Additonal Question Bank

FRM PART – I – FOUNDATION OF RISK MANAGEMENT
Topic - 1
The Building Blocks of Risk Management
Learning Objectives
The Building Blocks of Risk Management
LO 1 a: Explain the concept of risk and compare risk management with risk taking.
LO 1 b: Describe elements, or building blocks, of the risk management process and identify
problems and challenges that can arise in the risk management process.
LO 1 c: Evaluate and apply tools and procedures used to measure and manage risk, including
quantitative measures, qualitative assessment, and enterprise risk management.
LO 1 d: Distinguish between expected loss and unexpected loss, and provide examples of each.
LO 1 e: Interpret the relationship between risk and reward and explain how conflicts of interest can
impact risk management.
LO 1 f: Describe and differentiate between the key classes of risks, explain how each type of risk can
arise, and assess the potential impact of each type of risk on an organization.
LO 1 g: Explain how risk factors can interact with each other and describe challenges in aggregating
risk exposures.
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QUESTIONS
1. Which of the following statements regarding risk management is least likely correct?
A. Risk management is the process of quantifying and understanding the risk exposure
of the entity.
B. Risk management is about risk minimization.
C. Risk management is about understanding and embracing the risk.
D. A risk manager is not expected to predict the outcome of all possible risks.
2. In the event of a financial crisis, which of the following statements are most likely
correct?
I. Risk managers tend to exhibit ‘herd behavior”.
II. The previous use of derivatives increases volatility.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. The 5% VaR of a portfolio over a one-month period is $10m

Which of the following statements is most likely correct?
A. There is a 5% probability that the minimum loss that the portfolio is expected to lose
on a monthly basis is $10m.
B. There is a 95% probability that the minimum loss that the portfolio is expected to
lose on a monthly basis is $10m.
C. There is a 5% probability that the maximum loss that the portfolio is expected to
D. There is a 95% probability that the maximum loss that the portfolio is expected to
4. Jamie Smith, FRM, wishes to test the effect that a change in interest rates will have on
the value of the portfolio. The tool that Jamie is most likely to use is:
A. Risk management.
B. Stress testing.
C. Scenario analysis.
D. Sensitivity analysis.
5. Financial institutions charge clients an amount above their cost of capital in order to
make good losses on bad debts. This is an example of:
A. Unexpected losses.
B. Expected losses.

C. Risk management.
D. Good business practice.
6. Mark Vancar, FRM, recently attended a conference dealing with the risks of investing
in real estate. The presenter states that in the event that property owners have a
mortgage on their property and the market turns down, we have an example of
correlation risk. The two unfavorable events that occur together are:
I. Default risk
II. Recovery rate risk
III. Market risk
IV. Reputational risk
A. I and III.
B. I and II.
C. II and III.
D. II and IV
7. James Wie and Joanne Xie, two FRM candidates are having a discussion about risk and
return. Wie states that Risk is that portion of return variability that can be explained
and measured. Xie states the rule that the higher the risk the higher the expected return
on the investment is always the case.
Which of the candidate’s statements are most likely correct?
A. Wie only.
B. Xie only.
C. Wie and Xie.
D. Neither Wie or Xie.
8. Bank Baroda is in the process of dealing with a rogue trader, Nick Meeson. Which risk
is the bank most likely dealing with?
A. Credit risk.
B. Reputation risk.
C. Market risk.
D. Operational risk.
9. Investalot Inc recently made an investment in a venture capital business called

Notsosure. Notsosure is a recently formed company whose prospects are largely
uncertain. After being invested in Notsosure for six- months, the company files for
bankruptcy as a result of poor performance. Investalot reports the failed investment to
its’ shareholders at its next meeting. Which of Investalot’s risks have increased as a
result of the failed investment?
A. Market risk and Reputation risk.

B. Business risk and Strategic risk.

C. Strategic risk and Reputation risk.
D. Operational risk and Business risk.
10. Mr Risky Badethics recently entered into a short call option trade with Bank A. At the
expiry of the option Mr Badethics had incurred losses of $400,000. Mr Badethics decides
against making payment for these losses as he believes they are way too high. Which of
the following risks has Bank A incurred as a result of Mr Badethics non-payment?
A. Default risk.
B. Bankruptcy risk.
C. Downgrade risk.
D. Settlement risk.
11. Which of the following is not one of the risk management building blocks?
A. Risk factor breakdown.
B. Risk aggregation.
C. Balancing risk and reward.
D. Risk management
12. The risk of an earthquake occurring in New York is best described as follows:
A. An expected loss.
B. An unexpected loss.
C. A known unknown.
D. An unknown unknown
13. A risk manager is analyzing several portfolios, all with the same current market
value. Which of the portfolios would likely have the highest potential level of
unexpected loss during a sharp broad-based downturn in financial markets?
A. A portfolio of US Treasury notes with 2 to 5 years to maturity.
B. A portfolio of long stock positions in an international large cap stock index
combined with long put options on the index.
C. A portfolio of mezzanine tranche MBS structured by a large regional bank.
D. A short position in futures for industrial commodities such as copper and steel.

SOLUTION
1. B
It is important to remember that risk management is not about risk minimization but
rather risk management.
2. C
Derivative instruments made it easier for market participants to take on large amounts
of risk. In addition, risk managers “herd behavior”, once a crisis was underway,
actually increased market volatility.
3. A
There is a 5% probability that the minimum loss that the portfolio is expected to lose on
a monthly basis is $10m.
4. D
This is an example of sensitivity analysis. The reason for this is that sensitivity analysis
measures what the change in a single risk factor will have on the value of the portfolio.
In our case the risk factor was interest rates.
5. B
Expected loss (costs) is the expected loss in the ordinary course of the businesses
operations. The expected loss on a loan portfolio would be the loss that the company
expects to make on the loans as a result of non-payment. This amount can therefore be
priced into the cost of the product.
6. B
The two unfavorable events that occur together are:
 Default risk – borrowers tend to default on their loans.
 Recovery rate risk – the values of real estate tend to fall in such markets. This
further reduces the financial institution’s recovery on their loans.
7. A
Wie’s statement that Risk is that portion of return variability that can be explained and
measured is correct.
Xie’s statement is not always the case as there are several other factors that need to be
taken into account when assessing the relationship between risk and return.
8. D
One of the key sources of operational risk are individuals within the firm.

9. C
The risk of investing in an investment for which there is a large degree of uncertainty
surrounding its future success and profitability is called strategic risk.
The results of a failed investment or changed strategy may result in large losses and
reputational damage to a firm.
10. D
Settlement risk is the risk that the counterparty may not fulfill their obligation to make
payment when due. This may be as a result of the counterparty defaulting, liquidity
constraints or other operational issues.
11. D
the following 10 building blocks as part of the risk management process.
1. The risk management process
2. Identifying risk: knowns and unknowns
3. Expected loss, unexpected loss, and tail loss
4. Risk factor breakdown
5. Structural change: from tail risk to systemic crisis
6. Human agency and conflicts of interest
7. Typology of risks and risk interactions
8. Risk aggregation
9. Balancing risk and reward
10. Enterprise risk management (ERM)
12. D
Expected loss (costs) are expected losses incurred in the ordinary course of businesses
operations. This loss is fairly predictable and certain and is able to be worked out in
advance.
Unexpected loss (costs) are losses that may arise out of the ordinary course of the
businesses’ operations. This loss is fairly unpredictable and uncertain and is unable to
be worked out in advance.
Known unknowns are risks that people are aware of.
Unknown unknowns are risks that are so unexpected, they have not even been
considered.
13. C
The portfolio of mortgage backed securities would have the highest unexpected loss
since the securities should have highest correlation (covariance) and should have the
most risk of moving downward simultaneously in a crisis situation.

Topic - 2
How Do Firms Manage Financial Risk?
Learning Objectives
How Do Firms Manage Financial Risk?
LO 2 a: Compare different strategies a firm can use to manage its risk exposures and
explain situations in which a firm would want to use each strategy.
LO 2 b: Explain the relationship between risk appetite and a firm’s risk management
decisions.
LO 2 c: Evaluate some advantages and disadvantages of hedging risk exposures, and
explain challenges that can arise when implementing a hedging strategy.
LO 2 d: Apply appropriate methods to hedge operational and financial risks, including
pricing, foreign currency, and interest rate risk.
LO 2 e: Assess the impact of risk management tools and instruments, including risk limits
and derivatives.

QUESTION
1. Which of the following statements regarding hedging is least likely correct?

A. An effective hedge is likely to reduce the overall risk of the firm.
B. The purchase of a derivative contract is a valid hedge.
C. The purchase of an insurance contract is a valid hedge.
D. In practice the Modigliani and Miller theory is not realistic
2. When looking at the CAPM model, which of the following statements is most likely
correct?
I. The market is perfect.
II. The market is frictionless.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. During the lunch break at a recent risk conference, four analysts are discussing the
advantages and disadvantages of managing risk. Which of the four statements is most
likely correct?
A. Hedging in practice is a simple matching exercise.
B. In a progressive tax system hedging serves to increase the firm’s tax liability.
C. The hedged firm is likely to have a better reputation in the market.
D. Hedging is only beneficial to larger firms.
4. The process involved in determining the firm’s risk appetite will include which of the
following steps:
I. The government and regulatory landscape within which the firm operates must be
taken into account.
II. Quantitative (for example VaR) and scenario analysis, as well as economic models
and sensitivities to macro risk drivers, can be used.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
5. In the process of setting the risk appetite/tolerance of the firm, the_____will propose
the risk appetite of the firm and the______will need to approve the proposal.
A. Management team, Board of directors.
B. Management team, Investment committee.

C. Board of directors, Management team.

D. Governance team, Board of Directors.
6. Jook Inc. has established that their income statement and balance sheet is mostly
affected by credit risk. This is an example of:
A. Risk tolerance.
B. Risk appetite.
C. Risk setting.
D. Risk mapping
7. A firm wishes to smooth out their future operating expenses in order to keep their
prices to their customers constant. This is an example of hedging:
A. Pricing risk.
B. Reputation risk.
C. Business risk.
D. Interest rate risk.
8. A firm wishes to smooth out their future operating expenses in order to keep their
prices to their customers constant. The most effective method that can be used to hedge
this risk is:
A. Going short a forward contract.
B. Going long a forward contract.
C. Short a currency put option.
D. Making use of a natural hedge.
9. When dealing with hedging, which of the following statements are most likely correct?
I. A buy and hold strategy is a good example of a static hedge.
II. An advantage of dynamic hedging is that the cost of the hedge is reduced
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
10. A risk manager wishes to use an exchange-traded derivative in order to hedge the risk
of the firm. Which of the following descriptions are inconsistent with over-the-counter
derivatives relative to exchange-traded instruments?
A. Greater flexibility.
B. More liquid.
C. Less regulated.
D. High default risk.

11. Jacqui Jones, FRM, has implemented a system for her firm that limits the firm’s the
trading per counterparty to $5m. Which of the following limits has been implemented?
A. Risk specific limits.
B. Stop loss limits
C. Notional limits
D. Concentration limits.
12. Which of the following derivative contracts is most likely an example of a contingent
claim?
A. Forward contracts.
B. Futures contracts.
C. Swap contracts.
D. Option contracts

SOLUTION
1. C
C is incorrect because the purchase of an insurance company is not considered a hedge.
A derivatives instrument will be considered a valid hedge.
2. C
Both statements are correct. See several of the CAPM assumptions are listed below.
 There are no transaction costs or other impediments to trading – frictionless
markets.
 A perfect market exists with perfect information available to investors.
 There is either no taxation or equal taxation for all participants.
 All assets are infinitely divisible – divisible assets.
3. C
Hedging in practice is a difficult and complex job.
In a progressive tax system (taxes increase as earnings go up) – hedging can assist in
keeping earnings stable and less variable thus reducing the income tax liability.
The hedged firm with its reduced variability of earnings (and hence higher earnings
quality) will have a better reputation in the market.
4. C
Some of the following points can be used as guidance in determining risk appetite:
 Company goals and expertise in certain areas can be used as a basis for risk
tolerance.
 The amount of loss a company can sustain without impairing its going concern
ability.
 The competitive landscape within which the firm operates must be taken into
account.
 Quantitative (for example VaR) and scenario analysis, as well as economic models
and sensitivities to macro risk drivers, can also be used.
5. A
In the process of setting the risk appetite/tolerance of the firm, the management team
will propose the risk appetite of the firm and the Board of directors will need to
approve the proposal.

6. D
Risk mapping could be undertaken for major risk categories such as market risk, credit
risk, operational risk etc. The method would be to determine the values of all the assets,
liabilities, income and expenses of the firm that are impacted by the risk category.
7. A
Pricing risk hedge = The various input costs for a firm are very sensitive for a firm’s
profitability. As such the firm would prefer to hedge against price movements of these
costs in order to remain competitive. This would result in prices of inputs remaining
stable and determinable upfront.
8. B
A forward or futures contract can be entered into (long) to fix the quantity and price of
the firm’s inputs.
9. A
Static hedging is an upfront exercise. The initial risk is determined and that position is
then hedged upfront in an appropriate manner. This hedge stays in place until the end
of the required period.
An advantage of static hedging is that the cost of the hedge is reduced relative to a
dynamic hedge.
10. B
Over the counter
 No specific terms - created by two parties to meet their specific needs, i.e. custom
contract. (more flexible)
 Less regulated (informal)
 Less transparent (more private)
 Less liquid
 Default risk is high
11. D
A concentration limit is set, for example, by limiting the trading amount with each
counterparty of the firm.
12. D
An options is a derivative contract between two parties whereby one party, the buyer,
pays a sum of money called the option premium to the seller, to receive the right but
not the obligation to buy from the seller an underlying asset at a future date, the price
of which is established at the beginning of the contract.

Topic - 3
The Governance of Risk Management
Learning Objectives
The Governance of Risk Management
LO 3 a: Explain changes in corporate risk governance that occurred as a result of the 2007
— 2009 financial crisis.
LO 3 b: Compare and contrast best practices in corporate governance with those of risk
management.
LO 3 c: Assess the role and responsibilities of the board of directors in risk governance.
LO 3 d: Evaluate the relationship between a firm’s risk appetite and its business strategy,
including the role of incentives.
LO 3 e: Illustrate the interdependence of functional units within a firm as it relates to risk
management.
LO 3 f: Assess the role and responsibilities of a firm’s audit committee.

QUESTIONS
1. Which of the following statements regarding corporate governance and the board of
directors (bod) is least likely correct?
A. The bod must institute values into the firm that engender good corporate
governance and to ensure that the firm runs in a proficient and ethical manner.
B. The bod must ensure that the firm complies with all legal and regulatory
requirements.
C. The bod must determine management responsibilities and ensure that management
is accountable for their actions, across all areas of the business.
D. The bod must create long-term strategic objectives for the firm that are consistent
with managements’ best interests.
2. When looking at best practice in risk management, which of the following statements is
most likely correct?
I. A risk committee should be set up by the CEO.
II. The risk committee should be separate from the audit committee.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following statements is a reason to appoint a risk advisory director?

A. Risk determination is a difficult task and an expert in risk is needed.
B. Risk determination is a difficult task and an expert in investments is needed.
C. Risk is too complex for the bod to understand and an expert in risk is needed.
D. Risk is too important for a firm and an expert in risk is needed.
4. When looking at the role of the risk advisory director, which of the following
statements is most likely correct?
I. A risk committee should be set up by the CEO.
II. The risk committee should be separate from the audit committee.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
5. Three analysts are having lunch together and are discussing risk tolerance and business
strategy. They make the following comments:
Comment 1: Risk tolerance is more important than business strategy.

Comment 2: Business strategy is more important than risk tolerance.

Comment 3: Risk tolerance and business strategy are equally important.
Which of the above comments is correct?
A. Comment 1.
B. Comment 2.
C. Comment 3.
D. All three comments are incorrect.
6. The two teams – the business strategy team and the risk team – will need to work
together from the outset. Why is this necessary?
A. To ensure that the strategy team gets on well with the risk team.
B. To ensure that the risk team can teach the strategy team the best practices in risk.
C. To ensure that there is a consistent approach to risk and strategy.
D. To highlight the importance of risk within the firm.
7. Which of the following statements relating to the compensation committee is incorrect?

A. Executive compensation needs to be linked to the short-term profitability of the
company and to increases in share value in relation to competitors and comparable
companies,
B. Potential conflicts of interests must be eliminated between the compensation
committee and the company.
C. Executive compensation must be appropriate.
D. The options granted to management are reasonable.
8. John Risko, FRM has just been appointed to head up the risk management committee
for Bank A. He is unsure what his responsibilities entail. Which of the following
activities are not a part of his responsibilities?
A. Approval of credit limits
B. Review of operational risk.
C. Monitoring credit and security portfolios.
D. Setting executive compensation.
9. The functional units of a firm contain several units. Which unit is responsible for sign
off on the official P&L?
A. Operations.
B. Trading room management.
C. Risk management.
D. Finance

10. Which of the following is not a responsibility of the audit committee?

A. The audit committee does not have the authority to approve or reject non-audit
engagements with the external audit firm.
B. The audit committee should have unrestricted success to the internal auditor.
C. The audit committee controls the audit budget.
D. The audit committee undergoes training to stay educated about current financial
issues.
11. The net stable funding ratio is a regulation introduced by which of the following acts or
provisions?
A. Basel III.
B. BCBS – Corporate governance principles for banks.
C. The Dodd-Frank Act.
D. The SREP and EBA stress tests.

SOLUTION
1. D
 The bod must institute values into the firm that engender good corporate
governance and to ensure that the firm runs in a proficient and ethical manner.
 Legal and regulatory requirements. The bod must ensure that the firm complies
with all legal and regulatory requirements.
 Management responsibility. The bod must determine management responsibilities
and ensure that management is accountable for their actions, across all areas of the
business.
 Long-term strategic objectives. The bod must create long-term strategic objectives
for the firm that are consistent with shareholders’ best interests.
2. B
A risk committee should be set up by the board.
The risk committee should be separate from the audit committee.
3. A
The determination of risk appetite and other risks within a firm is a complex task and
not all the directors on the board are adequately skilled to perform this task. As a result,
a specific director called the risk advisory director, who is a specialist in risk, should be
appointed to this role.
4. C
Included in the role of risk advisory director are the following specific duties:
 Offer education regarding best risk and corporate governance practices.
 Review of audit reports (internal and external).
5. C
It is clear that firm’s risk tolerance and the firm’s business strategy need to work
together. The firm’s risk tolerance will set certain limits and boundaries for the firm’s
business strategy. The two teams – the business strategy team and the risk team – will
need to work together from the outset to ensure that there is a consistent approach to
risk and strategy.
6. C
The two teams – the business strategy team and the risk team – will need to work
together from the outset to ensure that there is a consistent approach to risk and
strategy.

7. A
The following key points relate to the compensation committee:
 Executive compensation needs to be linked to the long-term profitability of the
company and to increases in share value in relation to competitors and comparable
companies,
 Potential conflicts of interests must be eliminated between the compensation
committee and the company.
 Executive compensation is appropriate.
 The options granted to management are reasonable.
8. D
Within a banking environment, the risk management committee will also be
responsible for approving credit limits as well as the review of operational risk. The
risk management committee will also monitor credit and security portfolios.
9. B
Trading room management.
10. A
Responsibilities of the audit committee include:
 The appointment of the external auditors are subject to a vote of shareholders.
 The audit committee has the authority to approve or reject non-audit engagements
with the external audit firm.
 The internal auditor should report directly to the audit committee in cases of
integrity of the financial reports or accounting practices.
 The audit committee should have unrestricted success to the internal auditor.
 The audit committee controls the audit budget.
 The audit committee undergoes training to stay educated about current financial
issues.
11. A
The net stable funding ratio was introduced by the Basel III regulations.

Topic - 4
Credit Risk Transfer Mechanisms
Learning Objectives
Credit Risk Transfer Mechanisms
LO 4 a: Compare different types of credit derivatives, explain how each one transfers credit
risk, and describe their advantages and disadvantages.
LO 4 b: Explain different traditional approaches or mechanisms that firms can use to help
mitigate credit risk.
LO 4 c: Evaluate the role of credit derivatives in the 2007 — 2009 financial crisis, and
explain changes in the credit derivative market that occurred as a result of the crisis.
LO 4 d: Explain the process of securitization, describe a special purpose vehicle (SPV), and
assess the risk of different business models that banks can use for securitized products.

QUESTIONS
1. Which of the following techniques will not assist in mitigating credit risk?
A. Guarantees.
B. Netting.
C. Collateral.
D. Buy and hold.
2. Which of the following credit derivatives acts as a form of insurance?

A. Credit default swap (CDS).
B. Asset-backed security.
C. Collateralized mortgage obligation.
D. Credit card asset-backed security.
3. Jacqui Jones, FRM, is giving a presentation to a group of risk analysts. In the

presentation she describes a security as follows, ‘This instrument is a derivative
security that is collateralized by MBS. The motivation for its creation is to distribute the
prepayment risk among the different classes of bonds.’ What type of security is Jacqui
referring to?
A. Collateralized mortgage obligation (CMO).
B. Collateralized debt obligation (CDO).
C. Collateralized bond obligation (CBO).
D. Collateralized loan obligation (CLO).
4. What type of syndication will guarantee an obligor a fixed loan amount?

A. General syndication.
B. Specific syndication.
C. Firm commitment.
D. Best efforts.
5. Which of the following instruments is least likely to survive the 2007-2009 financial
crisis?
A. ABS.
B. CDS.
C. RMBS.
D. CDOs squared.
6. An analyst is assessing the use of credit derivatives and the resultant 2007-2009 crises.
Which of the following statements is correct?
A. The blame for the 2007-2009 crisis belongs with the credit derivatives themselves.

B. The blame for the 2007-2009 crisis belongs with the users of the credit derivatives.
C. The blame for the 2007-2009 crisis belongs with the Federal Reserve.
D. The blame for the 2007-2009 crisis is due to Donald Trump.
7. Which of the following is not an issue exhibited by the originate to distribute model
prior to the 2007-2009 financial crisis?
A. Bank leverage. The banks, in order to pass over the mandatory capital requirements,
under Basel, established highly levered off-balance sheet vehicles.
B. Faulty origination practices.
C. Banks retained, rather than transferring, the originated securities.
D. The use of MBS started slowing down.

SOLUTION
1. D
Buy and hold is not a credit mitigation strategy.
2. A
A credit default swap (CDS) is really just an insurance contract.
The buyer of the insurance, called the protection buyer, pays a premium called the CDS
spread, to the seller of the protection.
3. A
A CMO is a derivative security that is collateralized by MBS. The motivation for
creating a CMO is to distribute the prepayment risk among the different classes of
bonds.
4. C
Firm commitment – The bank guarantees that the obligor (borrower) will receive a
fixed dollar amount for their loan. To the extent that the bank cannot find additional
investors, the bank will need to take on a larger portion of the total loan.
5. D
Both the CDS and Asset-backed securities (ABS) markets continued strongly after the
crisis, as they fulfilled their purpose of managing and transferring credit risk. In
addition, asset-backed commercial paper (ABCP) and mortgage-backed securities
(MBS) are expected to survive post the crisis. Despite the systematic deficiencies that
are present in these instruments, these instruments themselves are effective credit
transferrers.
Collateralized debt obligations squared (CDOs squared) as well as the more complex
securitized instruments, such as single-tranche CDOs and complex ABCP, are unlikely
to survive post the crisis.
6. B
Initially, a large portion of the blame for the 2007-2009 financial crisis was given to
credit derivatives. However, the truth is that the blame needs to be given to the users of
these derivatives, who abused them.
7. D
In summary, the OTD model, exhibited the following issues:
 Bank leverage. The banks, in order to pass over the mandatory capital
requirements, under Basel, established highly levered off-balance sheet vehicles.

 Faulty origination practices.

 Banks retained, rather than transferring, the originated securities.
 Incentives were misaligned along the securitization chain and investor oversight
was minimal.
 The risks embedded in the securitized products were not transparent.
 There was an overreliance on the credit rating agencies in terms of the risks and
transparency of the securitized products.

Topic - 5
Modern Portfolio Theory and
The Capital Asset Pricing Model (CAPM)
Learning Objectives
Modern Portfolio Theory and The Capital Asset Pricing Model (CAPM)
LO 5 a: Explain modern portfolio theory and interpret the Markowitz efficient frontier.
LO 5 b: Understand the derivation and components of the CAPM.
LO 5 c: Describe the assumptions underlying the CAPM.
LO 5 d: Interpret the capital market line.
LO 5 e: Apply the CAPM in calculating the expected return on an asset.
LO 5 f: Interpret beta and calculate the beta of a single asset or portfolio.
LO 5 g: Calculate, compare, and interpret the following performance measures: the Sharpe
performance index, the Treynor performance index, the Jensen performance index, the
tracking error, information ratio, and Sortino ratio.

