repo transactions.
 B. Money market funds “broke the buck.”
C. The U.S. Congress eventually intervened by passing the Troubled Asset Relief Program
(TARP).
D. Credit spreads widened dramatically, even on some of the safest credit-based products.
A - Obviously, Lehman was a huge event and the first answer choice requires you to remember that
a repo haircut is the percentage deducted from the value of the asset used as collateral for the loan. If
haircuts are decreasing, it means banks are lending more money on the same collateral, implying an
improving credit environment—which clearly wasn't the case, as Lehman was collapsing. All the
other answer choices were consequences of the financial crisis.

46. The financial crisis was a worldwide event and several governments around the world acted both
unilaterally and collectively to manage the crisis in their countries. Which of the following actions is
correctly paired with a policy response by a country, what does that response actually mean, and
what short-term impact could it have?

A. Interest rate change—This government policy shift has a broad range of impacts from
lowering the cost of credit, reducing the interest cost of using other tools available at the Federal
Reserve. Typically the short-term impact here is limited because it takes time for the policy shift
to spread through the market.
B. Asset purchases—This central bank policy action can have an almost-immediate short-term
impact because it can lift impaired assets off a bank's balance sheet, increasing confidence in that
bank's counterparties and reducing a potential run on the bank.
C. Liquidity support—This government stabilization policy move can also have a near-immediate
impact as governments offer longer funding terms, higher credit lines, or lower reserve
requirements, all of which free up liquidity to support impaired asset prices on the balance sheet.
D. Recapitalization—This government policy choice can consist of a capital injection directly to
an institution via common stock or preferred equity and can have an immediate impact on an
institution's credit quality and significantly reduce the potential for a run on the bank.
D - Liquidity support is a central bank policy tool, so that is incorrectly matched with a
government policy description. All of the rest is true.

47. The financial crisis was not a linear event, meaning that shocks occurred and prices jumped by
what financial engineers call a jump diffusion process. There were two distinct periods of nonlinear
events for the most recent crisis. Which of the following timeframes is correctly paired with the stat of
the markets during that time period? (The two periods are August 2007 and September–October 2008;
each date is accurate, but the focus on the crisis may not be.)

A. August 2007—This period of the crisis had no sponsor-backed rescues of money market funds
but also increased the market's expectation that the money market sponsor (issuer or money
market mutual fund) would always rescue money market funds.
B. September–October 2008—This period of crisis amplified by the money market fund's
sponsors' reluctance to rescue money market funds was noted for some funds actually “breaking
the buck.”
C. During the period of August 2007, there was no clear pattern of runs on asset-
backed commercial paper in the market emerging yet. This occurred later in 2008.
 D. The large money market fund that broke the buck in August of 2007, the Reserve Primary
Fund, was part of the reason Lehman fell in 2008 because so much of Lehman's balance sheet
was funded by asset-backed commercial paper.
B - It is false that some sponsors bailed out or injected capital into their money market funds to
prevent them from breaking the buck, but it is true that this also changed the market's perception
that this would always be the sponsors' behavior. Be careful on the exam of questions that make
dual statements where one is true and one is false.

48. Jessica is considering investing in two assets, A and B, with betas 2.1 and 1.6 respectively. Her
broker tells her that the return on the market portfolio is 14% and that the risk-free rate is 6%. Given
that the expected return on both the assets is 20%, she should most likely invest in:

A. Asset B only
B. Asset A only
C. None of the assets
A - Required return on Asset A = 0.06 + [2.1 × (0.14 – 0.06)] = 22.8%
The required return on Asset A (22.8%) is more than the expected return (20%). Therefore, Jessica
should not invest in it.
Required return on Asset B = 0.06 + [1.6 × (0.14 – 0.06)] = 18.8%
The required return on Asset B (18.8%) is less than the expected return (20%). Therefore,
Jessica should invest in it.

49. What is the correlation between the small-cap and the stock market?

Expected Return Standard Deviation Beta

Small Caps 17% 15% 1.32
S&P 500 11% 9%
Bonds 7% 6%
International Stocks 19%
T-bills 4%
A. 0.7863
B. 0.7546
C. 0.7920
D. 0.7234
C - Correlation = beta × standard deviation of market/standard deviation of small caps = 1.32 ×
9%/15% = .7920

50. A security is fairly priced under CAPM and you have estimated its expected return to be 12.6%.
If you can invest in a risk-free asset at 5.3% and the beta of your security is 0.79, the risk premium
demanded by the investors to invest in the market portfolio is ________.

A. 8.98%
B. 9.24%
C. 12.83%
 D. 14.54%
B- The CAPM expected return relationship is:
R = Rf + β × (Rm – Rf).
Since β = 0.79, the market risk premium equals:
(Rm – Rf) = (R – Rf) / β = (12.6 – 5.3) / 0.79 = 9.24.

51. Which of the following assumptions are part of the CAPM?

A. There are no taxes or transaction costs.

B. Investors have heterogeneous expectations.
C. All of these answers are correct.
D. Investors can lend but not borrow, at the risk-free rate.
A - There are no taxes or transaction costs. The following are assumptions of the capital
market theory:

1. All investors are Markowitz-efficient investors.

2. Investors can borrow or lend any amount at the RFR.
3. All investors have homogeneous expectations.
4. All investors have the same one-period time horizon.
5. All investments are infinitely divisible.
6. There are no taxes or transaction costs involved in buying or selling assets.
7. There is no inflation or any change in interest rates.
8. Capital markets are in equilibrium.

52. Which of the following is not an assumption of the CAPM?

A. All investors have the same expectations regarding expected return, variances, and
covariances.
B. All assets are marketable and markets are perfectly competitive.
C. Investors' buy and sell decisions do not affect the prices prevailing in the market.
D. Investors are able to borrow at the market rate of return and lend at the risk-free rate of return.
D - Investors are able to borrow at the market rate of return and lend at the risk-free rate of return.

53. Dolly Drew, FRM, works for Delight Capital. Delight Capital would like to examine portfolio
concepts with regards to quantitative analysis.

Dolly has been asked by the senior partner in the firm to report on portfolio concepts for next
week's partners meeting. The senior partner has done some preliminary research on portfolio
concepts and has provided Dolly with a question that she would like answered.

Which of the following is the correct calculation of beta?

A. Beta = var(Ri, Rm) / var(Rm)

 B. Beta = cov(Ri, Rm) / var(Rm)
C. Beta = cov(Ri, Rm) / var(Ri)
D. Beta = var(Rm) / cov(Ri, Rm)
B - Beta = cov(Ri, Rm) / var(Rm)
cov(Ri, Rm) = covariance between the return on stock i and the market
var(Rm) = variance of the market

54. Suppose that the correlation of the return of a portfolio with the return of its benchmark is 0.92,
the volatility of the return of the portfolio is 14%, and the volatility of the return of the benchmark
is 8%. What is the beta of the portfolio?

A. 1.00
B. 1.61
C. 1.64
D. –1.35
B - The following equation is used to calculate beta:
βi=COVimσ2m=σiσm×ρimβi=COVimσm2=σiσm×ρim
where ρ represents the correlation coefficient and σ the volatility.

55. CAPM has many assumptions that are unrealistic in the real world. The arbitrage pricing
theorem builds on the CAPM to resolve some of the limitations. What is true of CAPM?

A. All investors universally prefer less risk assuming the same return.
B. Assumes capital gains tax affects all investors equally.
C. Works only for log-normally distributed asset prices, not returns.
D. Investors' expectation about future returns are very different.
A - All others are not assumptions of APT or CAPM.