Practice questions · Finance & Accounting
FRM (GARP): Practice Questions
Original concept-check questions for the FRM (GARP), spanning both parts: foundations, quantitative analysis, products and valuation, and the Part II risk types. Each answer is explained, including why the others are wrong. Filter by domain or difficulty. These are concept checks - not real exam questions.
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The main goal of enterprise risk management is to:
Correct answer: B. ERM aligns risk-taking with the firm's appetite and objectives; it does not eliminate risk or chase short-term profit. -
'Risk appetite' is best described as:
Correct answer: D. Risk appetite is the amount and type of risk a firm chooses to take to meet its objectives. The maximum loss in a crisis is closer to a stress-loss or worst-case figure, total assets is a balance-sheet size, and a regulatory capital figure is a minimum cushion required by rules - none of these is the firm's chosen risk-taking level. -
A key purpose of a risk governance framework is to:
Correct answer: C. Governance assigns accountability and oversight. It does not guarantee profit, remove capital needs or replace audit. -
Standard deviation of returns measures:
Correct answer: B. Standard deviation quantifies dispersion, a core risk measure. Central tendency is the mean; correlation relates two variables. -
The correlation coefficient between two variables always lies between:
Correct answer: D. Correlation is bounded by -1 (perfectly negative) and +1 (perfectly positive). '0 and 1 only' omits negative correlation, 'minus infinity and infinity' is the range for covariance not correlation, and '0 and 100' confuses it with a percentage scale. -
In a linear regression, R-squared indicates:
Correct answer: D. R-squared is the proportion of the dependent variable's variance explained by the model. The p-value tests statistical significance, the sample size is the number of observations, and the intercept is the fitted value when predictors are zero - all distinct from explained variance. -
A normal distribution is fully described by:
Correct answer: D. A normal distribution is fully specified by its mean and standard deviation. The median alone fixes only the centre, skewness is zero and kurtosis is three for any normal curve so they add no information, and the maximum and minimum are undefined since the normal extends infinitely. -
A futures contract differs from a forward in that a futures contract is:
Correct answer: C. Futures are standardised, exchange-traded and marked to market; forwards are customised and OTC. -
The buyer of a call option has the right to:
Correct answer: D. A call gives the right to buy at the strike. The right to sell is a put. -
A plain-vanilla interest-rate swap typically exchanges:
Correct answer: D. A vanilla swap exchanges fixed for floating interest. The other options describe FX, equity or credit-default swaps. -
When market interest rates rise, the price of an existing fixed-rate bond:
Correct answer: B. Bond prices move inversely to rates, so a rate rise lowers an existing fixed-rate bond's price. -
The 'delta' of an option measures its:
Correct answer: A. Delta is sensitivity to the underlying's price. Theta is time decay, vega is volatility sensitivity, rho is rate sensitivity. -
One-day 99% Value at Risk (VaR) is:
Correct answer: A. VaR is a threshold loss at a confidence level over a horizon, not the maximum possible loss. -
A limitation of VaR that expected shortfall addresses is that VaR:
Correct answer: B. VaR gives a threshold but not the tail's severity; expected shortfall averages losses beyond it. -
Duration measures a bond's:
Correct answer: B. Duration measures a bond's price sensitivity to interest-rate changes. Time to issue is when the bond was originally sold, the coupon rate is the periodic interest paid, and the credit rating reflects default risk - related bond attributes, but none of them is the rate-sensitivity measure. -
The historical-simulation method of computing VaR:
Correct answer: D. Historical simulation re-uses actual historical returns instead of assuming a distribution, unlike the parametric method. -
Backtesting a VaR model checks whether:
Correct answer: D. Backtesting compares realised breaches with the expected frequency to validate the model. -
Basis risk arises when:
Correct answer: C. Basis risk is the residual risk that hedge and exposure move differently. A perfect hedge has none. -
Stress testing complements VaR because it:
Correct answer: B. Stress tests probe tail scenarios that normal VaR may miss. They do not remove capital needs or guarantee outcomes. -
A long position in a fixed-rate bond is most exposed to:
Correct answer: B. Rising rates reduce a fixed-rate bond's price, the main market risk for a long holder. -
Expected loss on a loan is approximately:
Correct answer: D. Expected loss = probability of default x loss given default x exposure at default. -
'Loss given default' (LGD) is:
Correct answer: B. LGD is the unrecovered fraction of exposure on default. PD is the probability; EAD is the amount at risk. -
A credit-rating downgrade of a bond typically:
Correct answer: C. A downgrade signals higher credit risk, pushing yields up and prices down. -
Counterparty credit risk on a derivative is the risk that:
Correct answer: A. Counterparty risk is default by the trade's other side. The other options are market, not counterparty, risks. -
Operational risk is the risk of loss from:
Correct answer: D. That is the standard definition of operational risk. Price moves are market risk; default is credit risk. -
Which is an operational-risk event?