QUESTION
1
 2 2 2 2 2
1. The following formula: port   W   W   is the formula used to calculated
 1 i 2 2
portfolio standard deviation, assuming a correlation coefficient of?
A. Zero
B. +1
C. -1
D. +0.5
2. When deriving the Capital Asset Pricing Model. Which of the following statements is
correct?
I. The first term (variance term) gets close to zero as the size of the ‘n’ increases.
II. The second term will approach the average covariance as ‘n’ increases.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following statements relating to the CAPM assumptions is not correct?
A. A limited amount of short selling is allowed.
B. There are no transaction costs to other impediments to trading – frictionless
markets.
C. A perfect market exists with perfect information available to investors.
D. There is either no taxation or equal taxation for all participants.
4. Which of the following statements relating to the CAPM assumptions is not correct?
A. All assets are infinitely divisible – divisible assets.
B. All assets are marketable.
C. An investor’s utility function is based solely expected return.
D. The time period that investors are concerned about for expected return and risk is
one year.
5. Which of the following statements relating to the Capital market line is not correct?
A. The intercept is equal to the risk-free rate.
B. The slope is equal to the risk-reward ratio for a risky portfolio.
C. The capital market line below the efficient frontier.
D. Where the CML and the efficient frontier touch is called the market portfolio or M.

6. Harry Markham, FRM, and his boss Jerry Jones, CFA, are discussing the capital market
line (CML) and the securities market line (SML).
Markham states that the CML can only be used in the case of a diversified portfolio.
Jones comments that in the event that a portfolio is not diversified then the CAPM will
used.
Which of the above statements are correct?
A. Markham only.
B. Jones only.
C. Both Markham and Jones.
D. Neither Markham and Jones.
7. An analyst gathers the following data:

 Expected rate of return on the market = 19%
 Risk free rate = 11%
 Expected rate of return on Stock A = 22%
 Stock A’s beta = 1.10
Using the above data and the capital asset pricing model, what can you conclude about
the value of Stock A?
A. It is underpriced
B. It is overpriced
C. It is fairly priced
D. There is not enough information given to be able to calculate the price.
8. Which of the following statements relating to the Capital market line is are correct?
I. The capital market line (CML) is the line from the y-intercept that represents the
risk-free rate tangent to the original efficient frontier.
II. Investments on this line dominate all the portfolios on the original Markowitz
efficient frontier
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
9. An analyst developed the following data on Stock A and the market:

Return on the market = 0.16
Covariance between the return on Stock A and the return on the market = 0.038
Correlation coefficient between the return on Stock A and the return on the market
= 0.70
Standard deviation of the returns on Stock A = 0.17
Standard deviation of the returns on the market = 0.23

What is the beta of Stock A?

A. 0.165
B. 0.718
C. 1.00
D. 1.315
10. Which of the following statements relating to beta are correct?

I. Beta is a standardized measure of systematic risk based upon an asset’s covariance
with the market portfolio.
II. To calculate beta in practice, we would need to regress the returns of the specific
asset against the returns of the market.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
11. Data relating to Fund A is presented below for appraisal purposes:
Jensen’s alpha is equal to:

A. 1.00%
B. -0.2%
C. 2.00%
D. 0.84%
The Fund’s Sharpe ratio is equal to:

A. 0.80
B. 1.00
C. 4.80
D. 3.85

The Fund’s Treynor ratio is equal to:

A. 5.00
B. 1.00
C. 4.80
D. 0.8
14. Which of the following statements are correct when dealing with the Sharpe ratio?
A. A portfolio with superior performance will have a steep-sloping CAL and a high
Sharpe ratio.
B. The Sharpe ratio is considered to be a more accurate historical performance
measure.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
15. Which of the following statements are correct when dealing with Jensen’s alpha?
I. The difference between the actual return and that required to compensate for the
unsystematic risk is called alpha.
II. Alpha makes use of the e SML as a benchmark for performance appraisal.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
16. Which of the following statements are correct when dealing with Jensen’s alpha and the
Treynor measure?
I. Both Alpha and Treynor measure risk systematic risk (beta).
II. A manager with a positive alpha will have a Treynor measure above the market
Treynor.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

The Fund’s Sortino ratio is equal to:

A. 0.83
B. 1.00
C. 5.45
D. 16.67
The Fund’s information ratio is equal to:

A. 0.33
B. 0.20
C. 0.50
D. 1.00
19. Which of the following statements are correct when dealing with the information ratio
and the tracking error?
I. An aggressive investment manager would seek to achieve a low tracking error.
II. A passive investment manager would seek to achieve a high tracking error.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

20. Which of the following statements are correct when dealing with the Sortino measure?
I. The numerator is calculated as the return on the portfolio less a minimum
acceptable return (MAR) for the portfolio.
II. The denominator is the standard deviation of returns that fall below the MAR.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
21. Suppose the S&P 500 Index has an expected annual return of 7.6% and volatility of
10.8%. Suppose the Atlantis fund has an expected annual return of 7.2% and volatility
of 8.8% and is benchmarked against the S&P 500 index. If the risk-free rate is 2.0% per
year, what is the beta of the Atlantis Fund according to the CAPM?
A. 0.81
B. 0.93
C. 1.13
D. 1.23

SOLUTIONS
1. A
When there is no correlation between the two assets, then the third term in the equation
disappears (since the correlation is zero). Based on this, the portfolio standard deviation
calculation is as follows:
1
 2 2 2 2 2
port  W   W  
 1 i 2 2
2. B
What is interesting to note is that as the size of the portfolio increases, the variance gets
close to the average covariance. The reason for this is that the first term (variance term)
gets close to zero as the size of the ‘n’ increases, and the second term will approach the
n 1
average covariance as ‘n’ increase, because will approach 1.
n
3. A
 An unlimited amount of short selling is allowed.
 There are no transaction costs to other impediments to trading – frictionless
markets.
 A perfect market exists with perfect information available to investors.
 There is either no taxation or equal taxation for all participants.
4. C
 All assets are infinitely divisible – divisible assets.
 All assets are marketable.
 An investor’s utility function is based solely expected return and risk.
 The time period that investors are concerned about for expected return and risk is
one year.
5. C
 The intercept is equal to the risk-free rate.
 The slope is equal to the risk-reward ratio for a risky portfolio.
 The capital market line lies tangent to the efficient frontier.
Where the CML and the efficient frontier touch is called the market portfolio or M.

6. C
Based on the definition and characteristics of the CML, it can only be used to measure
the expected return for a diversified portfolio. In the event that a portfolio is an
individual security or not diversified then the CAPM will used.
7. A
Using the CAPM, the stock should get a return of:
E(r) = Rf + ß(Rm - Rf)
= 0.11 + (1.10)(0.19-0.11)
= .198
= 19.8%
The stock is expected to get a return of 22%, which is more than its CAPM return
above. Thus, it is underpriced since it has an excess return.
8. C
The capital market line (CML) is the line from the y-intercept that represents the risk-
free rate tangent to the original efficient frontier; it becomes the new efficient frontier
since investments on this line dominate all the portfolios on the original Markowitz
efficient frontier.
9. B
10. C
Beta is a standardized measure of systematic risk based upon an asset’s covariance
with the market portfolio.
To calculate beta in practice, we would need to regress the returns of the specific asset
against the returns of the market.
11. D
12. B
Sharpe = (9.00 – 4.00)/5.00 = 1.00

13. C
Treynor = (9.00 – 4.00)/1.04 = 5.17
14. C
A portfolio with superior performance will have a steep-sloping CAL and a high
Sharpe ratio. The Sharpe ratio is considered to be a more accurate historical
performance measure.
15. B
The difference between the actual return and that required to compensate for the
systematic risk is called alpha.
Alpha makes use of the ex post SML (security market line) as a benchmark for
performance appraisal.
16. C
Both Alpha and Treynor measure risk systematic risk (beta).
A manager with a positive alpha will have a Treynor measure above the market
Treynor.
17. B
18. A
19. D
An aggressive investment manager would seek to achieve a high tracking error.
A passive investment manager would seek to achieve a low tracking error.
20. C
The numerator is calculated as the return on the portfolio less a minimum acceptable
return (MAR) for the portfolio.
The denominator is the standard deviation of returns that fall below the MAR.

21. B

Topic - 6
Multifactor Models of Risk-Adjusted Asset Returns
Learning Objectives
Multifactor Models of Risk-Adjusted Asset Returns
LO 6 a: Explain the arbitrage pricing theory (APT), describe its assumptions, and compare
the APT to the CAPM
LO 6 b: Describe the inputs (including factor betas) to a multifactor model.
LO 6 c: Calculate the expected return of an asset using a single-factor and a multifactor
model.
LO 6 d: Explain models that account for correlations between asset returns in a multi-asset
portfolio.
LO 6 e: Explain how to construct a portfolio to hedge exposure to multiple factors.
LO 6 f: Describe and apply the Fama-French three factor model in estimating asset returns.

QUESTIONS
1. Which of the following are not inputs into the multifactor model
A. The stock’s unexplained return.
B. The firm specific return.
C. Macroeconomic deviations from expected values.
D. The stock’s sensitivity to a particular factor – factor betas.
2. Which of the following statements relating to multifactor models are correct?

I. The firm specific factor is also referred to as the error term.
II. In most cases the error term is a zero.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. The following data was presented for Company M:
The expected return on the stock, using a multifactor model is equal to:
A. 12%
B. 10%
C. 17%
D. 3%
4. When assessing an arbitrage opportunity in a multifactor model, which of the following

statements is correct?
I. Assuming two companies have the same beta exposures, but different expected
returns, the strategy would be to go long the higher return stock and short the
lower return stock.
II. Arbitrage occurs when two equivalent asset sell for two different prices. This
presents an opportunity to profit for no risk or cash outlay.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

5. Which of the following statements regarding the SML is not correct?

A. The SML is a curved line that reflects the required rate of return in the marketplace
for each level of non- diversifiable risk.
B. The SML is a line that results when plotting expected returns and beta coefficients.
C. The SML is used to describe the relationship between systematic risk and expected
return in financial markets.
D. Properly valued assets plot exactly on the SML.
6. When using the single factor model, any other single factors can be used (other than the
market factor as dictated by CAPM). Which of the following assumptions regarding the
use of a single factor model is not correct?
A. The portfolio is adequately diversified.
B. No arbitrage opportunities exist.
C. The returns on the stock can be explained by a single factor.
D. The CAPM is the only valid single factor model.
7. When using factor portfolios in order to hedge away a single risk, which of the
following statements are correct?
I. A manager would take an opposite position in a factor portfolio.
II. A factor portfolio is a well-diversified portfolio with a beta of 1 for that specific
factor only – all other betas in the portfolio would equal zero.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. When using factor portfolios in order to hedge away several risks, which of the
I. A manager wishing to hedge would need to create a new portfolio. This portfolio
would be invested in several factor portfolios.
II. The manager would then go long this new portfolio in the necessary ratios in order
to fully hedge his initial position.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

9. When working with the APT assumptions, which of the following assumptions are
correct?
I. The factor model describes the returns on the asset.
II. We are dealing with diversified portfolios and hence no arbitrage opportunities
exist.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
10. The information provided in the table below relates to YDC Inc.
The risk-free rate = 4%.

Using the Fama French model, which of the following is the correct expected return for
YDC Inc?
A. 18.18%
B. 5.18%
C. 14.18%
D. 4.00%
11. Assume that we have a portfolio of 50 securities. What is the total number of variance
covariance calculations required?
A. 50
B. 1,225
C. 1,275
D. 1,250
12. In 2015, Fama French added two new factors to their model, and at the same time
considered one of their original factors to be redundant. Which factor is now
considered redundant?
A. HML
B. SMB
C. RMW
D. CMA

13. An analyst is estimating the sensitivity of the return of stock A to different

macroeconomic factors. The following estimates for the factor betas are prepared:
Under baseline expectations, with industrial production growth of 3% and an interest

rate of 1.5%, the expected return for Stock A is estimated to be 5.0%. The economic
research department is forecasting an acceleration of economic activity for the
following year, with GDP forecast to grow 4.2% and interest rates increasing 25 bps to
1.75%. What return of stock A can be expected for next year according to this forecast?
A. 4.8%
B. 6.4%
C. 6.8%
D. 7.8%

SOLUTIONS
1. A
 The stock’s expected return.
 The firm specific return.
 Macroeconomic deviations from expected values.
 The stock’s sensitivity to a particular factor – factor betas.
2. C
The firm specific factor is also referred to as the error term. The reason for this is that
this is the portion of the return that is not explained by macro factors.
However, in most cases the error term is a zero. The reason for this is that firm-specific
events are random events.
3. A
The multifactor model equation for the stock can be expressed as follows:
Ri = E(Ri)+ bi1F1 + bi2F2 + εi
Ri = 10% + 1.5(0.05 – 0.02) + 2.5(0.03 – 0.04) + 0
Ri = 10% + 4.5 – 2.5% + 0
Ri = 12%
4. C
Assuming two companies have the same beta exposures, but different expected returns,
the strategy would be to go long the higher return stock and short the lower return
stock.
Arbitrage occurs when two equivalent asset sell for two different prices. This presents
an opportunity to profit for no risk or cash outlay.
5. A
 The SML is a straight line that reflects the required rate of return in the
marketplace for each level of non-diversifiable risk.
 The SML is a line that results when plotting expected returns and beta coefficients.
 The SML is used to describe the relationship between systematic risk and expected
return in financial markets.
 Properly valued assets plot exactly on the SML.
6. D
Any other single factors can also be used (without needing to rely on the CAPM
assumptions). These assumptions are:
 The portfolio is adequately diversified.

 No arbitrage opportunities exist.

 The returns on the stock can be explained by a single factor.
7. C
Assuming that the wealth manager wishes to hedge his risk against a single risk factor
– he would take an opposite position in a factor portfolio. This portfolio is a well-
diversified portfolio with a beta of 1 for that specific factor only – all other betas in the
portfolio would equal zero.
8. A
What if the manager wishes to hedge away several risks?
He would need to create a new portfolio. This portfolio would be invested in several
factor portfolios. He would then short this new portfolio in the necessary ratios in order
to fully hedge his initial position.
9. C
The APT assumptions
1. The factor model describes the returns on the asset. We saw this in the previous LO,
where specific factor models were created for each risk factor.
2. Due to the large number of assets, an investor can diversify his risk and thereby
eliminate specific risk attached to the individual assets.
3. We are dealing with diversified portfolios and hence no arbitrage opportunities
exist.
10. B
The formula for the FF model is:
Ri = Rf + (βmarket X Market factor) + (βSMB X SMB) + (βHMLHML) + εi
Required return = 0.04 + (1.20 X 0.025) + (0.90 X 0.052) + (-1.30 X 0.05)
Required return = 0.04 + 0.03 + 0.0468 – 0.065
Required return = 5.18%
11. C
The total number of variance covariance calculation are as follows:
Variance calculations = n = 50.
Total calculations = 50 + 1,225 = 1,275 calculations.

12. A
The FF model (in 2015) moved away from the HML factor and added two new factors:
 Robust minus Weak (RMW) = the difference between returns of companies with
robust operating profitability and weak operating profitability.
 Conservative minus Aggressive (CMA) = the difference between returns of
companies that invest conservatively and companies that invest aggressively.
13. B
The expected return for Stock A equals the expected return for the stock under the
baseline scenario, plus the impact of “shocks”, or excess returns of, both factors. Since
the baseline scenario incorporates 3% industrial production growth and a 1.5% interest
rate the “shocks” are 1.2% for the GDP factor and 0.25% for the interest rate factor.

Topic - 7
Risk Data Aggregation and Reporting Principles
Learning Objectives
Risk Data Aggregation and Reporting Principles
LO 7 a: Explain the potential benefits of having effective risk data aggregation and
reporting.
LO 7 b: Describe the impact of data quality on model risk and the model development
process.
LO 7 c: Describe key governance principles related to risk data aggregation and risk
reporting practices.
LO 7 d: Identify the governance framework, risk data architecture and IT infrastructure
features that can contribute to effective risk data aggregation and risk reporting practices.
LO 7 e: Describe characteristics of a strong risk data aggregation capability and
demonstrate how these characteristics interact with one another.
LO 7 f: Describe characteristics of effective risk reporting practices.
LO 7 g: Describe the role that supervisors play in the monitoring and implementation of the
risk data aggregation and reporting practices.

QUESTIONS
1. As per the Basel Committee on banking supervision, risk data aggregation is the
of risk data, in such a manner that the bank can use the data collected to measure its
current performance against its risk tolerance level.
Which of the following words do not fit into the above definition?
A. defining,
B. gathering, and
C. processing
D. monitoring
2. Which of the following statements are considered to be benefits of having effective risk
data aggregation and reporting?
I. Financial Health
II. Improved resolvability.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. When looking at the requirements of Principle 1 – Governance, which of the following

statements are not a requirement of this principle?
A. The structure of the bank, its geographical location and legal form should not affect
risk data aggregation policies.
B. Management must be involved and give priority to risk data aggregation policies.
This will include devoting financial and human resources to this initiative.
C. The board of directors must be aware and involved in the risk data aggregation
policies of the bank.
D. Risk data aggregation and risk reporting should be consistent across the entire
banking group.
4. Which of the following statements are requirements of Principle 1 – governance,

relating to data aggregation and reporting?
I. Risk data aggregation and risk reporting should be reviewed and approved by
independent, and qualified, information technology (IT) and risk professionals.
II. Risk data aggregation and risk reporting need not be taken into account when new
initiatives such as new product development, acquisitions/sales are undertaken.
A. I only.
B. II only.
C. Both I and II.

D. Neither I or II.
5. Which of the following statements correctly define Principle 2 – data architecture and
infrastructure relating to data aggregation and reporting?
I. Data architecture and infrastructure deals with the design, building and
maintenance of an IT infrastructure that supports risk data aggregation and risk
reporting capabilities during both normal and crisis periods.
II. The risk data aggregation process should be adaptable in the sense that risk data
can be generated on an ad hoc and on-demand basis if necessary.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
6. Which of the following statements are not requirements of Principle 2 – data

architecture and infrastructure, relating to data aggregation and reporting?
A. Be part of the bank’s planning process and be subject to a business impact analysis.
B. Be consistent across the entire banking group. This will include integration of data
classification and architecture across all of the bank’s operations.
C. Have adequate controls in place throughout the process from design to end
product.
D. Risk data aggregation and risk reporting should be accurate and reliable.
7. An analyst makes the following comment when discussing data aggregation and
reporting – ‘All material risk data should be captured and aggregated across all
banking operations. Data must be available per business unit, asset type, legal entity
and any other grouping that is relevant to the specific risk in question.’
Which of the following principles regarding data aggregation is he most likely
defining?
A. Principle 4: Completeness.
B. Principle 5: Timeliness.
C. Principle 2: Data architecture and infrastructure.
D. Principle 6: Adaptability.
8. Which of the following statements are not requirements of Principle 6 – adaptability,

A. The risk data aggregation process should be flexible.
B. The risk data aggregation process should be customizable.
C. The risk data aggregation process should be able to incorporate regulatory changes.

D. Risk data aggregation and risk reporting should be able to be generated quickly in
times of stress for all critical risks.
9. An analyst makes the following comment when discussing data aggregation and
reporting – ‘Risk data aggregation and risk reporting should be accurate and should
precisely convey the risk information. Reports should be reconciled and validated.
Which of the following principles regarding data aggregation is he most likely
defining?
A. Principle 4: Completeness.
B. Principle 5: Timeliness.
C. Principle 7: Accuracy
D. Principle 8: Comprehensiveness
10. Which of the following statements are not requirements of Principle 10 – frequency,
A. The frequency of the reports will be determined by the needs of the users,
B. The frequency of the reports will be determined by the type of risk.
C. The frequency of the reports will be determined by the purpose of the report.
D. The frequency of the reports will increase in normal times.
11. Which of the following is not a component of Model risk?

A. Input risk
B. Estimation risk
C. Output risk
D. Hedging risk
12. In characterizing various dimensions of a bank data, the Basel Committee has
suggested several principles to promote strong and effective risk data aggregation
capabilities. Which statement correctly describes a recommendation that the bank
should follow in accordance with the given principle?
A. The integrity principle recommends that data aggregation should be completely
automated without any manual intervention.
B. The completeness principle recommends that a financial institution should capture
data on its entire universe of material risk exposures
C. The adaptability principle recommends that a bank should frequently update its
risk reporting systems to incorporate changes in best practices.
D. The accuracy principle recommends that the risk data be reconciled with
management’s estimates of risk exposure prior to aggregation.

SOLUTIONS
1. D
As per the Basel Committee on banking supervision, risk data aggregation is the:
 defining,
 gathering, and
 processing
of risk data, in such a manner that the bank can use the data collected to measure its
current performance against its risk tolerance level.
2. C
Benefits of having effective risk data aggregation and reporting
 Financial Health. In times of market stress, the bank will be able to determine paths
to financial health by working with the aggregated risk data.
 Improved resolvability. In the event of a bank issue, the regulator can use the risk
aggregated data to assist the bank. The more important the bank is to the financial
system (called a G-SIB – globally systemically important bank), the more important
risk aggregated data becomes.
3. D
Principle 1 – requirements
 The structure of the bank, its geographical location and legal form should not affect
risk data aggregation policies.
 Management involvement and priority. Management must be involved and give
priority to risk data aggregation policies. This will include devoting financial and
human resources to this initiative.
 The board of directors must be aware and involved in the risk data aggregation
policies of the bank.
Risk data aggregation and risk reporting should be consistent across the entire banking
group belongs to principle 2.
4. A
Risk data aggregation and risk reporting should be:
 Reviewed and approved by independent, and qualified, information technology
(IT) and risk professionals.
Taken into account when new initiatives such as new product development,
acquisitions/sales are undertaken.

5. A
Principle 2: Data architecture and infrastructure
Principle 2, deals with the design, building and maintenance of an IT infrastructure that
supports risk data aggregation and risk reporting capabilities during both normal and
crisis periods.
6. D
 Be part of the bank’s planning process and be subject to a business impact analysis.
 Be consistent across the entire banking group. This will include integration of data
classification and architecture across all of the bank’s operations.
 Have adequate controls in place throughout the process from design to end
product.
7. A
Principle 4: Completeness
All material risk data should be captured and aggregated across all banking operations.
Data must be available per business unit, asset type, legal entity and any other
grouping that is relevant to the specific risk in question. The reason for this is to be able
to identify and report on risk exposures, risk concentrations and any emerging risks.
8. D
Principle 6 requirements:
 The risk data aggregation process should be flexible.
 The risk data aggregation process should be customizable. This will enable users to
investigate the detailed risks more deeply.
 The risk data aggregation process should be flexible enough to include external
banking factors and data that may have an impact on the bank.
 The risk data aggregation process should be able to incorporate regulatory changes.
9. C
Principle 7: Accuracy
Risk data aggregation and risk reporting should be accurate and should precisely
convey the risk information. Reports should be reconciled and validated.
10. D
Principle 10: Frequency
Risk data aggregation and risk reporting frequency and report distribution should be
set by senior management and the board. The frequency should be determined by the
needs of the users and nature of the reporting. The frequency of reporting should
increase in times of stress.

Principle 10 requirements:
 The frequency of the reports will be determined by the needs of the users, the type
of risk, and the purpose of the report.
11. C
Model risk is composed of four elements:
 Input risk
 Estimation risk
 Valuation risk
 Hedging risk
12. B
The completeness principle recommends that a bank be able to capture and aggregate
all data on the material risk to which it is exposed across the organization. This will
allow it to identify and report risk exposures, concentrations, and set exposure limits.

Topic - 8
Enterprise Risk Management and Future Trends
Learning Objectives
Enterprise Risk Management and Future Trends
LO 8 a: Describe Enterprise Risk Management (ERM) and compare an ERM program with a
traditional silo- based risk management program.
LO 8 b: Compare the benefits and costs of ERM and describe the motivations for a firm to
adopt an ERM initiative.
LO 8 c: Explain best practices for the governance and implementation of an ERM program.
LO 8 d: Describe important dimensions of an ERM program and relate ERM to strategic
planning.
LO 8 e: Describe risk culture, explain characteristics of a strong corporate risk culture, and
describe challenges to the establishment of a strong risk culture at a firm.
LO 8 f: Explain the role of scenario analysis in the implementation of an ERM program and
describe its advantages and disadvantages.
LO 8 g: Explain the use of scenario analysis in stress testing programs and in capital
planning.

QUESTIONS
1. Which of the following statements regarding enterprise risk management is not correct?
A. The downside of the traditional approach is that it ignores the fact that risks are
dynamic and interdependent The bod must ensure that the firm complies with all
legal and regulatory requirements.
B. Enterprise risk management assumes that risks are interdependent.
C. Enterprise risk management may end up incurring unnecessary costs.
D. The traditional approach to risk focuses on individual risks.
2. Which of the following dimensions is not an ERM practice?

A. Key exposures.
B. Targets.
C. Structure.
D. Metrics.
3. Which of the following statements regarding enterprise risk management is not correct?
A. Traditional risk management focuses on risks per individual unit.
B. Traditional risk management ignores the interdependency among firm risks.
C. Traditional risk management focuses on the interdependency among firm risks.
D. The ERM approach is a more modern approach to risk management.
4. Which of the following is not a benefit of ERM?

A. Organizational effectiveness
B. Risk reporting
C. Business performance
D. Leadership benefits
5. An operation that is overexposed to a certain supplier, is experiencing which type of

concentration?
A. Geographical concentration.
B. Industry concentration.
C. Product concentration.
D. Supplier concentration.
6. The Financial Stability Board (FSB) has identified four key risk culture indicators.
Which of the following is not one of the four key risk culture indicators?
A. Openness.
B. Effective communication.
C. Incentives.

D. Top management tone.
7. There are five issues that stand in the way of a robust risk culture within a firm. One of
the issues is described as follows, “A common risk language needs to be created by
defining risk management terms and concepts.” This issue is best described by which
of the following?
A. Risk indicator or risk lever.
B. Education for all.
C. Time and space.
D. Culture cycle.
8. The CEO of the bank, Mr Ilovepower wishes to appoint himself as the CRO of the bank.
The CFO of the bank tells the CEO that such an appointment is not allowed. Taking
into account the above discussion, which of the following statements is correct?
A. The CEO is allowed to appoint himself as the CRO.
B. The CEO is not allowed to appoint himself as the CRO.
C. The CFO should be appointed as the CRO.
D. Neither the CEO or CFO are allowed to be appointed as CRO.
9. The process of changing one parameter of a model to assess how sensitive the model is
to changes in that particular parameter is called___________.
A. Sensitivity analysis.
B. Scenario analysis.
C. Stress testing.
D. CCAR.
10. Which of the following key improvements driven by CCAR Is not correct?
A. CCAR macroeconomic scenarios are calculated at a point in time.
B. The scenarios interlink several factors and risks.
C. The risk variables that are used are not held static.
D. The model allows for the banks to plan their capital as the various scenarios unfold.
11. A board of directors is evaluating the implementation of a new ERM program at an

asset management company. Which statement below is consistent across the various
current definitions of an ERM program and most appropriate to be included in the
company’s ERM definition and goals?
A. The ERM program should reduce costs by transferring or insuring most of the
company’s major risk exposures.
B. The major goal of the new E program should be to reduce earnings volatility.

C. The ERM program should be managed separately from the operational side of the
company
D. The ERM program should provide an integrated strategy to manage risk across the
company as a whole.

SOLUTIONS
1. C
The downside of the traditional approach is that it ignores the fact that risks are
dynamic and interdependent. An example of this is that certain risks may offset each
other and in fact act as a hedge. By ignoring this interdependency a firm may well
hedge both risks thus incurring unnecessary costs. In addition, if each business unit
looks after its own risk, they may all be using different systems and methodologies for
measuring and managing risk. This will make decision making by top management
difficult and fragmented.
2. A
ERM practices can be described across five dimensions:
1. Targets.
2. Structure.
3. Metrics.
4. Strategies.
5. Culture.
3. C
Traditional risk management involved the firm assessing each of its risks (including
market, credit, operational risk etc.) as separate and independent risks without
consideration of the interaction that the risks may have with one another. In most cases
the business unit responsible for the risk looked after the specific risk. For example,
price risk will be looked after by the trading division.
4. D
 Organizational effectiveness
 Risk reporting
 Business performance
5. D
 Geographical and industry concentrations. An example is when operations are
overexposed to a certain economy or industry.
 Product concentrations. An example is when a derivative product may be priced
differently across different divisions.
 Supplier concentrations. An example is when the firm is too dependent on a
specific supplier.

6. A
The Financial Stability Board (FSB) has identified the following key factors:
 Accountability.
 Effective communication.
 Incentives.
 Top management tone.
7. B
The following five issues stand in the way of a robust risk culture within a firm:
 Risk indicator or risk lever? In an attempt to create and identify risk culture
indicators, care needs to be taken to ensure that these indicators are not used as
levers to change behavior.
 Education for all? A common risk language needs to be created by defining risk
management terms and concepts.
 Time and space. Cultural attitudes must be present in all parts of the firm and must
adapt over time to various changes.
 Culture cycle. The true risk culture of a firm often only becomes visible during
times of crisis. take care to ensure that the risk culture is robust in both times of
calm and crisis.
 The data curse. In the future, there will be massive amounts of risk culture data
which can be combined to spot risk.
8. A
The CRO role may be fulfilled by the CEO or CFO but it is often better to hire a
separate, experienced and independent period for this position.
9. A
Sensitivity analysis is the process of changing one parameter of a model to assess how
sensitive the model is to changes in that particular parameter.
Scenario analysis provides an estimate as to what a change in a set of risk factors will
have on the value of the portfolio.
A stress test can be used to examine the effect that extreme negative stress events will
have on the portfolio and is closely related to scenario analysis.
10. A
The following five key improvements were driven by CCAR:
 CCAR macroeconomic scenarios are calculated over several quarters and not only
at a point in time.
 The scenarios interlink several factors and risks.
 The risk variables that are used are not held static.

 The model allows for the banks to plan their capital as the various scenarios unfold.
 By applying the same scenarios to all market participants, the regulators are able to
compare bank risk exposures and assess systemic effects.
11. D
An effective ERM program should be integrated at several levels, across the company
as a whole and integrated with the operational side of the company.

Topic - 9
Learning From Financial Disasters
Learning Objectives
Financial Disasters
LO 9 a: Analyze the key factors that led to and derive the lessons learned from case studies
involving the following risk factors:
 Interest rate risk, including the 1980s savings and loan crisis in the US.
 Funding liquidity risk, including Lehman Brothers, Continental Illinois, and Northern
Rock.
 Implementing hedging strategies, including the Metallgesellschaft case.
 Model risk, including the Niederhoffer case, Long Term Capital Management, and the
London Whale case.
 Rogue trading and misleading reporting, including the Barings case.
 Financial engineering and complex derivatives, including Bankers Trust, the Orange
County case, and Sachsen Landesbank.
 Reputational risk, including the Volkswagen case.
 Corporate governance, including the Enron case.
 Cyber risk, including the SWIFT case.

QUESTIONS
1. Which of the following factors was a key contributor towards the failure of the S&L
industry in the 1980’s?
A. An upward sloping yield curve.
B. A decrease in inflation.
C. Regulation Q, which did not allow banks to pay interest on demand deposits.
D. The Federal Reserve increased short-term interest rates.
2. Which of the following risk factors was the key risk that resulted in the failure of
Lehman Brothers?
A. Interest rate risk.
B. Funding liquidity risk.
C. Market liquidity risk.
D. Model risk
3. With reference to the Barings bank financial disaster, which of the following statements
is most likely incorrect?
A. The reporting structure at Barings was ambiguous and convoluted.
B. Management did not fully understand how the money was being made.
C. Leeson was able to circumvent many of the risk controls in place because of the lack
of management oversight.
D. Trading and settlement responsibilities may be handled by the same person.
4. A key weakness of ________ lending model was that they relied primarily on federal
funding and certificates of deposit (floating rate debt) and very little on core retail
deposits. Which company is being referred to?
A. Northern Rock.
B. Continental Illinois Bank.
C. Orange County.
D. JP Morgan.
5. In an attempt to diversify their funding strategy, what type of diversification did

Northern make use of?
A. Time diversification.
B. Investment diversification.
C. Geographical diversification.
D. CAPM.

6. Which of the following option trading strategies was used by Niederh offer?
A. Long call
B. Short call
C. Long put
D. Short put
7. With reference to the Long-Term Capital Management (LTCM) financial disaster,

which of the following statements regarding LTCM’s massive amount of leverage is
correct?
I. Margin requirements were often waived based on the stellar reputations of the
partners.
II. Margin requirements were often waived as a result of the nature of their trades.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. With reference to the Metallgesellschaft financial disaster, which of the following risks
most likely caused their downfall?
A. Market risk
B. Operational risk
C. Reputational risk
D. Funding liquidity risk
9. With reference to the Bankers Trust financial disaster, which of the following risks most
likely caused their downfall?
A. Market risk
B. Operational risk
D. Funding liquidity risk
10. With reference to the Enron financial disaster, which of the following risks most likely
caused their downfall?
A. Market risk.
B. Operational risk.
C. Reputational risk.
D. Corporate governance risk.

11. James Umaga, FRM, is giving a class dealing with the financial disaster that was called
the London Whale. He makes the following two statements:
i. In order to reduce the risk of the bank, the CIO of JPM took long positions in
synthetic credit derivatives to offset the short positions in their synthetic credit
derivatives portfolio.
ii. Being aware that he had breached his VaR limits, the CIO set new VaR limits, that
reduced the VaR calculation by 50%.
Which of the following statements are correct?
A. Statement i. and ii are incorrect.
B. Statement i. and ii are correct.
C. Statement i. only.
D. Statement ii. only.
12. Which of the following companies made excessive use of leverage via the use of repos?
A. LTCM.
B. Bankers Trust.
C. Volkswagen.
D. Orange County.
13. Which of the following companies was hardest hit by the 200-2009 subprime crisis?
A. LTCM.
B. Barings Bank.
C. Volkswagen.
D. Sachsen Landesbank.
14. The Volkswagen emissions scandal is best described by which of the following risks?
A. Market risk.
15. The SWIFT case is an example of which type of risk?

A. Cyber risk.
16. The collapse of Long Term Capital Management (LTCM) is a classic risk management
case study. Which of the following statements about risk management at LTCM is
correct?

A. LTCM had no active risk reporting.

B. At LTCM, stress testing became a risk management department exercise that had
little influence on the firm’s strategy.
C. LTCM’s use of high leverage is evidence of poor risk management.
D. LTCM failed to account properly for the illiquidity of its largest position in its risk
calculations.

SOLUTIONS
1. D
During the 1970’s, as inflation rose, the Federal Reserve increased short-term interest
rates. This increase in rates increased the funding costs for S&Ls, and effectively wiped
out their interest rate spread, and hence their profit margin.
2. B
Funding liquidity risk.
3. D
The reporting structure was ambiguous and convoluted.
Management did not fully understand how the money was being made.
Leeson was able to circumvent many of the risk controls in place because of the lack of
management oversight.
Trading and settlement responsibilities must be handled by different people.
4. B
A key weakness of Continentals lending model was that they relied primarily on
federal funding and certificates of deposit (floating rate debt) and very little on core
retail deposits.
5. C
In an attempt to diversify their funding strategy, Northern diversified their funding
across geographical markets.
6. D
Victor Niederhoffer was a trader that ran a hedge fund. One of his strategies was to
write uncovered or naked options on deep out-of-the-money put options of the S&P
500.
7. A
The reason that this amount of leverage was allowed is that many financial institutions
waived margin requirements based on the stellar reputations of the partners.
8. D
The futures contracts needed payment (mark-to-market and margin calls) immediately.
The forward contract with the customer would only be paid at the end of the contract.
Hence the cash flow mismatch and an increase in funding liquidity risk.

9. C
Greater caution must be exercised when dealing with client communication as this can
cause significant reputational damage down the line.
10. D
Corporate governance risk.
11. B
In order to reduce the risk of the bank, the CIO of JPM took long positions in synthetic
credit derivatives to offset the short positions in their synthetic credit derivatives
portfolio.
Being aware that he had breached his VaR limits, the CIO set new VaR limits, that
reduced the VaR calculation by 50%.
12. D
Orange County made use of repos and had borrowed $12.9 billion in the repo market.
13. D
When the subprime crisis hit in 2007 and the value of the investments declined sharply,
Sachsen had to be sold to another German state bank.
14. C
Reputational risk.
15. A
Cyber risk.
16. D
A major contributing factor to the collapse of LTCM is that it did not account properly
for the illiquidity of its largest positions in its risk calculations. LTCM received
valuation reports from dealers who only knew a small portion of LTCM’s total position
in particular securities, therefore understanding LTCM’s true liquidity risk.
When the markets became unsettled due to the Russian debt crisis in August 1988 and
a separate firm decided to liquidate large positions which were similar to many at
LTCM, the illiquidity of LTCM’s positions forced it into a situation where it was
reluctant to sell and create an even more dramatic adverse market impact even as its
equity was rapidly deteriorating.
To avert a full collapse, LTCM’s creditors finally stepped in to provide $3.65 billion in
additional liquidity to allow LTCM to continue holding its positions through the
turbulent market conditions in the fall of 1998. However, as a result, investors and
managers in LTCM other that the creditors themselves lost almost all their investment
in the fund.

Topic - 10
Anatomy of the Great Financial Crisis of 2007-2009
Learning Objectives
Anatomy of the Great Financial Crisis of 2007-2009
LO 10 a: Describe the historical background and provide an overview of the 2007 — 2009
financial crisis.
LO 10 b: Describe the build-up to the financial crisis and the factors that played an
important role.
LO 10 c: Explain the role of subprime mortgages and collateralized debt obligations (CDOs)
in the crisis.
LO 10 d: Compare the roles of different types of institutions in the financial crisis, including
banks, financial intermediaries, mortgage brokers and lenders, and rating agencies.
LO 10 e: Describe trends in the short-term wholesale funding markets that contributed to
the financial crisis, including their impact on systemic risk.
LO 10 f: Describe responses taken by central banks in response to the crisis.

QUESTIONS
1. With reference to the 2007-2009 financial crisis, which of the following statements are
most likely correct?
I. Prior to the 2007-2009 financial crises, the largest portion of the market’s
participants were the institutional investors.
II. The cash holdings invested by the institutional investors were too large to be
insured by a regulated banking institution.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
2. When assessing the triggers and vulnerabilities of the 2007-2009 financial crisis, which
of the following statements are not correct?
A. Subprime mortgages were a major trigger of the financial crisis.
B. As housing prices started to fall in 2007, the subprime market started to collapse
C. When it was time to rollover the ABCP, the lenders were not willing to finance the
reissue.
D. Towards the end of September 2008, it was common for repos to trade at a haircut of
approximately 50%
3. Assume the following details:

A 5%, 10-year bond with a par value of $100,000.
The market value of the bond is $98,000.
The parties agree to sell the bond at $95,000 and to repurchase the bond 60 days later
for $96,000.
The value of the repo haircut is:
A. 1.053%
B. 3.061%
C. 2.000%
D. 5.000%
4. Lehman Brothers filed for bankruptcy in August 2008, which of the following is not a
consequence of the Lehman failure?
A. Reputational damage to the banks.
B. Systemic risk to the financial sector.
C. A major run on the banks.
D. The failure of AIG.

5. When reviewing the historical background leading to the recent financial crisis, which
of the following does not normally precede a financial crisis?
A. A large increase in housing prices.
B. A large increase in real growth rates in the equity market.
C. A large increase in GDP per capita.
D. A decrease in a public debt.
6. The funding structure used in securitization by the structured investment vehicle (SIV)
was?
A. Short-term in nature.
B. Medium-term in nature.
C. Long-term in nature.
D. Mezzanine finance.
7. When dealing with a securitized model, which of the following statements are not
correct?
A. In terms of this securitized model, loans were originated, pooled together and the
divided up and sold as securities.
B. The effect of securitization was that the default risk was transferred from the
originating bank to the investor of the securities.
C. Securitization acted as a disincentive for the originating bank to follow up and
collect their loans.
D. The result of securitization is that lending standards from the banks Improved.
8. The International Monetary Fund (IMF) assessed developed countries responses to the
financial crisis. Which of the following actions had the greatest impact?
A. Interest rate change.
B. Liquidity support.
C. Recapitalization.
D. Liability guarantees.
9. The International Monetary Fund (IMF) assessed developed countries responses to the
financial crisis. Which of the following statements are most likely correct with respect
to interest rate changes?
I. They found that there an impact in the short term based on the economic stress
index (ESI).
II. They found that there was little impact in the short term based on the financial
stress index (FSI).
A. I only.
B. II only.

C. Both I and II.

D. Neither I or II.
10. When assessing the global effects of the financial crisis on corporate lending, which of
the following statements is not correct:
A. Syndicated loans dropped significantly over the crisis period.
B. Commercial and industrial lending from the regulated banks increased over the
crisis period.
C. Commercial and industrial lending from the regulated banks decreased over the
crisis period.
D. Lending on the whole decreased over the crisis period.

SOLUTIONS
1. C
Prior to the 2007-2008 financial crises, the largest portion of the market’s participants
were the institutional investors (mutual funds, nonfinancial firms, state governments)
that invested principally with the shadow banks.
The cash holdings invested by the institutions were too large to be insured by a
regulated banking institution and as such they turned to the shadow banking system.
2. D
Subprime mortgages were a major trigger of the financial crisis.
As housing prices started to fall in 2007, the subprime market started to collapse, with
several lenders failing. As housing prices fell, homeowners started to default on their
mortgages, which dropped the prices of the asset-backed commercial paper.
A further issue was that when it was time to rollover the ABCP, the lenders were not
willing to finance the reissue. Thus, providing a liquidity squeeze. As the prices of the
ABCP fell, the investors that held ABCP via the shadow banking system started to
withdraw their investments causing a run on the banks. Towards the end of September
2008, it was common for repos to trade at a haircut of approximately 25%.
3. B
4. D
The failure of Lehman resulted in major reputational damage and systemic risk to the
financial sector, which soon spread to all sectors of the market. There was a major run
on the banks as well as a large resultant liquidity squeeze.
AIG did not fail but was rather bailed out by the Federal Reserve.
5. A
A further study showed a large increase in housing prices precedes a financial crisis.
Other factors that preceded a banking crisis included real growth rates in the equity

market, growth in GDP per capita, and growth a public debt. All of these factors were
present just before the 2007-2008 financial crisis.
6. A
Funds were raised via short-term commercial paper. The funds were invested via a
structured investment vehicle (SIV) that specialized in investing in these structured
products.
7. D
In terms of this securitized model, loans were originated, pooled together and the
divided up and sold as securities. The effect of this model was that the default risk was
transferred from the originating bank to the investor of the securities.
Securitization acted as a disincentive for the originating bank to follow up and collect
their loans. As a result, banks were more interested in originating loans than collecting
them – this resulted in lending standards from the banks declining.
8. C
Recapitalization of the banks had a positive effect. This was evident by CDS spreads on
the banks getting smaller.
9. B
Interest rate change
The central banks of the developed countries studied the impact of rate cuts.
They found that there was no impact in the short term based on the economic stress
index (ESI). The ESI is a grouping of business and consumers confidence measures,
stock prices of nonfinancial firms, and credit spreads. They found that there was little
impact in the short term based on the financial stress index (FSI). The FSI is a grouping
of stock prices, bank credit, and spreads.
10. C
One study (dealing with lending to corporates) found that syndicated loans (the
majority of loans made to large corporates are called syndicated loans irrespective of
the funding institution), dropped significantly over the period (2007 to 2009). However,
commercial and industrial lending from the regulated banks increased. A possible
reason for this was that the corporates were merely accessing their credit lines that
were granted to them before the crisis.

Topic - 11
GARP Code of Conduct
Learning Objectives
GARP Code of Conduct
LO 11 a: Describe the responsibility of each GARP Member with respect to professional

integrity, ethical conduct, conflicts of interest, confidentiality of information, and adherence
to generally accepted practices in risk management;
LO 11 b: Describe the potential consequences of violating the GARP Code of Conduct;

QUESTIONS
1. Henry Carver, FRM, directs a large portion of his trading commission to Broker A.
Broker A, wishing to thank Henry pays for an overseas trip for him with luxury
accommodation and spending money. Henry does not disclose the trip to his
supervisor. Which of the following statements is correct?
A. Carver has violated standard 1.2. – Independence and objectivity.
B. Carver has violated standard 1.5. – Dishonesty and deception.
C. Carver has not violated any standards.
D. Carver has violated standard 1.7. – Ethical behavior and customs.
2. James Keeper, FRM, a trader for a hedge fund, has recently been shorting large
amounts of Looser Inc. Keeper did not disclose these trades to his clients. The hedge
fund is a short only fund.Which of the following statements is correct?
A. Keeper has violated standard 1.2. – Independence and objectivity.
B. Keeper has violated standard 1.5. – Dishonesty and deception.
C. Keeper has not violated any standards.
D. Keeper has violated standard 5.1 – Diligence of work performed.
3. Mohamed Wajhi,, FRM, is an investment advisor. One of his big clients tells him that he
is planning to give away $1bn to an educational institution. Mohamed calls his friend at
Seriouseducation and tells her to call his client and ask for a large donation.
A. Wajhi has violated standard 1.2. – Independence and objectivity.
B. Wajhi has violated standard 1.5. – Dishonesty and deception.
C. Wajhi has violated standard 3.1 – Disclosure of confidential information.
D. Wajhi has not violated any standards.
4. Jacqui Jones, FRM, used her social media platforms to communicate with clients.
Jacqui’s communications are in conflict with the local regulators’ guidelines for
communication.
A. Jones has violated standard 4.1. – Complying with all applicable laws.
B. Jones has violated standard 1.5. – Dishonesty and deception.
C. Jones has violated standard 3.1 – Disclosure of confidential information.
D. Jones has not violated any standards.

5. Jaine Macdonald, FRM, wants to hire a submanager to add derivatives trading to his
business. He puts out a request for proposal and hires the cheapest manager. He does
so to avoid any unnecessary costs to his bottom line.
A. Macdonald has violated standard 4.1. – Complying with all applicable laws.
B. Macdonald has violated standard 1.5. – Dishonesty and deception.
C. Macdonald has violated standard 5.1 – Diligence of work performed.
D. Macdonald has not violated any standards.
6. Alexandra Himinez’s firm invests in long-term, secure assets for their client base. In an
attempt to motivate the staff they offer rewards for excellent quarterly performance.
Based on this incentive Alexandra starts to invest in high growth stocks in order to
boost the performance of her clients.
A. Himinez has violated standard 4.1. – Complying with all applicable laws.
B. Himinez has violated standard 1.5. – Dishonesty and deception.
C. Himinez has violated standard 4.3 – Appropriate and suitable risk management
services and advice.
D. Himinez has not violated any standards.
7. Pete Has, FRM, is an analyst that promotes the stocks of external companies. He writes
research reports for them based on in depth analysis that he performs on these
companies. He receives compensation from these companies when their stocks are sold
to investors. Has posts on his website that all the stocks covered are a strong buy and
are likely to increase in value. He does not disclose the relationship that he has with the
companies and that he is being paid by them.
A. Has has violated standard 4.1. – Complying with all applicable laws.
B. Has has violated standard 1.4. – Misrepresenting details relating to analysis,
recommendations and actions.
C. Has has violated standard 4.3 – Appropriate and suitable risk management services
and advice.
D. Has has not violated any standards.
8. Francois Boshoff, FRM, has been covering a construction company for many years. He
highly recommends their common stock. His son has just become the CEO of the
construction company and taken up stock to the value of $4m. Francois is in the process
of writing a follow-up report on the stock and does not plan to disclose his relationship
with the CEO.


A. Boshoff has violated standard 4.1. – Complying with all applicable laws.
B. Boshoff has violated standard 2.1 - Disclosure of conflicts.
C. Boshoff has violated standard 4.3 – Appropriate and suitable risk management
services and advice.
D. Boshoff has not violated any standards.
9. Which of the following statement regarding the GARP Code of Conduct is not correct?
A. Every GARP Member should know and abide by the Code of Conduct.
B. Local laws and regulations may also impose obligations on GARP Members.
C. Where local requirements conflict with the Code, such requirements will have
precedence.
D. Members have ethical responsibilities and can out-source or delegate those
responsibilities to others.
10. Which of the following statements regarding punishment for violations of the GARP
Code of Conduct is not correct?
A. Violations of this Code by may result in, among other things, the temporary
suspension or permanent removal of the GARP Member from GARP's Membership
roles.
B. Violations of this Code by may result in temporarily removing from the violator the
right to use or refer to having earned the FRM designation
C. Violations of this Code by may result in permanently removing from the violator
the right to use or refer to having earned the FRM designation
D. No formal determination is required to determine if a violation of the Code has
occurred.
11. Which of the following is a potential consequence of violating the GARP Code of
Conduct once a formal determination is made that such a violation has occurred?
A. Formal notification to the GARP Member’s employer of such a violation
B. Suspension of the GARP Member’s right to work in the risk management profession
C. Removal of the GARP Member’s right to use the FRM designation
D. Required participation in ethical training

SOLUTIONS
1. A
By accepting an overseas trip with luxury accommodation and spending money –
Carver has violated standard 1.2. – Independence and objectivity.
2. C
Keeper has not violated any standards as he was performing his job in the ordinary
course of business.
No communication to clients was necessary as the fund is a short only fund they should
be aware of the fund’s strategy and practices.
3. C
Wajhi has violated standard 3.1 – Disclosure of confidential information. He is not
allowed to give over any confidential information that belongs to his clients.
Wajhi received the information within the scope of the confidential relationship with
his client.
4. A
Jones has violated standard 4.1. – Complying with all applicable laws.
She must be aware of all regulations that she is subject to as well as the ever changing
landscape of social media communication and the rules and regulations that apply to
these forms of communication.
5. C
Macdonald has violated 5.1 – Diligence of work performed. He did not do sufficient
research to back up his view. He was not diligent and reasonable in his efforts to ensure
that the third- party research was sound. He merely based his view on the lowest price.
6. C
Himinez has violated standard 4.3 – Appropriate and suitable risk management
services and advice by investing in high growth stocks for her clients as this goes
against her investment mandate.
7. B
Has has violated standard 1.4. – Misrepresenting details relating to analysis,
recommendations and actions – as his website is misleading to investors by not
disclosing the relationship that he has with the companies and that he is being paid by
them.