Correct answer: B. A processing error/outage is operational. The others are market or credit events. -
A key tool for managing operational risk is:
Correct answer: A. Operational risk is managed with internal controls, loss-event data collection and resilience planning. Shortening bond duration and raising interest rates address interest-rate (market) risk, and buying more equities adds market exposure rather than controlling process and system failures. -
Funding liquidity risk is the risk that a firm:
Correct answer: C. Funding liquidity risk is the risk a firm cannot meet its cash obligations as they fall due. A credit downgrade is a credit-rating event, 'too much capital' is not a risk, and losing money on equities is market risk - distinct from being unable to fund cash needs. -
Market liquidity risk refers to:
Correct answer: A. Market liquidity risk is about trading cost/feasibility, distinct from funding liquidity and other risks. -
Tracking error measures:
Correct answer: A. Tracking error is the volatility of a portfolio's active return versus its benchmark. -
The 'three lines' approach to risk governance places independent risk management and compliance in which role?
Correct answer: A. Risk management and compliance form the second line, providing oversight and challenge to the first line that owns risk. Internal audit is the third line that gives independent assurance, and the second line sits within the firm, not outside it. -
The Sharpe ratio measures:
Correct answer: C. The Sharpe ratio divides excess return over the risk-free rate by the standard deviation, measuring reward per unit of total risk. Total return alone ignores risk, return per unit of systematic risk is the Treynor ratio, and default probability is a credit measure. -
In the Capital Asset Pricing Model (CAPM), an asset's beta measures its:
Correct answer: B. Beta in the CAPM measures an asset's sensitivity to overall market movements, a proxy for systematic risk. Total volatility is standard deviation, dividend yield is income, and the credit rating reflects default risk. -
A 'moral hazard' arises when:
Correct answer: D. Moral hazard occurs when a party takes on more risk because it does not bear the full consequences, such as an insured acting carelessly. Identical information and perfect efficiency reduce such problems, and the issue is about incentives once protected, not the mere absence of insurance. -
The 2007-2009 global financial crisis highlighted the danger of:
Correct answer: A. A key lesson of the crisis was that excessive leverage and correlations that spiked in stress can amplify losses across the system. Holding government bonds, keeping ample capital, and diversifying broadly are generally risk-reducing, not the causes highlighted. -
Covariance between two asset returns measures:
Correct answer: C. Covariance captures how two returns move together, with the sign showing whether they tend to move in the same or opposite direction. It is not an average return, the risk-free rate, or a maximum loss. -
A Type I error in hypothesis testing is the error of:
Correct answer: B. A Type I error rejects a true null hypothesis (a false positive). Failing to reject a false null is a Type II error, correctly accepting a true alternative is not an error, and an arithmetic mistake is unrelated to hypothesis-test error types. -
A distribution with positive skewness has:
Correct answer: D. Positive skewness means a longer right tail, with more extreme high values. A symmetric shape has zero skew, a longer left tail is negative skew, and skewness does not imply the mean is undefined. -
Kurtosis describes the:
Correct answer: A. Kurtosis measures tail heaviness and peakedness; excess kurtosis above zero signals fatter tails than the normal. Central location is the mean, an average of two variables is unrelated, and the slope of a regression line is its coefficient. -
In a Monte Carlo simulation for risk, the analyst:
Correct answer: C. Monte Carlo simulation draws many random scenarios from assumed distributions to estimate the distribution of possible outcomes. A single fixed scenario is deterministic, ignoring probability defeats the purpose, and relying only on historical averages is a different method. -
A confidence interval for a parameter gives:
Correct answer: B. A confidence interval is a range likely to contain the true parameter at a stated confidence level. It does not give the exact value with certainty, is more than a single point estimate, and is unrelated to default probability. -
The price of a forward contract on a non-dividend-paying asset is most directly affected by the:
Correct answer: D. The forward price reflects the spot price compounded at the risk-free rate (the cost of carry) over the contract's life. The asset's appearance, the count of exchanges, and any marketing budget have no bearing on the forward price. -
The seller (writer) of a call option:
Correct answer: A. The call writer is obligated to sell the underlying at the strike if the buyer exercises, in exchange for the premium received. The right to buy belongs to the call buyer, the writer does not receive the underlying free, and the writer's profit is capped at the premium with potentially large losses. -
A long position in a put option profits when the underlying asset's price:
Correct answer: C. A long put gains value as the underlying falls below the strike, net of the premium paid. A sharp rise hurts the put holder, staying at the strike leaves it worthless at expiry, and no change provides no payoff. -
Contango in a futures market describes a situation where:
Correct answer: B. Contango is when futures prices exceed the current spot price, often reflecting carrying costs. Futures below spot is backwardation, and the term has nothing to do with the absence of a market or inability to deliver. -
A credit default swap (CDS) provides the buyer of protection with:
Correct answer: D. A CDS pays the protection buyer if the reference entity suffers a defined credit event, in exchange for periodic premiums. It does not confer ownership, a dividend, or voting rights in the reference entity. -
The notional principal of a plain-vanilla interest-rate swap is:
Correct answer: A. In a vanilla interest-rate swap the notional is used to compute the interest payments but is not itself exchanged. It is not swapped in full, not an exchange fee, and not an option premium. -
Convexity in a bond describes the:
Correct answer: C. Convexity captures the curvature of the price-yield relationship, improving the duration-based estimate of price changes for larger yield moves. The relationship is not linear, and convexity is unrelated to the credit rating or coupon dates. -
The parametric (variance-covariance) approach to VaR assumes that:
Correct answer: B. The parametric approach assumes returns follow a specified distribution (commonly normal) and uses its parameters to compute VaR. It does not treat past returns as irrelevant, assume zero volatility, or focus solely on the maximum loss. -
Expected shortfall (conditional VaR) is generally considered superior to VaR because it:
Correct answer: D. Expected shortfall averages the losses beyond the VaR threshold, capturing tail severity and being a coherent risk measure. It is generally larger than VaR, it does use a confidence level, and it still requires data. -
Modified duration estimates the percentage change in a bond's price for a:
Correct answer: A. Modified duration estimates the approximate percentage price change for a small change in yield. It is not tied to credit-rating notches, coupon dates, or the stock market. -
The 'volatility smile' refers to the observation that implied volatility:
Correct answer: C. The volatility smile is the pattern where implied volatility varies with strike, often rising for deep in- or out-of-the-money options, contradicting constant-volatility assumptions. It is not constant, not zero, and not equal to the risk-free rate. -
The exponentially weighted moving average (EWMA) model estimates volatility by:
Correct answer: B. EWMA places greater weight on more recent observations, so volatility responds faster to recent market moves. It does not weight all observations equally (that is a simple moving average), ignore recent data, or use only one return. -
Marking a trading position to market means:
Correct answer: D. Marking to market revalues a position at current market prices, reflecting gains and losses promptly. It is not original-cost accounting, not ignoring value, and not setting value to zero. -
Under the Basel framework, a bank's regulatory capital requirement is mainly intended to:
Correct answer: A. Regulatory capital under Basel is a buffer to absorb unexpected losses, protecting depositors and the financial system. It is not about maximizing dividends, does not remove the need for risk management, and aims to limit, not increase, excessive leverage. -
A risk-weighted asset (RWA) calculation adjusts asset values by:
Correct answer: C. RWA weights assets by their riskiness so that riskier exposures attract more required capital. Physical size, color, and headcount are irrelevant to the risk weighting. -
Wrong-way risk in counterparty credit exposure occurs when:
Correct answer: B. Wrong-way risk arises when exposure to a counterparty increases at the same time its creditworthiness deteriorates, compounding the loss. Falling exposure as credit improves, no exposure, or a risk-free counterparty are not wrong-way risk. -
A credit migration matrix shows the probabilities of:
Correct answer: D. A credit migration (transition) matrix gives the probabilities that a borrower moves between credit ratings over a horizon, including to default. It does not describe interest-rate moves, dividends, or option expiry. -
Netting agreements between two derivatives counterparties reduce credit exposure by:
Correct answer: A. Netting lets offsetting exposures between two counterparties be combined into a single net obligation, lowering credit exposure on default. It does not work by increasing trades, removing collateral, or eliminating market risk. -
Collateral (margin) posted against a derivatives position primarily reduces:
Correct answer: C. Posting collateral or margin reduces counterparty credit exposure by providing assets that can be used if the counterparty defaults. It does not change market volatility, the risk-free rate, or staffing. -
Key risk indicators (KRIs) are used in operational risk to:
Correct answer: B. KRIs are metrics that give early warning of increasing operational risk, such as rising error rates or system downtime. They do not guarantee zero losses, replace financial statements, or set interest rates. -
A loss distribution approach (LDA) to operational risk combines:
Correct answer: D. The LDA combines a frequency distribution (how often losses occur) with a severity distribution (how large they are) to model aggregate operational losses. It is not based on a single loss, equity returns, or market rates. -
Business continuity planning in operational risk focuses on:
Correct answer: A. Business continuity planning ensures critical operations can be maintained or restored quickly after a disruptive event. It is not about maximizing profit, removing finance, or adding market exposure. -