8. B
Boshoff will have violated standard 2.1 - Disclosure of conflicts if he does not mention
his son’s stock ownership in the report.
9. D
Every GARP Member should know and abide by this Code. Local laws and regulations
may also impose obligations on GARP Members. Where local requirements conflict
with the Code, such requirements will have precedence.
Shall have ethical responsibilities and cannot out-source or delegate those
responsibilities to others.
10. D
Violations of this Code by may result in, among other things, the temporary suspension
or permanent removal of the GARP Member from GARP's Membership roles, and may
also include temporarily or permanently removing from the violator the right to use or
refer to having earned the FRM designation or any other GARP granted designation,
following a formal determination that such a violation has occurred.
11. C
According to the GARP Code of Conduct, violation(s) of this Code may result in,
among other things, the temporary suspension or permanent removal of the GARP
Member from GARP’s Membership roles, and may also include temporarily or
permanently removing from the violator the right to use or refer to having earned the
FRM designation or any other GARP granted designation, following a formal
determination that such a violation has occurred.

FRM PART – I – QUANTITATIVE ANALYSIS
Topic - 12
Fundamentals of Probability
Learning Objectives
Fundamentals of Probability
LO 12 a: Describe an event and an event space.

LO 12 b: Describe independent events and mutually exclusive events.
LO 12 c: Explain the difference between independent events and conditionally independent events.
LO 12 d: Calculate the probability of an event for a discrete probability function.
LO 12 e: Define and calculate a conditional probability.
LO 12 f: Distinguish between conditional and unconditional probabilities.
LO 12 g: Explain and apply Bayes’ rule.

QUESTIONS
1. Which of the following statements regarding properties of probabilities are correct?

1. Probabilities always lie between 0 and 1 inclusive.
2. Probabilities always add up to 1.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
2. Which of the following statements regarding probability concepts is least likely correct?
A. The outcomes of a discrete random variable can be counted.
B. The possible values of a individual continuous random variable has a zero probability
associated with it.
C. Mutually exclusive events are if the events have no outcomes in common
D. The possible values under consideration for a continuous random variable are finite.
3. Consider the random variable X = outcome when a fair die is rolled. The probability
for the following probability function: P(2 ≤ X<6) is equal to:
1
A.
6
4
B.
6
3
C.
6
5
D.
6
4. Which of the following statements regarding the formula for A and B independent events are
correct?
1. P(AB) = P(A) × P(B)
2. P(AB) = P(B) + P(A)
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
5. Consider a deck of playing cards, the probability of randomly selecting either an ace or a heart
= P(Ace or Heart) is equal to:
16
A.
52
17
B.
52

1
C.
52
13
D.
52
6. Consider the following probability matrix:
What is the joint probability of an average market and declining stock prices?
A. 25%
B. 10%
C. 15%
D. 40%
7. Which of the following statements regarding the conditional and unconditional probabilities
are correct?
1. An unconditional probability is a form of probability that is concerned with a specific event
only.
2. An unconditional probability is form of probability takes into account the fact that some
other event has occurred which is likely to affect the chance of our event occurring.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. Consider a deck of playing cards, the probability of randomly selecting a card that is both an
ace and a heart = P(Ace and Heart) is equal to:
16
A.
52
17
B.
52
1
C.
52
13
D.
52
9. Which of the following statements regarding Bayes’ formula are correct?

I. Bayes’ formula is used when we know that the event whose probability we have
just calculated has occurred, and we wish to evaluate conditional probabilities based on
this fact.

II. Bayes’ formula is used to update our knowledge of a specific event occurring in the
light of new information received, i.e. that an event has occurred.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
10. Which of the following formulas cannot be used to calculate updated probabilities?
11. An analyst has developed a ratio to identify company’s expectation to experience declining PE
multiples over time. Research shows that 55% of firms with declining PE’s have a negative
ratio, while only 25% of firms not experiencing a decline in PE’s have a negative ratio. The
analyst expects that 15% of all publicity traded companies will experience a decline in PE next
year. The analyst randomly selects a company, and its ratio is negative. Based on Bayes’
theorem, what is the probability that the company will experience a PE decline next year.
A. 28.00%
B. 38.97%
C. 8.25%
D. 99.40%
12. Matthew Nganou, FRM, is in the process of analyzing a selection of bond managers. The
following historical data is available:
The star bond managers are expected to outperform the market 80% of the time. The average
bond managers are expected to outperform the market 40% of the time. The probability of a
bond portfolio outperforming the market in any given year is independent of the previous
year’s performance. 30% of managers are considered to be stars and 70% are considered to be
average.
A fund manager that has worked in bonds for 5 years has outperformed the market each and
every year. What is the probability that the manager was a star when they started working as a
bond manager 5 years ago?
A. 30%
B. 70%
C. 0.24%
D. 32.77%

average.
A fund manager that has worked in bonds for 5 years has outperformed to market each and
every year. What is the probability that a star manager will outperform the market for 5 years
in a row?
A. 30%
B. 70%
C. 0.24%
D. 32.77%
average.
A fund manager that has worked in bonds for 5 years has outperformed to market each and
every year. What is the probability that a star manager will be a star manager today (i.e. after 5
years)
A. 30%
B. 6.80%
C. 32.77%
D. 93.27%
15. An insurance company estimates that 40% of policyholders who have only an auto policy will
renew next year, and 70% of policyholders who have only a homeowner policy will renew next
year. The company estimates that 80% of policyholders who have both an auto and a
homeowner policy will renew at least one of those policies next year. Company records show
that 70% of policyholders have an auto and a homeowner policy. Using the company’s
estimates, what is the percentage of policyholders that will renew at least one policy next year?
A. 29%
B. 41%
C. 53%
D. 57%

SOLUTIONS
1. C
Properties of probabilities
1. Probabilities always lie between 0 and 1 inclusive. This is a very important point to
remember.
2. Probabilities always add up to 1.
2. D
Discrete random variable – This is a random variable whose possible values can be listed, and
each value has some positive probability associated with it. The outcomes can be counted.
Continuous random variable – This is a random variable whose possible values cannot
be listed, as they are too numerous. There are normally many decimal places involved.
The possible values under consideration are infinite, and, as you will see later, each
individual value has zero probability associated with it. The outcomes can be measured.
Mutually exclusive – Two (or sometimes more) events are defined as being mutually exclusive
if the events have no outcomes in common.
3. B
X can take on values 1, 2, 3, 4, 5 and 6, and because the die is fair, each outcome has an equal
1
probability of occurring. This is an example of a discrete uniform random variable.
6
Calculating probabilities for such a random variable is simple.
Note that 2 is included because of the equal sign, but 6 is not.
4. A
This formula for A and B independent events is as follows:
P(AB) = P(A) × P(B) or alternatively P(AB) = P(B) × P(A)
The addition rule (statement 2) is concerned with the probability that at least one out of two
events occurs. This means that one OR both of the events can occur.
5. A
P(Ace or Heart) = P(A or B).
P(A or B) = P(A) + P(B) – P(AB)
This means that the chance of drawing a card at random from a pack of cards and
16 4
getting a card, which is either an Ace or a Heart or both is or .
52 13

6. B
7. C
Unconditional probability – This form of probability is concerned with a specific event only,
and does not take into account other events, which might occur simultaneously.
Conditional probability – This form of probability takes into account the fact that some other
event has occurred which is likely to affect the chance of our event occurring.
8. C
9. C
Bayes’ formula is used when we know that the event whose probability we have just calculated
has occurred, and we wish to evaluate conditional probabilities based on this fact.
Effectively, we are using Bayes’ formula to update our knowledge of a specific event occurring
in the light of new information received, i.e. that an event has occurred.
10. D
BAYES FORMULA:

11. A
X1 – PE will decline can be defined as: P(BX1) – ratio is negative when PE declines.
X2 – PE will go up can be defined as: P(BX2) – ratio is negative when PE goes up.
We are looking for the probability that PE will decline given a negative ratio.
Bayes’ theorem can be applied as follows:
12. A
Let us define the probabilities:
P of being a star = P(s) = 0.30
P of being average = P(a) = 0.70
Based on this, the unconditional probability that a random manager was a star five years ago is
30%.
13. D
Let us define the probabilities:
P of being a star = P(s) = 0.30
P of being average = P(a) = 0.70
P of outperforming the market = P(o)
In any single year, given that the probabilities are unconditional, the probability that a star will
outperform the market is 70%.
In other words:
P(o | s) = 0.80
To do this for five years in a row =
0.805 = 32.77% or 0.3277.
14. D
In order to work this out we need to use Bayes.
In other words, what is the probability of him being a star given that he has already
outperformed the market (for 5 years).
Step 1:
Let start of with the probability of him outperforming given that he is a star. This is equal to:
P(o | s) = 0.80

To do this for five years in a row =

0.805 = 32.77% or 0.3277
Step 2:
What is the probability that he is a star?
P(s) = 0.30
Step 3:
What is the probability that the manager will outperform =
P(o) = P(o | s) x P(s) + P(o | a) x P(a)
P(o) = 0.805 x 0.3 + 0.405 x 0.7
P(o) = 9.83% + 0.71%
P(o) = 10.54%
Now we can apply Bayes:
15. D
Let: A = event that a policyholder has an auto policy H = event that a policyholder has a
homeowner’s policy Then, based on the information given:

Topic - 13
Random Variables [QA-2]
Learning Objectives
Random Variables
LO 13 a: Describe and distinguish a probability mass function from a cumulative distribution

function, and explain the relationship between these two.
LO 13 b: Understand and apply the concept of a mathematical expectation of a random variable.
LO 13 c: Describe the four common population moments.
LO 13 d: Explain the differences between a probability mass function and a probability density
function.
LO 13 e: Characterize the quantile function and quantile-based estimators.
LO 13 f: Explain the effect of a linear transformation of a random variable on the mean, variance,
standard deviation, skewness, kurtosis, median, and interquartile range.

QUESTIONS
1. Which of the following statements regarding properties of the sample mean are correct?
I. The sample mean is unique.
II. The sample mean the mean calculated by adding up the values in your sample and
dividing by the sample size minus 1.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
2. Consider the following data: 8, 7, 9, 10. What is the median of the data set?
A. 8
B. 7
C. 9.5
D. 8.5
3. Consider the following probability distribution of Revenue for Tradealot:

Revenue probability distribution:
The expected Revenue for Tradealot is:

A. 200
B. 190
C. 300
D. 100
4. Which of the following is not a property of expectations?

A. E[X + Y] ≠ E[X] + E[Y]
B. E[cX ] = cE[X]
C. E[XY] ≠ E[X] x E[Y]
D. E[XY] = E[X] x E[Y]
5. Which of the following statements regarding the PMF is not correct?

A. The PMF, is the probability of a random variable taking on a certain value.
B. The value returned by the PMF must be non-negative.
C. The sum of the values of the random variable must equal one.
D. The PMF is the cumulative or total probability.

6. Consider the returns of the following four different portfolios over the past year: 10%, 30%, 5%
and 15%.
What is the standard deviation of the portfolios returns?
A. 15.0%
B. 87.5%
C. 25.0
D. 9.3%
7. The second central moment – the variance – can be calculated using which of the following
formulas?
8. Which of the following statements are correct when dealing with kurtosis?
I. Kurtosis = the level of symmetry of the data.
II. Zero kurtosis = 3
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
9. Consider the following data set: 0, 1, 1, 1, 997.

Which of the following descriptions best describe this data set?
A. Negatively skewed
B. Positively skewed
C. Mesokurtic
D. Leptokurtic
10. The recent performance of Prudent Fund, with USD 50 million is assets, has been weak and the
institutional sales group is recommending that it be merged with Aggressive Fund, a USD 200
million fund. The returns on the Prudent Fund are normally distributed with a mean of 3% and
a standard deviation of 7%. The returns on Aggressive Fund are normally distributed with a
mean of 7% and a standard deviation of 15%. Senior management has asked an analyst to
estimate the likelihood that returns on the combined portfolio will exceed 26%. Assuming the
returns on the two funds are independent, the analyst’s estimate for the probability that the
returns on the combined fund will exceed 26% is closest to:
A. 1.0%
B. 2.5%
C. 5.0%
D. 10.0%

SOLUTIONS
1. D
Sample mean – This is the mean calculated by adding up the values in your sample and
dividing by the sample size.
Because there are many different possible samples, there are many possible values for the
means of the various samples. Thus, the sample mean is not unique.
2. D
We just take the median to be the average of the middle 2 values. In this case, the middle two
8  9
values are 8 and 9, and their average is  8.5 .
2
3. B
E(X) = P(xi)xi = P(x1)x1 + P(xn)xn
E(Revenue) = (0.30)100 + (0.50)200 +(0.20)300
E(Revenue) = 30 + 100 + 60
E(Revenue) = 190
4. A
Property 1
E[X + Y] = E[X] + E[Y]
Property 2
E[cX ] = cE[X]
Property 3
E[XY] ≠ E[X] x E[Y]
Property 4
E[XY] = E[X] x E[Y]
Property 5
E[X2] ≠ E[X]2
5. D
The first function, the PMF, is the probability of a random variable taking on a certain value. As
a result of the PMF returning a probability, it must contain the following two properties:
 The value returned by the PMF must be non-negative.
 The sum of the values of the random variable must equal one.
The second function is called the CDF which is a cumulative or total probability.

6. D
7. A
Variance is calculated as follows:
8. B
Skewness = The level of symmetry of the data.
Zero kurtosis = 3
9. B
The mean of the data = 200. The median is the middle value, so in this case, the median is 1.
Because the mean is much larger than the median, courtesy of the large outlier, we can describe
the data set as being positively skewed.
Effectively, the large outlier distorts the mean, pulling it over to the right, making the
distribution positively skewed.
10. C

Topic - 14
Common Univariate Random Variables [QA-3]
Learning Objectives
Common Univariate Random Variables
LO 14 a: Distinguish the key properties and identify the common occurrences of the following
distributions: uniform distribution, Bernoulli distribution, binomial distribution, Poisson
distribution, normal distribution, lognormal distribution, Chi-squared distribution, Student’s t, and
F-distributions.
LO 14 b: Describe a mixture distribution and explain the creation and characteristics of mixture
distributions.

QUESTIONS
1. Which of the following statements regarding properties of a uniform distribution are correct?
I. The uniform distribution graph is a straight line and thus yields uniform probabilities.
 X 2  X1 
II. The uniform distribution probability calculation is: P  X1  X  X 2  
b  a
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
2. Which of the following statements regarding a random variable being binomial Is not correct?
A. The number of trials is fixed.
B. Each trial may have only two possible outcomes: success and failure.
C. The trials are independent of one another.
D. The sampling is done without replacement.
3. Assume that the number of defaults within a loan portfolio follows a Poisson process. The
expected number of defaults in a one-year period is 10.
What is the probability that exactly 8 defaults will occur in a one-year period?
A. 0.26%
B. 11.26%
C. 1.12%
D. 100%
4. Which of the following statements regarding the normal distribution are not correct?
A. The normal distribution is a discrete distribution.
B. The normal distribution has a kurtosis equal to 3.
C. The normal distribution has zero skewness.
D. The tails on a normal distribution extend indefinitely.
5. The heights of people in a city are normally distributed with mean 170 cm and standard
deviation 10 cm. What is the probability that a randomly chosen person from this population
has a height that is greater than 150 cm?
A. 0.0228
B. 0.9772
C. -0.9772
D. 0.8413
6. Which of the following statements regarding normal and lognormal distributions is correct?
A. The lognormal distribution is positively skewed.
B. The lognormal distribution has a lower bound of 0 and is also bounded from above.
C. The lognormal distribution is a discrete distribution.

D. The normal distribution is asymmetrical about its mean.
7. When testing the hypothesis of the population variance, which test statistic will be used?
A. A chi-square statistic
B. A F-statistic
C. A Z-statistic
D. A t-statistic
8. Which of the following statements regarding a mixture distribution are correct?

I. The skewness measure of the distribution can be changed by combining distributions with
different means.
II. The kurtosis measure of the distribution can be changed by combining distributions with
different variances.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
9. A portfolio manager holds three bonds in one of the portfolio and each bond has a 1-year
default probability of 15%. The event of default for each of the bonds is independent. What is
the probability of exactly two bonds defaulting over the next year?
A. 1.9%
B. 5.7%
C. 10.8%
D. 32.5%

SOLUTIONS
1. C
The uniform distribution graph is a straight line and thus yields uniform probabilities, hence
the name. The area under the graph between point a and point b equals 1.
In order to calculate the probability that x lies between two points, x1 and x2 say, we use:
2. D
There are a number of important conditions that need to apply for a random variable
to be binomial:
 The number of trials is fixed.
 Each trial may have only two possible outcomes: success and failure.
 The success probability p stays constant throughout the experiment and does not change
from trial to trial.
 The trials are independent of one another.
 The sampling is done with replacement.
3. B
4. A
The normal distribution is another special continuous distribution The graph is perfectly
symmetrical and therefore has zero skewness.
Its’ kurtosis is equal to 3. You will recall that excess kurtosis is measured relative to the number
3. We can, therefore, say that the graph has zero excess kurtosis.
The tails get smaller and smaller the further we move away from the mean. However, they
never equal zero – they extend indefinitely.
5. B
We want P(X>150). Standardizing gives P(Z>(150-170)/10) = P(Z>-2).
By symmetry, P(Z>-2) = P(Z<2). From tables, we can look up 2.00 and get 0.9772. So, the
answer is 0.9772.
6. A
One of the key differences between the two distributions: the normal distribution is
symmetrical about its mean, whereas the lognormal distribution is positively skewed.

The key properties of a lognormal distribution:

 It is positively skewed
 It has a lower bound of 0 but is not bounded from above
 It is a continuous distribution
7. A
When testing the hypothesis of the population variance, the test statistic to be used is a chi-
square (2) statistic with n-1 degrees of freedom.
8. C
The skewness measure of the distribution can be changed by combining distributions with
different means. The kurtosis measure of the distribution can be changed by combining
distributions with different variances.
9. B

Topic - 15
Multivariate Random Variables [QA - 4]
Learning Objectives
Multivariate Random Variables
LO 15 a: Explain how a probability matrix can be used to express a probability mass function.
LO 15 b: Compute the marginal and conditional distributions of a discrete bivariate random
variable.
LO 15 c: Explain how the expectation of a function is computed for a bivariate discrete random
variable.
LO 15 d: Define covariance and explain what it measures.
LO 15 e: Explain the relationship between the covariance and correlation of two random variables,
and how these are related to the independence of the two variables.
LO 15 f: Explain the effects of applying linear transformations on the covariance and correlation
between two random variables.
LO 15 g: Compute the variance of a weighted sum of two random variables.
LO 15 h: Compute the conditional expectation of a component of a bivariate random variable.
LO 15 i: Describe the features of an iid sequence of random variables.
LO 15 j: Explain how the iid property is helpful in computing the mean and variance of a sum of iid
random variables.

QUESTIONS
1. Consider the following data:

Variance of x = 100
Variance of y = 25
Covariance of x and y = 35
What is the value of the correlation coefficient?
A. 0.014
B. 0.70
C. 1.00
D. 0.28
2. Consider tow random variables X1 and X2 that are independent. What is the correlation
between X1 and X2?
A. 0
B. +1
C. -1
D. +0.5
3. Assume that X1 and X2 both have got univariate normal distributions, what can we conclude
about the joint distribution?
A. The joint distribution of X1 and X2 is bivariate normal.
B. The joint distribution of X1 and X2 is bivariate non-normal.
C. The joint distribution of X1 and X2 is not necessarily bivariate normal.
D. The joint distribution of X1 and X2 is univariate normal.
4. Consider the following probability matrix. The matrix describes the annual profits of two firms,
a big firm (X1) and a small firm (X2).
What is the marginal distribution of the big firm at the -$40m level?
A. 2.0%
B. 0%
C. 7.5%
D. 7.0%

Are the profits of Big firm and Small firm independent?

A. Yes
B. No
C. Unable to calculate
D. The profits are bivariate
What is the conditional distribution of Small firm’s if Big firm earns $100m for the year?
A. 0%, 22.58%, 41.94%, 35.48%
B. 0%, 3.5%, 6.5%, 5.5%
C. 0%, 22.58%, 41.94%, 38.48%
D. 0%, 22.58%, 45.94%, 35.48%

SOLUTIONS
1. B
R = 0.70
2. A
Independent random variables have a correlation of zero.
3. C
The joint distribution of X1 and X2 is not necessarily bivariate normal.
4. C
The marginal distributions are calculated by summing across the values at the $-40m level. In
other words, 2% + 4% + 1% + 0.5% = 7.5%.
5. B
No. The returns will be independent if the joint is the product of the marginals.
Let us look at the upper left cell, which is equal to 2.0%.
The marginal distribution for the upper left cell for Big firm = 2%+4%+1%+0.5% = 7.5%.
The marginal distribution for the upper left cell for Small firm = 2%+4%+1%+0.0%= 7.0%.
The product of the two = 7.5% x 7.0% = 0.52%
This is not equal to 2.0%, and as such the profits are not independent.
6. A
The conditional distribution is the row that corresponds to the $100m and is normalized to 1.
The row that corresponds to the $100m is 0%, 3.5%, 6.5%, 5.5% = 15.5%
Standardizing to 1 = 0%, 22.58%, 41.94%, 35.48% = 100%

Topic - 16
Sample Moments [QA - 5]
Learning Objectives
Sample Moments
LO 16 a: Estimate the mean, variance, and standard deviation using sample data.
LO 16 b: Explain the difference between a population moment and a sample moment.
LO 16 c: Distinguish between an estimator and an estimate.
LO 16 d: Describe the bias of an estimator and explain what the bias measures.
LO 16 e: Explain what is meant by the statement that the mean estimator is BLUE.
LO 16 f: Describe the consistency of an estimator and explain the usefulness of this concept.
LO 16 g: Explain how the Law of Large Numbers (LLN) and Central Limit Theorem (CLT) apply to
the sample mean.
LO 16 h: Estimate and interpret the skewness and kurtosis of a random variable.
LO 16 i: Use sample data to estimate quantiles, including the median.
LO 16 j: Estimate the mean of two variables and apply the CLT.
LO 16 k: Estimate the covariance and correlation between two random variables.
LO 16 l: Explain how coskewness and cokurtosis are related to skewness and kurtosis.

QUESTIONS
1. According to the central limit theorem: A random variable X with a mean  and variance 2
the sampling distribution of the sample mean x all possible samples of size n will be
approximately normally distributed, provided that n is sufficiently large. Which of the
following statements is correct?
I. The mean = 
2
II. The variance 
n
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
2. Consider the following data:
What is the median of the above data observations?

A. 0.5050
B. 0.4600
C. 0.5500
D. 1.0000

SOLUTIONS
1. C
According to the central limit theorem: a random variable X with a mean  and variance 2 the
sampling distribution of the sample mean x of all possible samples of size n will be
approximately normally distributed, provided that n is sufficiently large.
The mean = 
2
The variance  .
n
2. A
The median is the midpoint, which in this case sits between the third and fourth observations.
0.46  0.55
The median   0.5050 .
2

Topic - 17
Hypothesis Testing [QA - 6]
Learning Objectives
Hypothesis Testing
LO 17 a: Construct an appropriate null hypothesis and alternative hypothesis and distinguish

between the two.
LO 17 b: Differentiate between a one-sided and a two-sided test and identify when to use each test.
LO 17 c: Explain the difference between Type I and Type II errors and how these relate to the size
and power of a test.
LO 17 d: Understand how a hypothesis test and a confidence interval are related.
LO 17 e: Explain what the p-value of a hypothesis test measures.
LO 17 f: Interpret the results of hypothesis tests with a specific level of confidence.
LO 17 g: Identify the steps to test a hypothesis about the difference between two population means.
LO 17 h: Explain the problem of multiple testing and how it can bias results.

QUESTIONS
1. Which of the following statements regarding the hypothesis test are not correct?
A. Ho: b1 ≥0
B. Ha: b1 < 0
C. Ho states that there is no relationship between the variables
D. A failure to reject Ho would indicate a statistically significant relationship between the
variables.
2. Whilst sampling to infer population parameters and using a two-tailed hypothesis testing
Megan Crane observes a t-statistic of 2.74 based on a sample of 21 observations where the
theoretical mean is 0. The null and alternative hypotheses are:
A. Ho: population mean = 0; Ha: population mean > 0
B. Ho: sample mean = 0; Ha: sample mean not equal to zero
C. Ho: population mean = 0; Ha: population mean not equal to 0
D. Ho: population mean = 1; Ha: population mean > 0
3. Two independent samples are taken and their statistics computed as per below:
Population A: Sample size 13, mean 340 and standard deviation 41
Population B: Sample size 13, mean 299 and standard deviation 46
A researcher hopes to demonstrate that the mean of population B is less than the mean of
population A to a 5% level of significance. The critical t-value assuming that the two population
variances are equal is nearest to:
A. 1.7109
B. 2.0639
C. 1.7056

D. 2.0555
4. An analyst believes that the average PE ratio for an index is at the most 12. She finds that the
average PE and standard deviation of a sample of 30 is 13 and 5 respectively. What is the value
of the test statistic?
A. 1.10
B. 6.00
C. 3.37
D. 12.0
5. Which of the below does not represent a step of hypothesis testing?

A. Making the economic or investment decision
B. Specifying the significance level
C. Bias analysis
D. Setting up the hypothesis
6. An analyst is testing if the mean profits of a sector are greater than $2m. A sample of 30 is
taken, and the value of the test statistic is 1.6. If you choose a 5% significance level you would:
A. Fail to reject the null hypothesis and conclude that the population mean is less than or equal
to $2m
B. Reject the null hypothesis and conclude that the population mean is equal to $2m
C. Fail to reject the null hypothesis and conclude that the population mean is greater than $2m
D. Reject the null hypothesis and conclude that the population mean is equal to zero
7. In hypothesis testing, which of the below best defines a Type I error?

A. Not rejecting a true null hypothesis
B. Rejecting a false null hypothesis
C. Rejecting a true null hypothesis
D. Not ejecting a false null hypothesis

SOLUTIONS
1. D
We are testing the coefficients of the two independent variables i.e. b1 and b2. Because we are
interested in whether there is a statistically significant relationship or not, our hypotheses will
be:
H o : b1 ≥ 0
Ha: b1 < 0
Recall also that Ho is an equality statement, whereas Ha is not. Ho states that there is no
relationship between the variables, whereas Ha states that there is.
Thus, a rejection of Ho would indicate a statistically significant relationship between the
variables, whereas a non-rejection of Ho would indicate that there is no statistically significant
relationship between the variables.
2. C
A two-tailed test always uses equal/not equal to with the population mean used rather than
the sample mean.
3. A
The hypothesis test performed is a one-tailed test. The two samples are less than 30, which
means that the differences in means will be t-distributed with n1 + n2 - 2 degrees of freedom,
i.e. df = 24. For an alpha (significance) of 0.05 the t-tables, for 24 df give us a critical value of
1.710882 = 1.7109.
4. A
The test statistic would be calculated as follows: (Observed value - Hypothesized value)
/Standard error (13 - 12)/(5/SQRT 30) = 1.09545 Note: Standard error = Standard
deviation/SQRT(n).
5. C
The steps in hypothesis testing are: 1) Stating the hypotheses 2) Identifying the appropriate test
statistic and its probability distribution 3) Specifying the significance level 4) Stating the
decision rule 5) Collecting the data and calculating the test statistic 6) Making the statistical
decision 7) Making the economic or investment decision.
6. A
The analyst is trying to test if the mean profits are greater than $2m; this is the alternative
hypothesis as by convention we set up a null as being that which we are trying to disprove. The
null hypothesis is therefore that the mean profits are less than or equal to $2m. The critical Z
value for a 1 tailed test at the 5 percent significance level is 1.65. Since the calculated value of 1.6
is less than 1.65, we fail to reject the null hypothesis.
7. C
C is the definition of a Type I error. A and B are accurate decisions

Topic - 18
Linear Regression [QA - 7]
Learning Objectives
Linear Regression
LO 18 a: Describe the models which can be estimated using linear regression and differentiate them
from those which cannot.
LO 18 b: Interpret the results of an OLS regression with a single explanatory variable.
LO 18 c: Describe the key assumptions of OLS parameter estimation.
LO 18 d: Characterize the properties of OLS estimators and their sampling distributions.
LO 18 e: Construct, apply, and interpret hypothesis tests and confidence intervals for a single
regression coefficient in a regression.
LO 18 f: Explain the steps needed to perform a hypothesis test in a linear regression.
LO 18 g: Describe the relationship between a t-statistic, it’s p-value, and a confidence interval.

QUESTIONS
1. Which of the following statements regarding regression analysis are correct?

I. The independent variable is generally labeled X.
II. The dependent variable is generally labeled Y.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
2. Which of the following statements regarding the error term in the regression equation is
correct? The equation for the error term is denoted as follows:
3. Which of the following statements regarding the residuals or error term is not correct?
A. A residual is simply the vertical distance between a point on the scatter plot and the line of
regression.
B. The better the fit of the line to the points, the smaller the residuals.
C. Should the line of regression pass through a particular point, the residual value of that
point will be 1.
D. The reason for squaring the residuals is to eliminate the cancellation effect of big positive
and big negative residuals.
4. Which of the following statements regarding regression analysis are correct?

I. In the event that there was not a linear relationship between the dependent variable and
the parameters we could not use a linear regression model
II. In the event that there was not a linear relationship between the variables themselves we
could not use a linear regression model.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
E.
5. Consider the following regression equation:
ŷ  11.581 + 6.917x.
Assume that the value of the independent variable is equal to 10.5. What is the value of the
dependent variable?
A. 0
B. 11.581
C. 3.192

D. 84.209
6. Which of the following assumption is not a key assumption of OLS for estimation of
parameters?
A. All observations (X and Y) are independent and identically distributed (iid).
B. Large outliers are not expected to be present in the data as this is likely to distort the
regression results.
C. The expected value of the error (residual) term is 0.
D. There is a linear (straight line) relationship between the dependent variable Y and
the independent variable X.
7. Which of the following statements regarding the benefits of using OLS estimators are correct?
I. Due to its popularity and wide use, several software packages are available and are widely
used.
II. The regression coefficients used in OLS are easily understood and represent the desirable
properties of an estimator.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. Which of the following statements regarding the properties of OLS estimators are correct?
I. OLS estimators have got their own sampling distributions which allow us to estimate the
population parameters, such as the population mean, intercept and slope.
II. Assuming that b0 and b1 are normally distributed we can then assume that the sampling
distributions of b0 and b1 are unbiased and consistent estimators of the population
parameters B0 and B1.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

SOLUTIONS
1. C
The independent variable is generally labeled X and the dependent variable Y. Common sense
will tell you which is which.
2. B
The equation for the error term is denoted as follows:
i =Yi – (b0 + b1Xi)
3. C
Before moving on, let us explain a little about residuals or error term.
A residual is simply the vertical distance between a point on the scatter plot and the line of
regression. The regression line that is used is the one that minimizes the sum of the squares of
the residuals. In this way, it is the best line to use, and hence the name ‘least squares line of
regression’.
Obviously, the better the fit of the line to the points, the smaller will be the distances between
the line and the points, and hence the smaller the residuals. Should the line of regression pass
through a particular point, the residual value of that point will be 0.
The reason for squaring the residuals is to eliminate the cancellation effect of big positive and
big negative residuals. By squaring first, all residual distances become positive, so the best line
can then be found.
4. A
In the event that there was not a linear relationship between the dependent variable and the
parameters we could not use a linear regression model.
In the event that there was not a linear relationship between the variables themselves we could
still use a linear regression model.
5. D
ŷ  11.581 + 6.917x.
Substitute the 10.5 into the equation.
6. D
 All observations (X and Y) are independent and identically distributed (iid).
 Large outliers are not expected to be present in the data as this is likely to distort
the regression results.
 The expected value of the error (residual) term is 0. Another way of saying this is that E[i]
= 0. This assumption states that, when the regression line is ‘best’, the positive residuals
will exactly cancel out the negative residuals, making the average value of the error term 0.

Additional assumptions:
There is a linear (straight line) relationship between the dependent variable Y and the
independent variable X.
7. B
Due to its popularity and wide use, several software packages are available and are
widely used.
The regression coefficients used in OLS are easily understood and represent the desirable
properties of an estimator, in other words, they unbiased, consistent and efficient.
8. C
OLS estimators have got their own sampling distributions which allow us to estimate the
population parameters, such as the population mean, intercept and slope.
Assuming that b0 and b1 are normally distributed we can then assume that the sampling
distributions of b0 and b1 are unbiased and consistent estimators of the population parameters
B0 and B1.

Topic - 19
Regression with Multiple Explanatory Variables [QA - 8]
Learning Objectives
Regression with Multiple Explanatory Variables
LO 19 a: Distinguish between the relative assumptions of single and multiple regression.

LO 19 b: Interpret regression coefficients in a multiple regression.
LO 19 c: Interpret goodness of fit measures for single and multiple regressions, including R2 and
adjusted- R2.
LO 19 d: Construct, apply, and interpret joint hypothesis tests and confidence intervals for multiple
coefficients in a regression.

QUESTIONS
1. When looking at the relationship between the percentage bid-ask spread (as measured by the
spread divided by the stock price) and the number of market makers in the market and
the company’s market capitalization.
The following variables are applicable:
Percentage bid-ask spread = dependent variable = Y.
Number of market makers = independent variable 1 = X1.
Company’s market capitalization = independent variable 2 = X2.
The regression is estimated using data from 1819 NASDAQ-listed stocks from December 2002.
The following multiple regression equation is formulated:
Yi = b0 + b1X1i + b2X2i + i
Where:
Yi = Percentage bid-ask spread
b0 = Intercept
X1i = Number of market makers
X2i = Market capitalization of the company
The results from regressing Y on X1 and X2 are presented in the table below:
Which of the following most accurately represents the multiple regression equation?
A. Yi = -0.1369 + 0.0673(MM) + 0.0246 (Cap) + i
B. Yi = -0.7586 + -0.2790(MM) + -0.6635 (Cap) + i
C. Yi = -5.5416 + -0.4.1427(MM) + -27.0087 (Cap) + i
D. Yi = -0.7586 + 0.1369(MM) + -5.5416 (Cap) + i
spread divided by the stock price) and the number of market makers in the market and the
company’s market capitalization.
Company’s market capitalization = independent variable 2 = X2.

Yi = b0 + b1X1i + b2X2i + i
Where:
b0 = Intercept
Assuming the following regression equation:

Yi = -0.7586 + -0.2790(MM) + -0.6635 (Cap) + i
What would the effect on the bid-ask spread be if we added one more market makers?
A. It would increase by 0.2790
B. It would decrease by 0.2790
C. It would increase by 0.6635
D. It would decrease by 0.6635
3. Which of the following statements regarding multiple regression analysis are correct?
I. The general equation for the multiple linear regression model is: Yi = b0 + b1X1i + b2X2i
+………+ bkXki+ i
II. The residual error can be expressed as follows: î  Yi  Yî
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. When dealing with the R2 (coefficient of determination), which of the following equations is not
correct?
A. R2 = Total variation (TSS) – unexplained variation (SSR) / Total variation (TSS)
B. R2 = Explained variation / Total variation
C. R2 = ESS / TSS
D. R2 = RSS / TSS
5. When dealing with adjusted R2, which of the following is not a reason that adjusted R2 was
introduced as a measure?
A. One of the issues with the Coefficient of determination (R2) is that it itself may not a reliable
measure of the explanatory power of the additional variables.

B. Almost always, as additional independent variables are added to the model the R2 will
increase even if the contribution of the new variables is not statistically significant.
C. A high R2 may be as a result of a large number of independent variables in the model and
not as a result of their explanatory power.
D. Almost always, as additional independent variables are added to the model the R2 will
increase unless the contribution of the new variables is not statistically significant.
6. Which of the following assumptions is not an assumption of the multiple linear regression
model?
A. The expected value of the error (residual) term is 0.
B. The variance of the error term is the same for all observations.
C. The residuals are independently distributed.
D. The error term is lognormally distributed.
7. When assessing the effects of multicollinearity on our analysis, which of the following
statements are not correct?
A. The slope coefficients remain consistent. However, they tend to be unreliable.
B. The standard errors tend to be inflated and as such the test-statistics are not powerful and
lack the ability to reject the null hypothesis.
C. This leads to type I errors.
D. This leads to type II errors.
8. Which of the following statements regarding the hypothesis test are not correct?
A. Ho: b1 ≥0
B. Ha: b1 < 0
C. Ho states that there is no relationship between the variables
D. A failure to reject Ho would indicate a statistically significant relationship between the
variables.
spread divided by the stock price) and the number of market makers in the market and the
company’s market capitalization.
Yi = b0 + b1X1i + b2X2i + i
Where:
b0 = Intercept

Assuming a confidence level of 99%, what is the confidence interval for X2i (Market
capitalization of the company)?
A. -0.221; -0.337
B. -0.221; -0.0246
C. -0.026; -0.337
D. 0.221; 0.337
10. Which of the following statements regarding the F-test are correct?
I. The F-test assesses how well the independent variables explain the variation in the
dependent variable.
II. The alternative hypothesis relating to the F-test will be: Ho: b1 = b2 = b3 = … = bk = 0
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
11. Which of the following statements are not correct when stating the formula for the F-stat?
A. F = Mean regression sum of the squares / Mean squared error
B. F = MSR / MSE
C. F = (ESS/k) / (SSR/n-k-1)
D. F = (TSS/k) / (SSR/n-k-1)
12. The following ANOVA table has been presented:
Based on the ANOVA table, the F-stat is:

A. 1088.83
B. 1340.82
C. 1819.00
D. 4917.93

SOLUTIONS
1. B
Yi = b0 + b1X1i + b2X2i + i
Keep in mind that we use the regression coefficient column for our regression coefficients.
Yi = -0.7586 + -0.2790(MM) + -0.6635 (Cap) + i
2. B
Based on our example, assuming that we increase the number of market makers by one unit,
we would expect the percentage bid-ask spread divided by the stock price to decrease
by 0.2790. This is assuming that we hold the other independent variable constant.
3. B
The general equation for the multiple linear regression model is:
Yi = b0 + b1X1i + b2X2i +………+ bkXki+ i
The residual can be expressed as follows:
î  Yi  Yî
4. D
R2 = Total variation (TSS) – unexplained variation (SSR) / Total variation (TSS)
Which is also equal to:
R2 = Explained variation / Total variation
R2 = ESS / TSS
5. D
Adjusted R2
One of the issues with the Coefficient of determination (R2) is that it itself may not a reliable
measure of the explanatory power of the additional variables. Almost always, as additional
independent variables are added to the model the R2 will increase. This is so even if the
contribution of the new variables is not statistically significant. Based on this a high R2 may be
as a result of a large number of independent variables in the model and not as a result of their
explanatory power. This is referred to as overestimating the regression.
6. D
 The variance of the error term is the same for all observations. The statistical term for this is
homoskedasticity.
 The residuals are independently distributed. Here, we are saying that the residual for one
observation is not correlated with that of another observation. We say that there is no
autocorrelation among the residual terms.

 The error term is normally distributed. This assumption makes the mathematics easier to
work with.
7. C
What effect does multicollinearity have on our analysis?
The slope coefficients remain consistent. However, they tend to be unreliable.
The standard errors tend to be inflated and as such the test-statistics are not powerful and lack
the ability to reject the null hypothesis.
This leads to type II errors – that we conclude that the variable is not statistically significant.
8. D
We are testing the coefficients of the two independent variables i.e. b1 and b2. Because we are
interested in whether there is a statistically significant relationship or not, our hypotheses will
be:
H o : b1 ≥ 0
Ha: b1 < 0
Recall also that Ho is an equality statement, whereas Ha is not. Ho states that there is no
relationship between the variables, whereas Ha states that there is.
Thus, a rejection of Ho would indicate a statistically significant relationship between the
variables, whereas a non-rejection of Ho would indicate that there is no statistically significant
relationship between the variables.
9. A
In our case degrees of freedom will be:
= 1819 – 2 (number of independent variables) – 1 (which is the slope)
= 1816
Critical values:
Look up on the t-test tables at 1816 degrees of freedom. However, the table does not go up to
that high so we will use degrees of freedom of 200. The critical value is 2.345.
Putting this all together, we get a 99% confidence interval to be:
j 
bˆ  t  sbˆ
c j 
= -0.6635  2.345 * 0.0246
= -0.2790  0.058
= (-0.221 ; -0.337)
10. A
The F-test assesses how well the independent variables explain the variation in the dependent
variable.
Based on this the null hypothesis will be:
H o : b1 = b 2 = b 3 = … = b k = 0

11. D
Based on the above four variables, the formula for the F-stat is:
F = Mean regression sum of the squares / Mean squared error
F = MSR / MSE
F = (ESS/k) / (SSR/n-k-1)
12. A
F = (ESS/k) / (SSR/n-k-1)
F = (2681.6482 / 2) / (2236.2820/ 1816)
F = 1088.8325

Topic - 20
Regression Diagnostics [QA - 9]
Learning Objectives
Regression Diagnostics
LO 20 a: Explain how to test whether a regression is affected by heteroskedasticity.

LO 20 b: Describe approaches to using heteroskedastic data.
LO 20 c: Characterize multicollinearity and its consequences; distinguish between multicollinearity
and perfect collinearity.
LO 20 d: Describe the consequences of excluding a relevant explanatory variable from a model and
contrast those with the consequences of including an irrelevant regressor.
LO 20 e: Explain two model selection procedures and how these relate to the bias-variance trade-off.
LO 20 f: Describe the various methods of visualizing residuals and their relative strengths.
LO 20 g: Describe methods for identifying outliers and their impact.
LO 20 h: Determine the conditions under which OLS is the best linear unbiased estimator.

QUESTIONS
1. Which of the following statements regarding when the omitted variable bias occurs are correct?
I. There is a correlation between the omitted variable and the movement of the independent
variable.
II. The omitted variable assists in the determination of the dependent variable.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
2. Which of the following statements regarding homoscedasticity and heteroskedasticity are not
correct?
A. Homoskedasticity is when the variance of the error term is the same for all observations.
B. Heteroskedasticity is when the variance of the error term is not the same for all
observations.
C. Heteroskedasticity can be broken down into conditional and unconditional
heteroskedasticity.
D. Unconditional heteroskedasticity presents an issue for the regression analysis.
3. Which of the following statements regarding multiple regression analysis are correct?
I. The general equation for the multiple linear regression model is: Yi = b0 + b1X1i + b2X2i
+………+ bkXki+ i

II. The residual error can be expressed as follows: 
ˆ i  Yi  Yi
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. Which of the following assumptions is not an assumption of the multiple linear regression
model?
A. The expected value of the error (residual) term is 0.
B. The variance of the error term is the same for all observations.
C. The residuals are independently distributed.
D. The error term is lognormally distributed.
5. When assessing the effects of multicollinearity on our analysis, which of the following
A. The slope coefficients remain consistent. However, they tend to be unreliable.
B. The standard errors tend to be inflated and as such the test-statistics are not powerful and
lack the ability to reject the null hypothesis.
C. This leads to type I errors.
D. This leads to type II errors.

6. When dealing with multicollinearity, which of the following statements are correct?
I. One of the ways to detect multicollinearity is a high R2 and a statistically significant F-
statistic but the t-tests indicate that none of the individual coefficients is significantly
different to zero.
II. The best way to correct for multicollinearity is to leave out one or more of the
variables that are correlated.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

SOLUTIONS
1. C
Omitted variable bias occurs when the following two conditions are met:
 There is a correlation between the omitted variable and the movement of the independent
variable.
 The omitted variable assists in the determination of the dependent variable.
2. D
The variance of the error term is the same for all observations. This is called homoskedasticity.
Heteroskedasticity is when the variance of the error term is not the same for all observations.
Heteroskedasticity can be broken down into conditional and unconditional heteroskedasticity.
Unconditional heteroskedasticity
This occurs when the heteroskedasticity is unrelated to level of the independent variables. In
other words it does not move around as the independent variables are changed.
This violates the regression assumptions but does not present an issue for the regression
analysis.
3. B
The general equation for the multiple linear regression model is:
Yi = b0 + b1X1i + b2X2i +………+ bkXki+ i
The residual can be expressed as follows:


ˆ i  Yi  Yi
4. D
 The variance of the error term is the same for all observations. The statistical term for this is
homoskedasticity.
 The residuals are independently distributed. Here, we are saying that the residual for one
observation is not correlated with that of another observation. We say that there is no
autocorrelation among the residual terms.
 The error term is normally distributed. This assumption makes the mathematics easier to
work with.
5. C
What effect does multicollinearity have on our analysis?
The slope coefficients remain consistent. However, they tend to be unreliable.
The standard errors tend to be inflated and as such the test-statistics are not powerful and lack
the ability to reject the null hypothesis.
This leads to type II errors – that we conclude that the variable is not statistically significant.

6. C
How are we able to detect multicollinearity?
One of the ways to detect multicollinearity is a high R2 and a statistically significant F-statistic
but the t-tests indicate that none of the individual coefficients is significantly different to zero.
How do we correct multicollinearity?

The best way to correct for multicollinearity is to leave out one or more of the variables that are
correlated.

Topic - 21
Stationary Time Series [QA-10]
Learning Objectives
Stationary Time Series
LO 21 a: Describe the requirements for a series to be covariance stationary.

LO 21 b: Define the autocovariance function and the autocorrelation function.
LO 21 c: Define white noise, describe independent white noise and normal (Gaussian) white noise.
LO 21 d: Define and describe the properties of autoregressive (AR) processes.
LO 21 e: Define and describe the properties of moving average (MA) processes.
LO 21 f: Explain how a lag operator works.
LO 21 g: Explain mean reversion and calculate a mean-reverting level.
LO 21 h: Define and describe the properties of autoregressive moving average (ARMA) processes.
LO 21 i: Describe the application of AR, MA, and ARMA processes.
LO 21 j: Describe sample autocorrelation and partial autocorrelation.
LO 21 k: Describe the Box-Pierce Q-statistic and the Ljung-Box Q statistic.
LO 21 l: Explain how forecasts are generated from ARMA models.
LO 21 m: Describe the role of mean reversion in long-horizon forecasts.
LO 21 n: Explain how seasonality is modeled in a covariance-stationary ARMA.

QUESTIONS
1. In order for the assumption of covariance stationary to be valid we need several conditions to
be in place. Which of the following assumptions are not correct?
A. The expected value of the time-series must be constant and finite for all periods.
B. The variance of the time-series must be constant and finite for all periods.
C. The covariance of the time-series with itself over a fixed number of periods (both past and
future) must be both constant and finite.
D. The covariance must resemble a white noise process.
2. Which of the following statements regarding the autocorrelation function are correct?
I. The autocorrelation function is when the covariances have been converted to correlations.
II. The correlation will sit between -1 and +1.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Archie Bal, FRM, is busy looking at the implications of time series data that is not covariance
stationary. Which of the following statements in this regard are correct?
I. When time series data is not covariance stationary, the estimated regression will not
work unless we transform the data.
II. Transforming the data involves changing the data in such a way that we can find a model-
able covariance stationary property and work with this.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. Which of the following statements are correct regarding white noise?

A. White noise exhibits a mean of one and a constant variance.
B. White noise exhibits a mean of zero and a constant variance.
C. White noise exhibits a mean of one and a variance of two.
D. White noise and zero-mean white noise are different concepts.
5. When making use of the white noise process, which of the following statements are not correct?
A. The model’s forecast error should follow the white noise process.
B. The model’s forecast error should exhibit heteroskedasticity.
C. In the event that the autocorrelation function is perfectly serially uncorrelated then the
process would show zeros for all the lags / displacements.
D. The autocorrelation at τ = 0 will always equal one.

6. A distributed lag is when the model assigns weights to past values in the time series. Which of
the following equations regarding the model are correct?
I. Yt- + 0.4 yt-1 + 0.3 yt-2 + 0.2 yt-3
II. Yt-(1 + 0.4L+ 0.3L2 + 0.2L3)
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
7. Which of the following statements are not correct when dealing with the standard deviation of
its autocorrelations or partial correlations in a time series?
A. In a time series, the standard deviation of its autocorrelations or partial correlations,
1
assuming T observations, will equal .
T
B. One of the ways to determine if a time series is considered white noise is to display their
2
autocorrelation and partial autocorrelation functions in bands of 
T
C. If the time series is white noise then we could expect 95% of the sample autocorrelations
2
and sample partial autocorrelations to fall within the interval of 
T
D. An autoregression is a nonlinear regression of a time series against the past values of the
series.

SOLUTIONS
1. D
In order for the assumption of covariance stationary to be valid we need the following
conditions to be in place:
1. The expected value of the time-series must be constant and finite for all periods.
2. The variance of the time-series must be constant and finite for all periods.
3. The covariance of the time-series with itself over a fixed number of periods (both past and
future) must be both constant and finite.
2. C
Autocorrelation function – The autocorrelation function is when the covariances have been
converted to correlations. As we have seen in earlier topics, the correlation will sit between -1
and +1.
3. C
When time series data is not covariance stationary, the estimated regression will not work
unless we transform the data. Transforming the data involves changing the data in such a way
that we can find a model-able covariance stationary property and work with this.
4. B
A time series that exhibits a zero mean and a constant variance is called white noise or zero-
mean white noise. When we say zero mean we are talking about it’s unconditional mean.
5. B
When using the white noise process, the model’s forecast error should follow the white noise
process. If not, then the errors can be forecast based on past values. However, the model itself is
inaccurate and cannot be used to predict accurately. In the event that the autocorrelation
function is perfectly serially uncorrelated then the process would show zeros for all the lags /
displacements. Keep in mind that the autocorrelation at τ = 0 will always equal one. The reason
for this is that this is the correlation of the series with itself.
6. C
A distributed lag is when the model assigns weights to past values in the time series. The
model will look as follows:
Yt- + 0.4 yt-1 + 0.3 yt-2 + 0.2 yt-3
This can be re-written as follows:
Yt-(1 + 0.4L+ 0.3L2+ 0.2L3)
7. D
In a time series, the standard deviation of its autocorrelations or partial correlations, assuming
1
T observations, will equal
T

One of the ways to determine if a time series is considered white noise is to display their
2
autocorrelation and partial autocorrelation functions in bands of 
T
If the time series is white noise then we could expect 95% of the sample autocorrelations and
sample partial autocorrelations to fall within this interval.