Cyber risk is increasingly treated as a category of:
Correct answer: C. Cyber risk, arising from failed systems, attacks and external events, is generally classed within operational risk. It is not market, interest-rate, or currency risk, which concern prices and rates. -
A liquidity coverage ratio (LCR) requirement is designed to ensure a bank holds enough high-quality liquid assets to:
Correct answer: B. The LCR requires enough high-quality liquid assets to cover projected net cash outflows over a 30-day stress scenario. It is not about funding dividends, buybacks, or eliminating credit risk. -
A maturity mismatch that contributes to funding liquidity risk occurs when a bank:
Correct answer: D. Funding long-term assets with short-term liabilities creates a maturity mismatch and rollover risk, a core source of funding liquidity risk. Holding only cash, having no liabilities, or perfectly matching maturities would reduce, not create, the mismatch. -
The bid-ask spread is a measure of:
Correct answer: A. The bid-ask spread reflects market liquidity, with wider spreads signalling higher transaction costs and lower liquidity. It is not a direct measure of credit risk, the risk-free rate, or a bond coupon. -
Information ratio measures a portfolio's:
Correct answer: C. The information ratio divides active return (over a benchmark) by tracking error, measuring consistency of active performance. It is not total return alone, default probability, or dividend yield. -
Alpha in portfolio performance refers to the return:
Correct answer: B. Alpha is the excess return above what is expected given the portfolio's risk or benchmark, attributed to skill. Return explained by the market is beta-driven, dividends alone are not alpha, and alpha is not the risk-free rate. -
Risk budgeting in portfolio management is the practice of:
Correct answer: D. Risk budgeting allocates the portfolio's total risk across positions, factors or strategies in line with objectives. It is not about maximizing cash spending, avoiding all risk, or setting a marketing budget. -
Liquidity-adjusted VaR adds to standard VaR an allowance for the:
Correct answer: A. Liquidity-adjusted VaR augments standard VaR with the cost of unwinding positions, which can be large in illiquid or stressed conditions. It is unrelated to dividend yield, the risk-free rate, or shareholder count. -
A 'fat tail' in a return distribution means that extreme outcomes are:
Correct answer: C. Fat tails mean extreme outcomes (large gains or losses) occur more often than a normal distribution predicts, a key concern in risk modeling. They are not less likely, not impossible, and not confined to positive outcomes. -
A coherent risk measure should satisfy properties including subadditivity, which means the risk of a combined portfolio is:
Correct answer: D. Subadditivity requires that the risk of a combined portfolio be no greater than the sum of the individual risks, reflecting diversification benefits. VaR can violate this, which is one reason expected shortfall is preferred. The other options misstate the property. -
The Basel Committee's main role is to:
Correct answer: A. The Basel Committee on Banking Supervision develops global prudential standards for banks, such as capital and liquidity rules. It does not set monetary policy, trade derivatives, or audit individual firms. -
Stress testing under regulatory frameworks requires firms to assess losses under:
Correct answer: C. Regulatory stress testing evaluates losses under severe but plausible adverse scenarios to gauge resilience. It is not limited to the most likely case, does require scenarios, and does not assume guaranteed profits. -
Incremental VaR measures the change in portfolio VaR from:
Correct answer: A. Incremental VaR is the change in total portfolio VaR caused by adding or removing a specific position, helping assess its risk contribution. It is not about closing the whole portfolio, a rate change alone, or dividends. -
A bank holding a portfolio of fixed-rate mortgages faces prepayment risk, which is the risk that borrowers:
Correct answer: C. Prepayment risk is that borrowers refinance and repay early when rates drop, returning principal that must be reinvested at lower yields. It is not about never repaying, certain default, or voluntary extra interest. -
Specific (idiosyncratic) risk in a portfolio can largely be reduced by:
Correct answer: A. Idiosyncratic risk is largely diversifiable by holding many uncorrelated assets, leaving mainly systematic risk. Concentration increases it, leverage magnifies risk, and ignoring the portfolio does not manage it. -
Model risk is the risk that:
Correct answer: C. Model risk is the risk of adverse consequences from errors in a model or its inappropriate use. A correctly used, perfect model is the absence of the risk, and the issue is not a lack of models or their cost. -
A risk-neutral valuation approach prices a derivative by:
Correct answer: A. Risk-neutral valuation computes expected payoffs using risk-neutral probabilities and discounts them at the risk-free rate. It does not assume large risk premiums, ignore the payoff, or rely solely on historical averages. -
The leverage ratio in the Basel framework is a backstop measure that compares capital to:
Correct answer: C. The Basel leverage ratio compares Tier 1 capital to total, non-risk-weighted exposure, acting as a backstop to the risk-based requirements. It deliberately does not risk-weight, and it is not based on net income or market capitalization.
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