Topic - 22
Non-Stationary Time Series [QA - 11]
Learning Objectives
Non-Stationary Time Series
LO 22 a: Describe linear and nonlinear time trends.

LO 22 b: Explain how to use regression analysis to model seasonality.
LO 22 c: Describe a random walk and a unit root.
LO 22 d: Explain the challenges of modeling time series containing unit roots.
LO 22 e: Describe how to test if a time series contains a unit root.
LO 22 f: Explain how to construct an h-step-ahead point forecast for a time series with seasonality.
LO 22 g: Calculate the estimated trend value and form an interval forecast for a time series.

QUESTIONS
1. Which of the following statements regarding linear models are not correct?
A. A linear trend is a trend that can be graphed using a straight line.
B. In this model the dependent variable (Y) changes at rate constant with time.
C. The equation for the linear trend model is: Yt = b0 + b1t+ i
D. The equation for the linear trend model is: Yt = b0 + b1(t) + b2(t)2 + i
2. Which of the following statements regarding the quadratic model are correct?
I. The quadratic model can model trends by working with the sign and the level of the
coefficients.
II. When dealing with time-series data, the data will often exhibit growth factors that grow at
a continuous rate
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. David Jones, FRM, is in the process of constructing a quadratic model, he needs assistance with
his model. Assist David by informing him which of the following signs of the variables will
result in a U shape when graphed?
A. Both b1 and b2 are negative.
B. Both b1 and b2 are positive.
C. When b1 is positive and b2 is negative.
D. When b1 is negative and b2 is positive.
4. An analyst wishes to predict future inflation rates.

Monthly U.S. CPI information is used for this purpose. The data runs from January 1995 for a
period of 228 months.

The model for this will be: Y  bˆ  bˆ t
t o 1
The table below is an extract of the regression results:
The estimated regression equation is:


Yt  2.8853  0.0038t

Calculate the inflation rate for month 120.

A. 1.9733%
B. 2.8853%
C. 2.4290%
D. 0.0038%
5. Which of the following statements are correct when looking at a time series model?
A. If the variable grows at a constant rate = use a linear model.
B. If the variable grows at a constant amount = use a log-linear model.
C. In the event that the plotted points resemble a curved shape, this would indicate a
linear line and a linear model would be more appropriate.
D. In the event that the plotted points resemble a curved shape, this is an indication that the
error terms are serially correlated (autocorrelation).
6. Which of the following regarding random walks is correct?

A. A random walk is a time series in which the value of the series in one period is the value of
the series in the previous period plus an unpredictable random error.
B. The random walk equation is a special case of an AR(1) model with b0 =1 and b1 = 0.
C. The expected value of εt is 1.
D. The random walk equation is a special case of an AR(2) model with b0 =1 and b1 = 0.
7. Which of the following regarding random walks is incorrect?

A. The best forecast of xt that can be made in period t − 1 is xt−1.
B. Because exchange rates follow a random walk, the best forecast of the future exchange rate
is the current exchange rate.
C. A random walk has a defined mean-reverting level.
D. A random walk is a time series in which the value of the series in one period is the value of
the series in the previous period plus an unpredictable random error.
8. Which of the following regarding the Dickey–Fuller test for a unit root is incorrect?
A. The regression-based unit root test is based on a transformed version of the AR(1) model xt
= b0 + b1xt−1 + εt, by subtracting xt−1 from both sides of the AR(1) model producing b0 + g1xt–1
+ εt, E(εt) = 0 where g1 = (b1 − 1).
B. If b1 = 1, then g1 = 0 and thus a test of g1 = 0 is a test of b1 = 1.
C. To conduct the test, one calculates a t-statistic in the conventional manner for g^1 and using
conventional critical value tables.
D. Dickey and Fuller convert the AR(1) model and run a simple regression.

SOLUTIONS
1. D
Linear Trend Model
A linear trend is a trend that can be graphed using a straight line. In this model the dependent
variable (Y) changes at rate constant with time.
The equation for the linear trend model is:
Yt = b0 + b1t+ i
2. A
The quadratic model can model trends by working with the sign and the level of the
coefficients.
When dealing with time-series data, the exponential model states that the data will often
exhibit growth factors that grow at a continuous rate, i.e. exponential growth.
3. D
The quadratic model can model trends by working with the sign and the level of the
coefficients.
By way of example: Assuming that both b1 and b2 are negative, the trend will increase at a
decreasing rate. Assuming that both b1 and b2 are positive, the trend will increase at an
increasing rate.
When b1 is positive and b2 is negative, the trend will exhibit an upside down U shape.
When b1 is negative and b2 is positive, the trend will exhibit a U shape.
4. C
Assuming that we wanted to predict the inflation rate at month 120, we would do so as follows:
ŷ120  2.8853  0.0038 120 
ŷ120  2.429 percent
5. D
The question is which model should be used with a particular time-series?
If the variable grows at a constant amount = use a linear model.
If the variable grows at a constant rate = use a log-linear model.
In the event that the plotted points resemble a curved shape, this would indicate a non-linear
line and a log-linear model would be more appropriate. This is an indication that the error
terms are serially correlated (autocorrelation) and therefore by using the natural log, the
regression line will fit the data better. This is often the case for financial data such as stock
prices.
6. A
The random walk equation is a special case of an AR(1) model with b0 = 0 and b1 = 1. The
expected value of εt is 0.

7. C
A random walk has an undefined mean-reverting level of 0/0.
8. C
To conduct the test, one calculates a t-statistic in the conventional manner for g^1 but using a
revised set of critical values computed by Dickey and Fuller (larger in absolute value than the
conventional values).

Topic - 23
Measuring Return, Volatility, and Correlation [QA - 12]
Learning Objectives
Measuring Return, Volatility, and Correlation
LO 23 a: Calculate, distinguish, and convert between simple and continuously compounded

returns.
LO 23 b: Define and distinguish between volatility, variance rate, and implied volatility.
LO 23 c: Describe how the first two moments may be insufficient to describe non-normal
distributions.
LO 23 d: Explain how the Jarque-Bera test is used to determine whether returns are normally
distributed.
LO 23 e: Describe the power law and its use for non-normal distributions.
LO 23 f: Define correlation and covariance and differentiate between correlation and dependence.
LO 23 g: Describe properties of correlations between normally distributed variables when using a
one-factor model.

QUESTIONS
1. Which of the following statements regarding implied volatility are correct?

A. To calculate implied volatility we use the standard deviation of returns over a one-year
period.
B. To calculate implied volatility we use the standard deviation of returns over a one-day
period.
C. To calculate implied volatility we use the square of the volatility measure (standard
deviation).
D. To calculate implied volatility we set the Black-Scholes-Merton (BSM) model equal to the
market price of the option – we can work backwards to infer the volatility.
2. Which of the following statements regarding the power law are correct?
I. The power law indicates that the probability of extreme events is low but are still higher
than indicated by the normal distribution.
II. The power law can be expressed as follows: P(V > X) = K x X-α
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following statements regarding covariance is not correct?

A. The covariance of returns is 0 if the returns on the two assets are unrelated.
B. The covariance of returns is positive if the return on both assets is above (or below) the
corresponding expected value at the same time.
C. The covariance of returns is negative if, when the return on one asset is above its expected
value, the return on the other asset is below its expected value and vice versa.
D. The covariance of returns ranges between -1 and +1.
4. Which of the following statements regarding the single factor model are correct?
I. A commonly used single factor model is the capital asset pricing model (CAPM).
2
II. The following equation will be used for single factor model: Ui  iF  1   Z i
i
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
5. Which of the following statements regarding the normal distribution are not correct?
A. The area under the graph equals 1.
B. The graph is perfectly symmetrical and therefore has zero skewness.
C. The tails get smaller and smaller the further we move away from the mean.
D. Empirically, the normal distribution does not approximate real-world data very well.

6. Which of the following statements regarding kurtosis is not correct?

A. A peaked distribution is referred to as leptokurtic.
B. A flat or non-peaked distribution is referred to as platykurtic.
C. The middle-of-the-road distribution is referred to as mesokurtic.
D. Excess kurtosis is equal to 3.
7. Which of the following steps is not part of the Spearman rank correlation process?
A. Rank the observations from lowest to highest.
B. Allocate the ranks to the relevant data
C. Calculate the difference in the rankings of each observation and square them.
D. Apply the Spearman rank correlation equation.
8. Which of the following portfolio standard deviation calculations is correct for a portfolio with
zero correlation?
9. Which of the following is not a cause of non-normality?

A. Autocorrelation.
B. Illiquidity.
C. Nonlinearity.
D. Heteroskedasticity

SOLUTIONS
1. D
To calculate implied volatility we set the Black-Scholes-Merton (BSM) model equal to the
market price of the option – we can work backwards to infer the volatility.
2. C
The issue that we experience in real life situations is that the distributions are seldom normal
distributions and often exhibit fatty tails with much larger standard deviations. One method of
dealing with this is to apply the power law to the normal distribution. The power law indicates
that the probability of extreme events is low but are still higher than indicated by the normal
distribution.
The power law can be expressed as follows:
P(V > X) = K x X-α
3. D
 The covariance of returns is 0 if the returns on the two assets are unrelated.
 The covariance of returns is positive if the return on both assets is above (or below) the
corresponding expected value at the same time.
 The covariance of returns is negative if, when the return on one asset is above its expected
value, the return on the other asset is below its expected value and vice versa.
 The correlation coefficient ranges between -1 and +1.
4. C
A commonly used single factor model is the capital asset pricing model (CAPM). The CAPM
has a return component for each asset. This return has a systematic component (Beta) that is
correlated with the market portfolio return and an unsystematic component that is independent
of the other stocks on the market.
The following equation will be used:
2
Ui  iF  1   Z i
i
5. D
Also, because the graph is symmetrical about the mean, and because the area under the graph
equals 1 (as it is a probability), it follows that each side of the graph represents 50% of the total
area.
The graph is perfectly symmetrical and therefore has zero skewness.
Its’ kurtosis is equal to 3. You will recall that excess kurtosis is measured relative to the number
3. We can, therefore, say that the graph has zero excess kurtosis.
The tails get smaller and smaller the further we move away from the mean. However, they
never equal zero – they extend indefinitely. These are called asymptotic tails. Empirically, the
normal distribution approximates real-world data very well.

6. D
A peaked distribution is referred to as leptokurtic. This type of distribution has most of its
values clustered closely around the mean.
A flat or non-peaked distribution is referred to as platykurtic. This type of distribution is very
flat and has large dispersion statistics.
The middle-of-the-road distribution is referred to as mesokurtic. A normal distribution fits this
description.
Excess kurtosis – Kurtosis minus 3. This is a measure used so as to make the excess kurtosis of
a normal distribution equal to 0.
7. A
1. Rank the observations from highest to lowest.
2. Allocate the ranks to the relevant data
3. Calculate the difference in the rankings of each observation and square them.
4. Apply the Spearman rank correlation equation.
8. B
When there is no correlation between the two assets, then the third term in the equation
disappears (since the correlation is zero). Based on this, the portfolio standard deviation
calculation is as follows:
1
 2 2 2 2 2
port  w   w  
 1 i 2 2
9. D
1. Autocorrelation. We have discussed this in the previous section. Autocorrelation causes
outcomes that are more extreme than those predicted by the normal distribution.
2. Illiquidity. As a result of illiquidity, which is prevalent in alternative investments, values
are often estimated as opposed to using market values. This results in positive
autocorrelation, which produces non-normal returns.
3. Nonlinearity. An example of non-linear returns is that of a call option that exhibits non-
symmetrical returns.

Topic - 24
Simulation and Bootstrapping [QA - 13]
Learning Objectives
Simulation and Bootstrapping
LO 24 a: Describe the basic steps to conduct a Monte Carlo simulation.

LO 24 b: Describe ways to reduce Monte Carlo sampling error.
LO 24 c: Explain the use of antithetic and control variates in reducing Monte Carlo sampling error.
LO 24 d: Describe the bootstrapping method and its advantage over Monte Carlo simulation.
LO 24 e: Describe pseudo-random number generation and how a good simulation design alleviates
the effects the choice of the seed has on the properties of the generated series.
LO 24 f: Describe situations where the bootstrapping method is ineffective.
LO 24 g: Describe the disadvantages of the simulation approach to financial problem solving.

QUESTIONS
1. Which of the following statements is not an application of Monte Carlo simulation?

A. Assessing and estimating the potential risks of a particular trading strategy
B. Studying returns on assets that have complicated features associated with them, or that
have parameters that change constantly
C. Assessing and estimating the success rate of a particular trading strategy
D. Examining the interaction between different classes of investments using very small
samples.
2. Consider the following information:
What is the standard error if we increase the number of simulations to 500?

A. 18
B. 9.04
C. 8.04
D. 100
3. Which of the following statements regarding the antithetic variates are correct?
I. By using the antithetic variates we make use of a negative covariance between the original
sample and its compliment.
II. Using an antithetic variate approach the MCS sampling error is smaller smaller using this
approach than a standard MCS approach.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. Which of the following statements are not correct when dealing with the control variate
technique?
A. Another alternative that can be used to reduce the sampling error is called the control
variate technique.
B. The control variate technique removes a variable used (x) that has unknown properties and
replaces it with a variable (y) that has known properties.
C. Our new x* estimate will have a higher sampling error than our original x variable if the
control statistic and the statistic of interest exhibit a high degree of correlation.
D. The known variable (y) and the new MCS results (x*) will now have similar properties.

5. Which of the following statements are not correct when dealing with the Dickey-Fuller test?
A. In the Dickey-Fuller test, we can reuse the same sample set for each simulation run
while we test for different parameters of the Dickey-Fuller test.
B. This Dickey-Fuller test will serve to reduce the sampling variation among the different
experiments.
C. This Dickey-Fuller test will result in reduced sampling error but not increased accuracy.
D. By using the same data we reduce the variability of the sample error.
6. The_______can be used to generate random numbers randomly from historical data using the
replacement method.
A. The bootstrapping method
B. The pseudo-random number generating method
C. The Dickey-Fuller method
D. The Derivative method
7. Which of the following statements are not correct when dealing with the bootstrapping
method?
A. A disadvantage of using this method is that we are not making any assumptions regarding
the real distribution of the parameter estimate.
B. Using the real data will allow the inclusion of fatter tails – which in truth is more close to
the real world circumstances.
C. The bootstrapping method generates estimates that are closer to the real distribution
properties of the original data.
D. When using the bootstrapping method, the autocorrelations that were present in the
original data set will not be present in the sample.
8. Which of the following statements regarding a pseudo-random number generator are correct?
I. A commonly used pseudo-random number generator generates number sequences
between 0 and 1 with each number having an equal chance of being selected.
II. The numbers are drawn from a continuous distribution.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
9. Which of the following statements regarding outliers and the bootstrapping method are
correct?
I. In the event of outliers, the estimates arrived at may be inaccurate depending on the
number of times the outliers are included in the sample.
II. An effective method of dealing with outsiders is to use a large sample size.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

10. Which of the following is not a disadvantage of the simulation approach to financial problem
solving?
A. The results may not be precise.
B. High costs of the calculations.
C. The results relate to the specific experiment only.
D. The results are easy to replicate.

SOLUTIONS
1. D
Applications of Monte Carlo simulation involve:
 Assessing and estimating the potential risks of a particular trading strategy
 Studying returns on assets that have complicated features associated with them, or that
have parameters that change constantly
 Assessing and estimating the success rate of a particular trading strategy
 Examining the interaction between different classes of investments using large sample
sizes.
2. C
3. C
By using the antithetic variates we make use of a negative covariance between the
original sample and its compliment.
As such the error terms are independent for two sets by way of the negative covariance term.
This results in the MCS sampling error always being smaller using this approach.
4. C
In the event that an experiment contains a wide range of possible outcomes – sampling error is
likely to be present. Another alternative that can be used to reduce the sampling error is called
the control variate technique. This technique removes a variable used (x) that has unknown
properties and replaces it with a variable (y) that has known properties.
Our new x* estimate will have a lower sampling error than our original x variable if the control
statistic and the statistic of interest exhibit a high degree of correlation. The known variable (y)
and the new MCS results (x*) will now have similar properties.
5. D
The Dickey-Fuller test.
If time series data is not covariance stationary then the estimated regression for AR(1) will not
work unless we transform the data. Based on this we need to test if a time series is covariance
stationary or not. We can use the Dickey Fuller test for this. In this test, we can reuse the same
sample set for each simulation run while we test for different parameters of the Dickey-Fuller

test. This will serve to reduce the sampling variation among the different experiments. This will
result in reduced sampling error but not increased accuracy.
6. A
The bootstrapping method can be used to generate random numbers randomly from historical
data using the replacement method.
7. A
An advantage of using this method is that we are not making any assumptions regarding the
real distribution of the parameter estimate. Rather, we are using the real data relating to this
parameter, which includes outliers and other type events. This will allow the inclusion of fatter
tails – which in truth is more close to the real world circumstances. Thus, this method generates
estimates that are closer to the real distribution properties of the original data. A possible
downside of this method is that autocorrelations that were present in the original data set will
not be present in the sample. The reason for this is that the variables are not drawn in the same
sequence as the original set of data.
8. A
A commonly used pseudo-random number generator generates number sequences between 0
and 1 with each number having an equal chance of being selected. The numbers can be drawn
from either a discreet or a continuous distribution.
9. C
In the event of outliers, the estimates arrived at may be inaccurate depending on the number of
times the outliers are included in the sample. The same outlier can be included several times as
replacement sampling is used. An effective method of dealing with outsiders is to use a large
sample size.
10. D
 The results may not be precise. This may occur when the model is not correctly specified.
 High costs of the calculations.
 The results relate to the specific experiment only.
 The results are difficult to replicate. This may occur when a seed is not chosen as the start
of the experiment.

FRM PART – I – FINANCIAL MARKETS AND PRODUCTS
Topic - 25
Banks [FMP-1]
Learning Objectives
Banks
LO 25 a: Identify the major risks faced by a bank, and explain ways in which these risks can arise.
LO 25 b: Distinguish between economic capital and regulatory capital.
LO 25 c: Summarize Basel Committee regulations for regulatory capital and their motivations.
LO 25 d: Explain how deposit insurance gives rise to a moral hazard problem.
LO 25 e: Describe investment banking financing arrangements including private placement, public
offering, best efforts, firm commitment, and Dutch auction approaches.
LO 25 f: Describe the potential conflicts of interest among commercial banking, securities services,
and investment banking divisions of a bank and recommend solutions to the conflict of interest
problems.
LO 25 g: Describe the distinctions between the “banking book” and the “trading book” of a bank.
LO 25 h: Explain the originate-to-distribute model of a bank and discuss its benefits and drawbacks.

QUESTIONS
1. Which of the following risks is not one of the major risks facing a bank?
A. Credit risk
B. Market risk
D. Operational risk
2. Which of the following statements regarding economic and regulatory capital are correct?
I. Economic capital is capital that a bank must have as required by the regulators.
II. In most instances economic capital will exceed regulatory capital.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Depositors, knowing that they are insured anyway, may not pay close attention to which banks
they are depositing their money with. They may merely deposit with the bank that offers them
the highest interest rate. This is an example of:
A. Moral hazard
B. Adverse selection
C. Risk seeking
D. Diversification
4. One way that the investment bank assists the issuer is when the investment banker acts as a
broker to sell whatever it can at a stipulated price. This is called a:
A. Best-efforts basis
B. Private placement
C. Initial public offering (IPO)
D. Indications of interest
5. Which of the following statements regarding a Dutch auction are correct?

I. A Dutch auction process starts with a much higher price then any bidder will pay and
slowly the price is reduced until the bidder agrees to pay the price.
II. The price accepted by the last bidder is the price that will be paid by all successful bidders.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
6. Which of the following statements regarding conflicts of interest at a bank are correct?
A. A bank may experience a conflict of interest when it provides several services.
B. A conflict of interest may interfere with an analyst’s independence and objectivity.
C. A conflict of interest may lead to trading on material nonpublic information.

D. A conflict of interest may lead to a Chinese wall.
7. Which of the following statements regarding conflicts of interest at a bank are correct?
I. As a result of these conflicts the regulators often require a certain degree of separation
between the various divisions within the bank.
II. Chinese walls are a type of internal control mechanism that prevents information from
being shared between divisions.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. The following was caption was found on the balance sheet of a Zed Bank - “Loans to clients”.
This is an example of:
A. The banking book
B. The trading book
C. A story book
D. The net interest margin
9. Which of the following statements regarding the bank’s trading book are not correct?
A. The trading book refers to the trading activities of the bank.
B. The trading activities of the bank will be marked to market on a daily basis based on the
current market prices of the securities.
C. In the event of a less liquid market or if the securities do not have a current market price –
a modeled price may need to be used – called marked-to-model.
D. The value of the loans are recorded at their current principal amounts plus any accrued
interest.
10. Which of the following are not advantages of the originate-to-distribute model?
A. In the past, it was difficult to gain access to the financial assets of the commercial banks.
Through securitization investors can now avoid this additional layer. In addition, the
investor can gain exposure to the specific asset that they wish to hold.
B. Investors have better legal claims against the specific underlying mortgages and portfolios
than they would have had in the past.
C. The costs of the intermediaries are increased.
D. Securitization allows the banks to increase the amount available for lending.
11. In terms of Basel I and the risk weighted assets (RWA) requirement, which of the following
statements is least likely correct?
A. When determining the capital requirements, assets are weighted by their levels of risk.
B. The RWA ratio measures capital as a percentage of risk-adjusted assets.
C. The RWA ratio was called the Cooke ratio must exceed 8%.
D. RWA only include on-balance sheet assets.

12. Which of the following liquidity ratios focuses on the bank’s ability to withstand a 30-day
reduced period of liquidity?
A. Leverage ratio
B. Liquidity coverage ratio (LCR)
C. Net stable funding ratio (NSFR)
D. Assets to equity ratio

SOLUTIONS
1. C
The three major risks facing a bank are:
Market risk – This is the risk that arises from movements in stock prices, exchange rates,
interest rates and commodity prices. This loss will arise from losses as a result of the bank’s
trading operations.
Credit risk – This is the risk of loss due to the counterparty failing to make payment on the
amount that is owed. This type of risk is also called counterparty of default risk.
Operational risk – These risks are the internal risks faced by the bank. This risk arises as a result
of people and processes that combine to produce the bank’s output.
2. B
Economic capital refers to the amount of capital that the bank believes that it needs in order to
operate based on its levels of risk. In most instances economic capital will exceed regulatory
capital.
3. A
Moral hazard is a concept that people tend to take more risks when they are insured than they
would have taken had they not been insured. In the context of a banking model, the depositors,
knowing that they are insured anyway, may not pay close attention to which banks they are
depositing their money with. They may merely deposit with the bank that offers them the
highest interest rate. In turn, the bank may make higher risk loans with the money that have
received from depositors.
4. A
Another way that the investment bank assists the issuer is through the best-efforts basis – In
this case, the investment banker acts as a broker to sell whatever it can at a stipulated price.
5. C
A Dutch auction process starts with a much higher price than any bidder will pay and slowly
the price is reduced until the bidder agrees to pay the price. The price accepted by the last
bidder is the price that will be paid by all successful bidders.
6. D
A bank may experience a conflict of interest when it provides several services. These include
commercial banking, investment banking and securities services. An example of this type of
conflict is when the investment banking division is in the process of selling an equity or bond
issue on behalf of a client. They may ask the securities division to rate the issue as a buy in
order to generate positive interest in the issue. This request interferes with an analyst’s
independence and objectivity. A further conflict may arise when certain parts of the bank are
privy to material nonpublic information. This information must be kept private and not passed
on to other parts of the bank, for example the trading division, as this would represent a
conflict.

7. C
As a result of these conflicts the regulators often require a certain degree of separation between
the various divisions within the bank. Chinese walls are a type of internal control mechanism
that prevents information from being shared between divisions.
8. A
The banking book refers to the loans that are made by the bank and are the activities of the
commercial bank.
9. D
The trading book refers to the trading activities of the bank. The trading activities of the bank
will be marked to market on a daily basis based on the current market prices of the securities
(in a liquid market). In the event of a less liquid market or if the securities do not have a current
market price – a modeled price may need to be used – called marked-to-model.
10. C
Some advantages of this model include:
 In the past, it was difficult to gain access to the financial assets of the commercial banks. In
order to do so, they would need to hold deposits, debt or equity in the bank. Through
securitization investors can now avoid this additional layer. In addition, the investor can
gain exposure to the specific asset that they wish to hold.
 Investors have better legal claims against the specific underlying mortgages and portfolios
than they would have had in the past.
 The costs of the intermediaries are reduced. This will reduce the funding costs paid by
borrowers and can enhance risk-adjusted returns to ultimate investors.
 Securitization allows the banks to increase the amount available for lending. This is due to
the fact that the securities are sold to the general public. These additional funds can now be
used to grant more loans.
11. D
Risk weighted assets (RWA).
When determining the capital requirements, assets were weighted by their levels of risk. The
RWA ratio measures capital as a percentage of risk-adjusted assets. The ratio was called the
Cooke ratio (after Peter Cooke - Bank of England) and must exceed 8%. Assets included both on
and off-balance sheet assets.
This requirement was not being met by the majority of banks at the time.
The riskier the asset category the greater the weighting assigned to that asset.
12. B
Liquidity coverage ratio (LCR)
The LCR focuses on the bank’s ability to withstand a 30-day reduced period of liquidity. The
stressed liquidity event may be as a result of a loss of deposits, a loss of funding, a degradation
in the value of the collateral etc. The LCR was implemented on 1 January 2015. The LCR ratio is
calculated as follows:

Topic - 26
Insurance Companies and Pension Plans [FMP - 2]
Learning Objectives
Insurance Companies and Pension Plans
LO 26 a: Describe the key features of the various categories of insurance companies and identify the
risks facing insurance companies.
LO 26 b: Describe the use of mortality tables and calculate the premium payment for a policy
holder.
LO 26 c: Distinguish between mortality risk and longevity risk and describe how to hedge these
risks.
LO 26 d: Describe a defined benefit plan and a defined contribution plan for a pension fund and
explain the differences between them.
LO 26 e: Calculate and interpret loss ratio, expense ratio, combined ratio, and operating ratio for a
property- casualty insurance company.
LO 26 f: Describe moral hazard and adverse selection risks facing insurance companies, provide
examples of each, and describe how to overcome the problems.
LO 26 g: Evaluate the capital requirements for life insurance and property-casualty insurance
companies.
LO 26 h: Compare the guaranty system and the regulatory requirements for insurance companies
with those for banks.

QUESTIONS
1. Which of the following types of insurance has got the longest tail risk?
A. Life insurance
B. Casualty insurance
C. Health insurance
D. Motor insurance
2. Assume that the interest rate applicable to the insurance contract is 6%. Premiums are paid at
the beginning of the year. A $1,000,000 insurance contract is being considered for a 50 year-old
female in fair health. What is the breakeven premium for one year?
A. $3,193
B. $3,012
C. $1,000
D. $3,491
3. Using the mortality table given below, what is the probability that a female that has just been
born will live to be 21 years old?
A. 99.08%
B. 0.00000436%
C. 99.12%
D. 60.67%
4. Which of the following ratios is most likely to have a declining ratio over time?
A. Loss ratio
B. Expense ratio
C. Combined ratio
D. Operating ratio
5. Which of the following statements regarding moral hazard are correct?

I. Moral hazard is a concept that people tend to take more risks when they are insured than
they would have taken had they not been insured.
II. Moral hazard is when individuals who know that they are high-risk individuals are more
likely to be the ones applying for insurance.

A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
6. Which of the following risks best defines the risk of outliving ones assets?
A. Mortality risk
B. Longevity risk
C. Operational risk
D. Health risk
7. An insurance company that wishes to make use of a natural hedge to hedge away longevity
and mortality risk, should be involved in which of the following business units?
A. Sell annuities only
B. Sell life insurance only
C. Sell life insurance and sell annuities
D. Purchase a reinsurance company
8. Which of the following statements are not correct when dealing with asset/liability
management?
A. The key objective of an insurance company is to fund the future pension liabilities with
assets.
B. The asset/liability management (ALM) perspective on risk is very important as we look at
the risk relative to the liabilities.
C. In ALM assets are managed to take into account the relative position of asset/liability
values.
D. Life insurance policies tend to have shorter durations than nonlife policies.
9. Which of the following statements regarding moral hazard are correct?

I. A guaranty system applies to both banks and insurance companies.
II. On the insurance side –the system is regulated at a state level.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
10. Which of the following plans places all of the risk onto the employer?
A. A defined benefit plan
B. A defined contribution plan
C. An ESOP
D. A medical aid plan

SOLUTIONS
1. B
Casualty insurance has a long tail risk as a result of certain claims only being discovered and
submitted long after the insurance coverage has ended.
2. B
One year premium:
Step one:
Look at the mortality tables. The tables tell us that a healthy, female, aged 50 has a 0.003193
chance of dying within the year. This would translate into a 99.97% chance of living (1 –
0.003193).
Step two:
Work out the expected cash outflow for the year.
3. A
4. B
Expense ratio = This ratio should approximate 25% and should decrease over time
5. A
would have taken had they not been insured.
Adverse selection is when individuals who know that they are high-risk individuals are more
likely to be the ones applying for insurance. Based on this the insurance company must
perform its underwriting.
6. B
Longevity risk is the risk of outliving ones assets.

7. C
From the insurance company’s point of view, there may be a natural hedge if they deal with
both insurance and annuity products. By way of example, longevity risk is bad for the annuity
business (as they need to keep paying the annuity for a long period of time) but good for the
insurance side of the business (as payment of the life payout is delayed). Mortality risk is good
for the annuity side of the business (as payments end early) but bad for the insurance side of
the business (as the life payout occurs earlier).
8. D
The key objective of an insurance company is to fund the future pension liabilities with assets.
Based on this, the asset/liability management (ALM) perspective on risk is very important as
we look at the risk relative to the liabilities.
ALM is part of the company’s risk management process and deals with financial risks and the
interaction between assets and liabilities. What this means is that assets are managed to take
into account the relative position of asset/liability values.
9. C
A guaranty system applies to both banks and insurance companies.
On the insurance side –the system is regulated at a state level.
10. A
A defined benefit (DB) plan is where the entity promises to make payments to the employee
post their retirement. The benefit to be received is defined up front based on various factors.
For example a formula could determine the amount of the benefit based on a function of the
length of service and the final year’s compensation of the employee.
The company will make periodic payments into a fund or trust, during the life of the employee,
to ensure that when the employee retires there will be sufficient funds available to provide the
promised benefit. These assets are called plan assets and are managed to ensure that they
generate the necessary returns to ensure that the benefit can be provided upon retirement. The
risk of the benefit plan therefore rests with the employer.

Topic - 27
Fund Management [FMP - 3]
Learning Objectives
Fund Management
LO 27 a: Differentiate among open-end mutual funds, closed-end mutual funds, and exchange-
traded funds (ETFs).
LO 27 b: Identify and describe potential undesirable trading behaviors at mutual funds.
LO 27 c: Calculate the net asset value (NAV) of an open-end mutual fund.
LO 27 d: Explain the key differences between hedge funds and mutual funds.
LO 27 e: Calculate the return on a hedge fund investment and explain the incentive fee structure of
a hedge fund including the terms hurdle rate, high-water mark, and clawback.
LO 27 f: Describe various hedge fund strategies, including long/short equity, dedicated short,
distressed securities, merger arbitrage, convertible arbitrage, fixed income arbitrage, emerging
markets, global macro, and managed futures, and identify the risks faced by hedge funds.
LO 27 g: Describe characteristics of mutual fund and hedge fund performance and explain the effect
of measurement biases on performance measurement.

QUESTIONS
1. Which of the following statements regarding ETF’s are correct?

I. ETF’s are required to disclose their holdings twice a day.
II. All three instruments, Open-end funds, closed-end funds and ETF’s are regulated by the
Securities and Exchange Commission (SEC).
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
2. Which of the following is not a difference between open-end and closed-end funds?
A. Closed-end funds tend to invest in broader areas while open-end funds tend to invest in
more niche areas.
B. Open-end funds keep increasing the number of shares available while the number of shares
for a closed-end fund are fixed.
C. Closed-end funds cannot redeem their shares – they need to find an investor to purchase
their shares.
D. Open-end funds always trade at the next available NAV while a closed end fund can trade
at prices not close to their NAV’s.
3. You are provided with the following information relating to fund XY:
Total market value of fund: $90m
Trading Expenses owing: $10m
Number of shares issued: $10m
The NAV of the fund is closest to?
A. $8 per share
B. $9 per share
C. $10 per share
D. Cannot be worked out
4. Which of the following is not a difference between a hedge fund and a mutual fund?
A. Hedge funds are generally only cater to high net worth individuals, as apposed to mutual
funds that cater for all investor types.
B. The regulation surrounding hedge funds is limited and disclosure is often opaque, as
apposed to mutual funds that are highly regulated with transparent reporting.
C. Hedge funds make use of leverage and short selling. This is not allowed for a mutual fund.
D. Hedge fund investments are easier to redeem than mutual funds.
5. Assume the following information:

Investment A has a 35% probability of a 60% return and a 65% probability of a 40% loss.
Management fees are 1% of assets under management.
Incentive fees are 20% of profits after management fees.

The return attributable to the Manager is closest to?

A. 4.76%
B. 2%
C. 1.3%
D. 6.06%

Investment A has a 35% probability of a 60% return and a 65% probability of a 40% loss.
Management fees are 1% of assets under management.
Incentive fees are 20% of profits after management fees.
The return attributable to the Investor is closest to?

A. 6.06%
B. -42%
C. -11.06%
D. -27.3%
7. Which of the following hedge fund strategies is not part of a relative-value strategy?
A. Merger arbitrage
B. Fixed-income arbitrage funds
C. Convertible bond arbitrage funds
D. Asset-backed fixed-income
8. John Terry, FRM, is planning to Purchase a sizable shareholding in company XYM such that he
can affect changes to the company and increase the value of the company.
Which of the following hedge fund strategies is Terry most likely using?
A. Distressed or restructuring
B. Merger arbitrage
C. Activist shareholder
D. Special situations
9. Which of the following statements regarding the performance of hedge funds are correct?
I. Prior to 2008 hedge funds performed well relative to the S&P 500 index.
II. After 2008, hedge fund performance deteriorated relative to the S&P 500.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
10. Jamie Vix, FRM, is giving a presentation on the effects of bias in the hedge fund industry. She
describes the following situation to her class, “by adding the previous performance records of
firms that are recently added to a benchmark index means that only the best results are
presented”.

Which of the following biases is Jamie most likely describing?

A. Backfill bias
B. Survivorship bias
C. Stale price bias
D. Past data relevance
11. Callum Pol, FRM, describes the following practice, “Assume that prices of stocks in the market
have been rising during the day, it is likely that the shares in the mutual fund are worth more
than the current NAV. A good investment is to buy shares in the mutual fund.” This type of
practice is best described by which of the following terms?
A. Late trading.
B. Market timing.
C. Front running.
D. Directed brokerage.

SOLUTIONS
1. B
ETF’s are required to disclose their holdings twice a day, thus providing increased
transparency into their holdings. Open-end funds usually only disclose their holdings once a
quarter.
Since all three instruments, Open-end funds, closed-end funds and ETF’s, obtain funds
from small retail clients, they are regulated by the Securities and Exchange Commission (SEC).
2. A
Differences between open and closed-end mutual funds
 Open-end funds tend to invest in broader areas while closed-end funds tend to invest in
more niche areas.
 Open-end funds keep increasing the number of shares available while the number of
shares for a closed-end fund are fixed.
 Closed-end funds cannot redeem their shares – they need to find an investor to purchase
their shares.
 Open-end funds always trade at the next available NAV while a closed end fund can trade
at prices not close to their NAV’s.
3. A
Fund NAV
90  10

10
= $8.00
4. D
Some of the differences between hedge funds and mutual funds include:
 Hedge funds are generally only cater to high net worth individuals, as apposed to mutual
funds that cater for all investor types.
 The regulation surrounding hedge funds is limited and disclosure is often opaque, as
apposed to mutual funds that are highly regulated with transparent reporting.
 Hedge funds make use of leverage and short selling. This is not allowed for a mutual fund.
 Hedge fund investments are more difficult to redeem than mutual funds, and often have
lock-in clauses to prevent early redemptions.
5. D
Assume that the investment does in fact generate a profit (keep in mind that there is
only a 35% probability of this occurring), the return to the manager will be as follows:
= 2% (MF) + (60% - 2%) x 20%
= 2% + 11.6%
= 13.6%

Assume that the investment generates a loss (keep in mind that there is a 65% probability of
this occurring), the return to the manager will be as follows:
= 2% (MF) + zero incentive fee
= 2%
Let us apply the probabilities to the profit and loss:
Expected return = (13.6% X 0.35) + (2% X 0.65)
Expected return = 4.76% + 1.3%
Expected return = 6.06%
6. C
Assume that the investment does in fact generate a profit (keep in mind that there is only
a 35% probability of this occurring), the return to the investor will be as follows:
= 60% - 13.6% (to the manager)
= 46.4%
Assume that the investment generates a loss (keep in mind that there is a 65% probability of
this occurring), the return to the investor will be as follows:
= -40% - 2% (man fee payable to the manager)
= -42%
Let us apply the probabilities to the profit and loss:
Expected return = (46.4% X 0.35) + (-42% X 0.65)
Expected return = 16.24% - 27.3%
Expected return = -11.06%
7. A
 Fixed-income arbitrage funds: Invest in fixed-income securities going long or short to take
advantage of mispricings in the market.
 Convertible bond arbitrage funds: Invest in convertible bonds to convert them into equities
and take advantage of mispricings between the two.
 Asset-backed fixed-income arbitrage funds: Invest in fixed-income securities going long or
short.
8. C
 Distressed or restructuring: Purchase the stock of undervalued company’s that are
undergoing a difficult time of a restructuring. Sell the stock of overvalued companies.
 Merger arbitrage: Purchase the shares of a company being acquired and sell the shares of a
company being sold.
 Activist shareholder: Purchase a sizable shareholding in the company such that you can
affect change and increase the value of the company.
 Special situations: Look out for companies that are undergoing special situations e.g. selling
off divisions, repurchasing securities, issuing new stock etc.
9. C
Taking the period further, we see that prior to 2008 hedge funds performed well relative to the
S&P 500 index. After 2008, hedge fund performance deteriorated relative to the S&P 500.

10. A
 Backfill bias, by adding the previous performance records of firms that are recently added
to a benchmark index means that only the best results are presented.
 Survivorship bias, returns from data that have been terminated are excluded from
the return results presented.
 Stale price bias, is due to infrequent pricing and the use of appraisal values. As a result,
price volatility is reduced.
 Past data relevance, is questioning the relevance of past data when assessing the skill of a
hedge fund manager.
11. B
Market timing. NAV pricing may be stale in the open-ended mutual fund market. The reason
for this, is that mutual fund trading is not active. As a result, assume that prices of stocks in the
market have been rising during the day, it is likely that the shares in the mutual fund are worth
more than the current NAV. A good investment is to buy shares in the mutual fund. On the
other side, when prices in the market are falling, it is advisable to sell shares in the mutual
fund. Such a practice is legal but may result in the value of the fund moving around
excessively. In addition, it is more costly for investors as they will need to keep excess
cash in the fund, in order to provide for redemptions.

Topic - 28
Introduction to Derivatives [FMP - 4]
Learning Objectives
Introduction to Derivatives
LO 28 a: Define derivatives, describe features and uses of derivatives, and compare linear and non-
linear derivatives.
LO 28 b: Describe the over-the-counter market, distinguish it from trading on an exchange, and
evaluate its advantages and disadvantages.
LO 28 c: Differentiate between options, forwards, and futures contracts.
LO 28 d: Identify and calculate option and forward contract payoffs.
LO 28 e: Differentiate among the broad categories of traders: hedgers, speculators, and arbitrageurs.
LO 28 f: Calculate and compare the payoffs from hedging strategies involving forward contracts
and options.
LO 28 g: Calculate and compare the payoffs from speculative strategies involving futures and
options.
LO 28 h: Calculate an arbitrage payoff and describe how arbitrage opportunities are temporary.
LO 28 i: Describe some of the risks that can arise from the use of derivatives.

QUESTIONS
1. Which of the following is not a characteristic of a forward contract in relation to a futures

contract?
A. Less regulated (informal)
B. Less transparent (more private)
C. More liquid
D. Default risk is high
2. Jed John, FRM, is giving a class on derivatives, he uses the following descriptions to describe a
certain instrument:
 The transaction is reported to certain regulatory agencies
 The price of the transaction is recorded
 The terms of the transaction are standard
 The terms of the contract are known to all parties
Which derivative instrument is Jed discussing?
A. Forward contract
B. Futures contract
C. Swap contract
D. Options contract
3. Which of the following statements regarding the payoff and profit of a put option at expiry are
correct?
I. At expiry the put option is worth the greater of: Zero, Or the difference between the
exercise price and the underlying price.
II. Profit = PT – P0
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. Assuming that an investor is long (has purchased/owns) the underlying asset, which of the
following statements regarding hedging instruments are correct?
I. He can go short or sell a forward contract.
II. He can sell a put option.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
5. Assuming that an investor is short the underlying asset, which of the following statements
regarding hedging instruments are correct?
I. He can go long or buy a forward contract.
II. He can buy a call option.

A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
6. An investor is has got $1,000,000 to invest and would like to invest his money in Apple Inc for a
period of six months. The current spot price of Apple is $200 per share. He can invest directly in
Apple stock or he could do so by purchasing futures contracts on Apple stock that expires in six
months time. The futures price of the six-month contract is $220 per share. The initial margin is
$20 per share.
Assuming that the spot price of Apple Inc at the end of six months is $230. The investor’s profit
is closest to:
A. -$50,000
B. $150,000
C. $500,000
D. -$1,500,00
7. An investor is has got $1,000,000 to invest and would like to invest his money in Apple Inc for a
period of six months. The current spot price of Apple is $200 per share. He can invest directly in
Apple stock or he could do so by purchasing a call option on Apple stock that expires in six
months time. The options price of the six- month contract is $210 per share. The initial option
premium is $10 per share.
Assuming that the spot price of Apple Inc at the end of six months is $200. The investor’s profit
is closest to:
A. $-3,000,000
B. $0
C. -$2,000,000
D. -$1,000,000
8. Assuming that an investor is short the underlying asset, Which of the following statements
regarding arbitrage are correct?
I. Arbitrage occurs when two equivalent assets sell for two different prices.
II. Arbitrage presents an opportunity to profit for no risk or cash outlay.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
9. Which of the following statements regarding risks of derivatives are correct?

I. There are certain risks that are attached to using derivatives.
II. Losses using derivatives can be far greater than the losses would have been had derivatives
not been used.
A. I only.
B. II only.

C. Both I and II.

D. Neither I or II.
10. An investor that aims to make a profit from taking a position on the market is referred to as a
_________
A. Hedger
B. Speculator
C. Arbitrageur
D. FCM
11. Which of the following derivative instruments is best described as being nonlinear?
A. Forwards
B. Futures
C. Options
D. Swaps
12. A French bank enters into a 6-month forward contract with an importer to sell GBP 40 million
in 6 months at a rate of EUR 1.21 per GBP. If in 6 months the exchange rate is EUR 1.16 per
GBP, what is the payoff for the bank from the forward contract?
A. EUR -2,941,176
B. EUR -2,000,000
C. EUR 2,000,000
D. EUR 2,941,176

SOLUTIONS
1. C
Less regulated (informal)
Less transparent (more private)
Less liquid
Default risk is high
2. B
In a futures contract:
 The transaction is reported to a recognized exchange (a futures exchange)
 The transaction is reported to a clearinghouse
 The terms of a futures contract are known to all parties
3. C
Payoff of a put option at expiry is worth the greater of:
i. Zero, Or
ii. The difference between the exercise price and the underlying price
PT = Max(0, X - ST)
Put option
Profit = Put option payoff – Put option premium
Profit = PT – P0
4. A
He can go short or sell a forward contract. Or He can buy a put option.
5. C
He can go long or buy a forward contract. Or He can buy a call option.
6. C
Profit =
($230 - $220) x 50,000
= $500,000
7. D
Remember that it is an option so we would choose not to exercise and as such our losses are
limited to the option premium of $10 per share x 100,000 shares = $1,000,000 loss.
8. C
Arbitrage occurs when two equivalent assets sell for two different prices. This presents an
opportunity to profit for no risk or cash outlay.

9. C
There are however certain risks that are attached to using derivatives. For example, a
speculator may use derivatives to turn a profit on a certain position that he takes in an asset. To
the extent that this position does not go the way that the speculator though it would, this may
result in large losses – far greater than the losses had derivatives not been used.
10. B
Speculators aim to make a profit from taking a position on the market. Their aim is to profit
from price movements in the underlying instrument.
11. D
A nonlinear derivative depends on the state of the underlying asset and is a function of the
change in the value of the underlying.
An example of a nonlinear derivative are most option contracts. The reason for this is that the
value of the option does not move at a constant rate when the underlying asset moves.
12. C
The value of the contract for the bank at expiration: GBP 40,000,000 * 1.21 EUR/GBP
The cost to close out the contract for the bank at expiration: GBP 40,000,000 * 1.16 EUR/GBP
The final payoff in EUR to the bank can be calculated as:

40,000,000 *(1.21 – 1.16) = EUR 2,000,000.

Topic - 29
Exchanges and OTC Markets [FMP - 5]
Learning Objectives
Exchanges and OTC Markets
LO 29 a: Describe how exchanges can be used to alleviate counterparty risk.

LO 29 b: Explain the developments in clearing that reduce risk.
LO 29 c: Describe netting and describe a netting process.
LO 29 d: Describe the implementation of a margining process and explain the determinants of initial
and variation margin requirements.
LO 29 e: Compare exchange-traded and OTC markets and describe their uses.
LO 29 f: Identify the classes of derivative securities and explain the risk associated with them.
LO 29 g: Identify risks associated with OTC markets and explain how these risks can be mitigated.
LO 29 h: Describe the role of collateralization in the over-the-counter market and compare it to the
margining system.
LO 29 i: Explain the use of special purpose vehicles (SPVs) in the OTC derivatives market.

QUESTIONS
1. Which of the following functions is not a standardized product of an exchange?

A. Maturity
B. Size
C. Location
D. Delivery
2. Which of the following functions is not a key function of an exchange?

A. Trading venue.
B. Standardized products.
C. Reporting.
D. Risk minimization
3. Which of the following statements is not correct when dealing with a clearinghouse and
marking-to-market?
A. The Clearinghouse protects itself by enforcing weekly settlement of outstanding positions
from the buyer and the seller.
B. The process of daily settlement is called marking-to-market.
C. The procedure of marking to market is essentially translating paper gains and losses into
cash gains and losses on a daily basis.
D. It is similar to terminating a contract at the end of each day and reopening it the next day.
4. Which of the following forms of clearing is the most effective?

A. Direct clearing
B. Netting
C. Complete clearing
D. Clearing ring
5. Which of the following terms best describe the ability to purchase from one party and to sell to
a different party when transacting a futures contract on an exchange?
A. Offset
B. Fungible
C. Mark-to-market
D. Cleared transaction
6. When looking at bilateral and central clearing which of the following statements are correct?
I. Bilateral clearing makes use of a master agreement with a credit support annexure (CSA).
II. Central clearing is when the two parties use a central clearinghouse to reduce exposure to
the credit risk of the transaction.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

7. Which is the biggest OTC derivative market?

A. Foreign exchange derivatives.
B. Interest rate derivatives.
C. Credit derivatives.
D. Equity derivatives
8. What method is used to value the size of the OTC derivatives market?
A. Gross notional value
B. Net notional value
C. Market value
D. DCF
9. Which of the following risk mitigating structures is he most commonly used today?
A. Special purpose vehicles (SPVs)
B. Derivative product companies (DPCs)
C. Credit derivative product companies (CDPCs)
D. Central Counterparties (CCPs)
10. Which of the following statements is not correct when dealing with CCPs?
A. CCPs prioritize OTC parties over the other parties such as bondholders. This passes risk on
to other markets.
B. CCPs are not exposed to legal risk.
C. CCPs, when managing counterparty risk are not exposed to residual risk as they match all
of their trades.
D. CCP members are required to post initial and variation margin.
11. Which of the following statements regarding margins on a futures contract are not correct?
A. The initial margin on a futures contract acts like a down payment for the commitment to
purchase the underlying at the future date.
B. The margin requirements are set by the clearinghouse.
C. In most cases the futures margin is much higher than the stock margin.
D. The margin on a futures contract are set based on historical price movements.
12. Which of the following statements regarding the role of a clearinghouse are not correct?
A. The Clearinghouse protects itself by enforcing monthly settlement of outstanding positions
B. This process of daily settlement is called marking-to-market.
D. Marking-to-market is similar to terminating a contract at the end of each day and
reopening it the next day.

13. When assessing margin requirements in centrally cleared and bilateral markets, which of
the following statements are correct?
I. Margin requirements involve the setting of initial and variation margin for OTC
transactions.
II. Margins must be posted in cash or marketable securities and act as collateral for the OTC
transaction.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
14. Which of the following types of netting result in the greatest amount of risk reduction?
A. No netting
B. Central netting
C. Bilateral netting
D. Pooled netting

SOLUTIONS
1. C
Standardized products. Standardized terms include, maturity, size, price, delivery etc.
2. D
The key functions of an exchange are:
 Trading venue. This can be a physical location or an online platform.
 Standardized products. Standardized terms include, maturity, size, price, delivery etc.
 Reporting. Prices are reported to various market participants.
3. A
The Clearinghouse protects itself by enforcing daily settlement of outstanding positions from
the buyer and the seller. This prevents form large amounts building up and not being collected.
This process of daily settlement is called marking-to-market.
This procedure of marking to market is essentially translating paper gains and losses into cash
gains and losses on a daily basis.
It is similar to terminating a contract at the end of each day and reopening it the next day.
4. C
Complete clearing. Clearing is done through the central counterparty (CCP). As apposed to
members doing their own clearing, clearing is done through an independent third party. The
CCP assumes the contractual responsibilities of the exchange members that The serves to
reduce counterparty risk. The CCP makes use of initial and variation margin to reduce risk.
5. B
Fungibility describes the ability to purchase from one party and to sell to a different party when
transacting a futures contract on an exchange.
6. C
Bilateral clearing makes use of a master agreement with a credit support annexure (CSA).
Central clearing is when the two parties use a central clearinghouse to reduce exposure to the
credit risk of the transaction.
7. B
Interest rate derivatives.
8. A
Gross notional value
9. D
The most effective method of reducing risk within the OTC market is by using CCPs.

10. B
 CCPs prioritize OTC parties over the other parties such as bondholders. This passes risk on
to other markets.
 CCPs are exposed to legal risk.
 CCPs, when managing counterparty risk are not exposed to residual risk as they match all of
their trades.
 CCP members are required to post initial and variation margin.
11. C
The initial margin on a futures contract acts like a down payment for the commitment to
purchase the underlying at the future date. This payment is like a good-faith payment
(normally less than 10% of the price). These margin requirements are set by the clearinghouse.
In most cases the stock margin is much higher than the futures margin. The margin on a
futures contract are set based on historical price movements. The margin requirement will take
into account normal price movements and the fact that accounts are marked-to-market on a
daily basis.
12. A
This process of daily settlement is called marking-to-market. This procedure of marking to
market is essentially translating paper gains and losses into cash gains and losses on a daily
basis. It is similar to terminating a contract at the end of each day and reopening it the next day.
13. C
Margin requirements involve the setting of initial and variation margin for OTC
transactions. These margins must be posted in cash or marketable securities and act as
collateral for the OTC transaction.
14. B
Central netting results in the greatest amount of risk reduction.

Topic - 30
Central Clearing [FMP - 6]
Learning Objectives
Central Clearing
LO 30 a: Provide examples of the mechanics of a central counterparty (CCP).

LO 30 b: Describe the role of CCPs and distinguish between bilateral and centralized clearing.
LO 30 c: Describe advantages and disadvantages of central clearing of OTC derivatives.
LO 30 d: Explain regulatory initiatives for the OTC derivatives market and their impact on central
clearing.
LO 30 e: Compare margin requirements in centrally cleared and bilateral markets, and explain how
margin can mitigate risk.
LO 30 f: Compare and contrast bilateral markets to the use of novation and netting.
LO 30 g: Assess the impact of central clearing on the broader financial markets.
LO 30 h: Identify and explain the types of risks faced by CCPs.
LO 30 i: Identify and distinguish between the risks to clearing members as well as non-members.

QUESTIONS
1. Which of the following is not a category of central clearing?

A. Long history of clearing.
B. No history of clearing.
C. Average history of clearing.
D. No history, but planning to be cleared in the future.
2. When assessing the mechanics of a central counterparty (CCP), which of the following
conditions need to be in place:
I. Legal and economic terms need to be standardized.
II. Level of complexity needs to be low
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following is not an advantage of central clearing of OTC derivatives?

A. Loss mutualization
B. The CCP offsets transactions resulting in improved flexibility and reduced costs.
C. Product liquidity
D. Adverse selection
4. Which of the following is not an advantage of central clearing of OTC derivatives?

A. Bifurcation.
B. Moral hazard.
C. Adverse selection.
D. Loss Mutualization
5. Which of the following regarding margin requirements in centrally cleared and bilateral
markets is not correct?
A. The margins on an OTC contract are set based on expected price movements.
B. The margin requirement will take into account normal price movements and the fact that
accounts are marked-to-market on a daily basis.
C. The clearinghouse will collect and disburse money on a daily basis.
D. By carefully setting the correct margin requirements the clearinghouse can adequately
manage the risk of default.
6. When assessing margin requirements in centrally cleared and bilateral markets, which of
the following statements are correct?
I. Margin requirements involve the setting of initial and variation margin for OTC
transactions.
II. Margins must be posted in cash or marketable securities and act as collateral for the OTC
transaction.

A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
7. Which of the following types of netting result in the greatest amount of risk reduction?
A. No netting
B. Central netting
C. Bilateral netting
D. Pooled netting
8. When making use of novation and netting, which of following statements are correct?
I. Novation is a legal process by which the CCP becomes the party instead of the original
buyer and seller.
II. This process converts central trading into bilateral trading.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
9. When assessing the impact of central clearing on the broader financial markets which of
I. Overall, the benefits of a CCP outweigh the disadvantages as a result of overall
systemic risk being reduced.
II. CCPs have not yet proven to be successful for long-dated OTC contracts.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
10. When assessing the impact of central clearing on the broader financial markets which of
I. CCPs protect the OTC market participants but this may come at the expense of creditors.
II. CCPs have not yet proven to be successful for long-dated OTC contracts.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
11. Which of the following statements regarding operational risk faced by the CCP are not correct?
A. Operational risks are the internal risks faced by the firm.
B. Operational risk arises as a result of people and processes that combine to produce the
firm’s output.
C. Operational risks are non-financial risks.

D. The factors that give rise to operational risk are external.
12. When assessing the loss allocation methods available to the CCP, which of the following
statements are correct:
I. Variation margin gains haircutting (VMGH) is when the full value of the amount owed is
not received by the member.
II. A tear-up is when the unmatched positions are terminated.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
13. Which of the following statements regarding liquidity risk faced by the CCP are not correct?
A. Liquidity risk is present due to the large amounts are cash received (margins) and paid out
by the CCP.
B. The CCP will invest in short-term secure investments (Treasury bills, repos, short-
term deposits) in order to reduce both credit and liquidity risk.
C. The CCP will need to have a certain amount of their investments easily convertible to cash
in the event of a payment being needed or a member defaulting.
D. The Basel I requirements set out the various capital that is required to be maintained.
14. Which of the following statements regarding model risk faced by the CCP are not correct?
A. Since OTC derivatives are not priced by the market, but rather via the use of models, they
are exposed to model risk.
B. An error in the model can be a serious matter.
C. Models tend to be nonlinear in nature, which may not be effective for a large position that
increases in a linear manner.
D. A margin multiplier may be needed to correct for model risk.
15. Which of the following risks best describes the following statement. “The risk of default and
credit exposure to the member of the CCP increase at the same time”.
A. Settlement risk
B. Concentration risk
C. Wrong-way risk
D. Sovereign risk
16. Which of the following risks best describes the following statement. “The risk of members of
the CCP and the margins related to this all residing in the same geographical region”.
A. Settlement risk
B. Concentration risk
C. Wrong-way risk
D. Sovereign risk

17. When assessing risks to clearing members as well as non-members which of the following
I. A non-member may not lose anything to the extent that their margins are segregated or
guaranteed, or segregated and guaranteed.
II. If a non-member cannot move his trade away in the event of a clearing member defaulting,
he may incur losses as a result of needing to close out his position.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
18. When assessing risks to clearing members as well as non-members which of the following
I. A non-member of the CCP does not need to contribute to the default fund.
II. A non-member may incur losses depending on the CCP’s rules of loss allocation
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

SOLUTIONS
1. C
OTC derivatives can be broken down into four categories of central clearing:
A. Long history of clearing – e.g. interest rate swaps.
B. No history (not suitable for clearing) – e.g. exotic or illiquid derivatives.
C. Short history of clearing – e.g. indexed credit default swaps.
D. No history, but planning to be cleared in the future – e.g. interest rate swaptions.
2. C
In order for an OTC product to be centrally cleared, the following conditions need to be in
place:
I. Legal and economic terms need to be standardized.
II. Level of complexity needs to be low – this includes valuation so that margining and mark-
to-market
3. D
Advantages of a CCP
 Loss mutualization is when the members of the CCP contribute towards a default fund.
The fund will cover losses that cannot be recovered from the defaulting member.
 The CCP offsets transactions resulting in improved flexibility and reduced costs.
 Product liquidity is improved as a result of daily margining and improved valuations.
 As a result of central clearing operational efficiency is improved and costs are reduced.
4. D
Disadvantages of a CCP
 Exotic derivatives are not cleared by the CCP.
 Only clearing members are allowed to clear.
 The concept of bifurcation, in other words when trading is done on instruments where
some are cleared and others are not, increases cash flow volatility for all participants.
 Moral hazard is present when clearing, as members tend to take excessive risks knowing
that hey are covered by the CCP.
 Adverse selection is when market participants with superior knowledge and skills trade
products that are underpriced by the CCP.
5. A
The margins on an OTC contract are set based on historical price movements. The margin
requirement will take into account normal price movements and the fact that accounts are
marked-to-market on a daily basis.
The clearinghouse will collect and disburse money on a daily basis. By carefully setting the
correct margin requirements the clearinghouse can adequately manage the risk of default.

6. C
Margin requirements involve the setting of initial and variation margin for OTC
transactions. These margins must be posted in cash or marketable securities and act as
collateral for the OTC transaction.
7. B
Central netting results in the greatest amount of risk reduction.
8. A
Novation is a legal process by which the CCP becomes the party instead of the original buyer
and seller.
This process converts bilateral trading into central trading.
9. C
Overall, the benefits of a CCP outweigh the disadvantages as a result of overall systemic
risk being reduced.
CCPs have not yet proven to be successful for long-dated OTC contracts.
10. C
CCPs protect the OTC market participants but this may come at the expense of creditors. CCPs
have not yet proven to be successful for long-dated OTC contracts.
11. D
Operational risks are the internal risks faced by the firm. This risk arises as a result of people
and processes that combine to produce the firm’s output. These risks are non-financial risks.
The factors that give rise to this risk may be external, but the risk is an internal one.
12. C
Examples of loss allocation methods include:
 Variation margin gains haircutting (VMGH). In this case a haircut is taken on the full
value. In other words, the full value of the amount owed is not received by the member.
 A tear-up is when the unmatched positions are terminated. Any losses can be recovered
from the defaulting party’s margin account or from the default fund.
13. D
Liquidity risk is present due to the large amounts are cash received (margins) and paid out by
the CCP. The CCP will invest in short-term secure investments (Treasury bills, repos,
short- term deposits) in order to reduce both credit and liquidity risk.
The CCP will need to have a certain amount of their investments easily convertible to cash in
the event of a payment being needed or a member defaulting.
The Basel III requirements set out the various capital that is required to be maintained.

14. C
Since OTC derivatives are not priced by the market, but rather via the use of models, they are
exposed to model risk.
Keep in mind that the values are important as they determine the amount of initial and
variation margin. Hence an error in the model can be a serious matter.
Models tend to be linear in nature, which may not be effective for a large position that increases
in a nonlinear manner. A margin multiplier may be needed for this.
15. C
The risk of default and credit exposure to the member of the CCP increase at the same time =
wrong-way risk.
16. B
The risk of members of the CCP and the margins related to this all residing in the same
geographical region = concentration risk.
17. C
A non-member may not lose anything to the extent that their margins are segregated or
guaranteed, or segregated and guaranteed. A non-member also needs to consider if he can
move his trade away in the event of a clearing member defaulting. If not, he may incur losses as
a result of needing to close out his position.
18. C
A non-member of the CCP does not need to contribute to the default fund. As such, in the event
of a CCP failure the non-member may not be impacted to the extent that the clearing member is
still solvent. However, non-members may still be impacted depending on the CCP’s rules of
loss allocation – a portion of losses due to VMGH or tear-up may be passed on to the non-
member.

Topic - 31
Futures Markets [FMP - 7]
Learning Objectives
Futures Markets
LO 31 a: Define and describe the key features of a futures contract, including the underlying asset,
the contract price and size, trading volume, open interest, delivery, and limits.
LO 31 b: Explain the convergence of futures and spot prices.
LO 31 c: Describe the rationale for margin requirements and explain how they work.
LO 31 d: Describe the role of an exchange in futures and over-the-counter market transactions.
LO 31 e: Identify the differences between a normal and inverted futures market.
LO 31 f: Explain the different market quotes.
LO 31 g: Describe the mechanics of the delivery process and contrast it with cash settlement.
LO 31 h: Evaluate the impact of different trading order types.
LO 31 i: Describe the application of marking to market and hedge accounting for futures.
LO 31 j: Compare and contrast forward and futures contracts.

QUESTIONS
1. Which of the following is not a characteristic of a futures contract?

A. The transaction is reported to a recognized exchange
B. The transaction is reported to a clearinghouse
C. The transaction is reported to certain regulatory agencies
D. The terms of the transaction are customized
2. Which of the following statements regarding the payoff and profit of a put option at expiry are
correct?
I. The basis is defined as the difference between the spot price of the asset and the futures
price.
II. As the futures contract nears expiry, the spot price and the futures price start to converge
and the basis should approach zero.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following statements regarding margins on a futures contract are not correct?
A. The initial margin on a futures contract acts like a down payment for the commitment to
purchase the underlying at the future date.
B. The margin requirements are set by the clearinghouse.
C. In most cases the futures margin is much higher than the stock margin.
D. The margin on a futures contract are set based on historical price movements.
4. Which of the following statements regarding the role of a clearinghouse are not correct?
A. The Clearinghouse protects itself by enforcing monthly settlement of outstanding positions
B. This process of daily settlement is called marking-to-market.
D. Marking-to-market is similar to terminating a contract at the end of each day and reopening
it the next day.
5. A platinum producer, with a December year end, sells a Dec 2021 platinum contract in June
2020. The price of the futures contract is $1,400 per ounce. Each contract is for the sale of 100
ounces of platinum. Assume the following spot prices of platinum:
 December 2020, $1,300.
 December 2021, $1,500.
What is the recorded accounting profit for the year ended 31 December 2021?
A. $20,000 gain.
B. $10,000 gain.
C. $10,000 loss.

D. $20,000 loss.
6. A platinum producer, with a December year end, sells a Dec 2021 platinum contract in
June 2020. The futures contract is sold as a hedge for expected production as at 31 December
2021.The price of the futures contract is $1,400 per ounce. Each contract is for the sale of 100
ounces of platinum. Assume the following spot prices of platinum:
 December 2020, $1,300.
 December 2021, $1,500.
What is the recorded accounting profit for the year ended 31 December 2021?
A. $20,000 gain.
B. $10,000 gain.
C. $10,000 loss.
D. $20,000 loss.
7. Which of the following statements regarding normal and inverted futures markets are correct?
I. In the event that prior settlement prices are rising over time we call this normal market.
II. In the event that prior settlement prices are dropping over time we call this an inverted
futures market.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. When dealing with a futures quote, which of the following headings most likely represents the
difference between yesterday’s closing price and the last price currently traded?
A. The high column
B. The change column
C. The last column
D. The prior settlement column
9. Which of the following methods is not a valid method for settlement of a futures contact?
A. Bilateral clearing
B. Cash settlement
C. Offsetting
D. Exchange for physicals (EFP)
10. An order to buy or sell a stock at the best current price is called a_______order.
A. Market order
B. Limit order
C. All-or-nothing order
D. Hidden orders

11. An experienced commodities risk manager is examining corn futures quotes from the CME
Group. Which of the following observations would the risk manager most likely view as a
potential problem with the quotation data?
A. The volume in a specific contract is greater than the open interest.
B. The prices indicate a mixture of normal and inverted markets.
C. The settlement price for a specific contract is above the high price.
D. There is no contract with maturity in a particular month.

SOLUTIONS
1. D
Features of a futures contract
 The transaction is reported to a recognized exchange (a futures exchange)
 The transaction is reported to a clearinghouse
2. C
The basis is defined as the difference between the spot price of the asset and the futures price.
Basis = Spot price less futures price
As the futures contract nears expiry, the spot price and the futures price start to converge and
the basis should approach zero.
3. C
The initial margin on a futures contract acts like a down payment for the commitment to
purchase the underlying at the future date. This payment is like a good-faith payment
(normally less than 10% of the price). These margin requirements are set by the clearinghouse.
In most cases the stock margin is much higher than the futures margin. The margin on a
futures contract are set based on historical price movements. The margin requirement will take
into account normal price movements and the fact that accounts are marked-to-market on a
daily basis.
4. A
This process of daily settlement is called marking-to-market. This procedure of marking to
market is essentially translating paper gains and losses into cash gains and losses on a daily
basis. It is similar to terminating a contract at the end of each day and reopening it the next day.
5. D
Profit or loss for the year ended 31 December 2020
($1,400 - $1,300) x 100 = gain of $10,000.
($1,300 - $1,500) x 100 = loss of $20,000.
6. C
Zero. The reason for this is that we delay the accounting treatment until such time as
the hedged item is produced and sold.
($1,400 - $1,500) x 100 = loss of $10,000.

7. C
The prior settlement represents the closing price from yesterday and to the extent that the
futures contract prices are increasing) we call this a normal futures market. In the event that
prior settlement prices are dropping we call this an inverted futures market.
8. B
The change column represents the difference between yesterday’s closing price and the
last price currently traded.
9. A
Physical delivery
Cash settlement
Offsetting
Exchange for physicals (EFP)
10. A
Market orders – This is an order to buy or sell a stock at the best current price.
Limit orders – The individual placing a limit order specifies the buy or sell price.
All-or-nothing orders will only be executed if the entire order can be filled.
 Hidden orders are orders where only the broker knows the full volume that is to
be traded.
11. C
The reported high price of a futures contract should reflect all prices for the day, so the
settlement price should never be greater than the high price.

Topic - 32
Using Futures for Hedging [FMP - 8]
Learning Objectives
Using Futures for Hedging
LO 32 a: Define and differentiate between short and long hedges and identify their appropriate
uses.
LO 32 b: Describe the arguments for and against hedging and the potential impact of hedging on
firm profitability.
LO 32 c: Define the basis and explain the various sources of basis risk, and explain how basis risks
arise when hedging with futures.
LO 32 d: Define cross hedging, and compute and interpret the minimum variance hedge ratio and
hedge effectiveness.
LO 32 e: Compute the optimal number of futures contracts needed to hedge an exposure, and
explain and calculate the “tailing the hedge” adjustment.
LO 32 f: Explain how to use stock index futures contracts to change a stock portfolio’s beta.
LO 32 g: Explain how to create a long-term hedge using a “stack and roll” strategy and describe
some of the risks that arise from this strategy.

What is basis risk?
Basis risk is the risk that the value of the hedging instrument will not move in line with
that of the underlying exposure. Another definition of basis risk is the risk that the hedging
instrument spread (for example, the cash futures) will widen or narrow during the time
that the hedge is in place.
QUESTIONS
1. Which of the following is not a characteristic of a short hedge?

A. The hedger sells a futures contract to hedge his position.
B. The hedger currently has a short position in the underlying asset.
C. The hedger expects the market to fall and hence the value of his long position to drop.
D. The short position in the futures contract will rise in value as the market falls thus
offsetting the losses on the long asset position.
2. Which of the following statements is not correct when looking at the disadvantages of hedging?
A. Hedging comes at a cost that often offsets some of the gains made from the underlying
transaction.
B. In the event that hedging protects the company, the question must be asked if the
shareholders could not have hedged themselves in an easier and more efficient manner.
C. There may be instances where the underlying asset is hedged by another activity within
the firm, in other words a natural hedge.
D. Hedging may be necessary to the extent that any price increases incurred by the firm as a
result of increased input costs can be passed on directly to the consumer.
3. Which of the following statements regarding the strengthening and weakening of the basis are
correct?
I. Strengthening of the basis – when the spot price of the asset increases at a faster rate than
the futures price over the time horizon.
II. Weakening of the basis – when the futures price increases at a faster rate than the spot
price of the asset over the time horizon..
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. In the in the event that a maturity mismatch exists between the asset and hedging instrument,
basis risk will exist. This is an example of a__________ mismatch.
A. Liquidity mismatch
B. Duration mismatch
C. Credit mismatch
D. Roll-over mismatch

5. Which of the following ratios best defines the optimal hedge ratio?
6. Which of the following statements regarding the coefficient of determination (R2) of the hedge
ratio, are correct?
I. The coefficient of determination (R2) can be used to determine the effectiveness of the
hedge.
II. The R2 measures how well the dependent variable (futures price) explain the
variability in the independent variable (spot prices).
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

The size of the portfolio is $100m. The Beta of the portfolio is 1.5 relative to the stock index. The
stock index futures are trading at $1,500 with a multiplier of 250.
Which of the following options in order to hedge the portfolio with futures is correct?
A. Buy 400 futures contracts.
B. Sell 400 futures contracts.
C. Buy 100,000 futures contracts.
D. Sell 100,000 futures contracts.

Initial information:
The size of the portfolio is $100m. The Beta of the portfolio is 1.5 relative to the stock index. The
stock index futures are trading at $1,500 with a multiplier of 250.
Subsequent information:
The stock index futures are trading at $1,600 with a multiplier of 250 and the spot price of the
sock index is $1,400.
The total number of futures contracts needed, after adjustment will be:
A. Buy 400 futures contracts.
B. Sell 400 futures contracts.
C. Buy 350 futures contracts.
D. Sell 350 futures contracts.
9. Manager Adjust a lot manages an equity portfolio with a market value of $10m and a beta of
0.9. He wishes to adjust the beta of the portfolio to 1.4. The current futures price is $150,000.
Calculate the number of contracts needed to adjust the portfolio to a beta of 1.4.

A. Buy 33.33 contracts

B. Sell 33.33 contracts
C. Buy 33.33 contracts
D. Sell 33.33 contracts
10. Which of the following statements regarding rollover risk, are correct?
I. In the event that the maturity of the hedge is shorter than the maturity of the underlying
asset, then the hedge will need to be rolled over when it expires, for a further period.
II. Rollover risk exists when we rollover as a result of being exposed to both the basis risk of
the initial transaction as well as the basis risk of the new transaction.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
11. A German housing corporation needs to hedge against rising interest rates. It has chosen to use
futures on 10-year German government bonds. Which position in the futures should the
corporation take, and why?
A. Take a long position in the futures because rising interest rates lead to rising futures prices.
B. Take a short position in the futures because rising interest rates lead to rising futures
prices.
C. Take a short position in the futures because rising interest rates lead to declining futures
prices.
D. Take a long position in the futures because rising interest rates lead to declining futures
prices.

SOLUTIONS
1. B
The hedger sells a futures contract to hedge his position.
The hedger currently has a long position in the underlying asset.
The hedger expects the market to fall and hence the value of his long position to drop. The
short position in the futures contract will rise in value as the market falls thus offsetting the
losses on the long asset position.
2. D
Hedging also presents the following disadvantages:
 Hedging comes at a cost that often offsets some of the gains made from the
underlying transaction.
 In the event that hedging protects the company, the question must be asked if the
shareholders could not have hedged themselves in an easier and more efficient manner.
 There may be instances where the underlying asset is hedged by another activity within
the firm, in other words a natural hedge. Thus the need for a hedge by using a
futures contract may prove to be expensive and unnecessary.
 Hedging may be unnecessary to the extent that any price increases incurred by the firm as
a result of increased input costs can be passed on directly to the consumer. In this
way there is no need to hedge as all the increased costs can be passed on to the consumer.
3. C
Strengthening of the basis – when the spot price of the asset increases at a faster rate than the
futures price over the time horizon.
Weakening of the basis – when the futures price increases at a faster rate than the spot price of
the asset over the time horizon.
4. B
 Liquidity mismatch – in the event that the asset is hedged with an illiquid hedging
instrument, basis risk will exist.
 Maturity / duration mismatch – in the event that a maturity mismatch exists between the
asset and hedging instrument, basis risk will exist.
 Credit mismatch - in the event that a credit mismatch exists between the asset and hedging
instrument, basis risk will exist.
5. B
The optimal hedge ratio can be calculated as follows:

6. A
The coefficient of determination (R2), or goodness of fit calculation, can be used to determine
the effectiveness of the hedge. In other words how well does the independent variable (futures
price) explain the variability in the dependent variable (spot prices).
7. B
The first step is to apply the formula:
Based on this we need to sell approximately 400 contracts in order to hedge our long stock
position.
8. D
The total number of futures contracts needed, will now be:
9. A
10. C
In the event that the maturity of the hedge is shorter than the maturity of the underlying asset,
then the hedge will need to be rolled over when it expires, for a further period. This is to ensure
that it matches the maturity of the underlying asset. Rollover risk exists when we rollover as a
result of being exposed to both the basis risk of the initial transaction as well as the basis risk of
the new transaction.
11. C
Government bond futures decline in value when interest rates rise, so the housing corporation
should short futures to hedge against rising interest rates.

Topic - 33
Foreign Exchange Markets [FMP - 9]
Learning Objectives
Foreign Exchange Markets
LO 33 a: Explain and describe the mechanics of spot quotes, forward quotes, and futures quotes in
the foreign exchange markets, and distinguish between bid and ask exchange rates.
LO 33 b: Calculate bid-ask spread and explain why the bid-ask spread for spot quotes may be
different from the bid-ask spread for forward quotes.
LO 33 c: Compare outright (forward) and swap transactions.
LO 33 d: Define, compare, and contrast transaction risk, translation risk, and economic risk.
LO 33 e: Describe examples of transaction, translation, and economic risks, and explain how to
hedge these risks.
LO 33 f: Describe the rationale for multi-currency hedging using options.
LO 33 g: Identify and explain the factors that determine exchange rates.
LO 33 h: Calculate and explain the effect of an appreciation/depreciation of a currency relative to a
foreign currency.
LO 33 i: Explain the purchasing power parity theorem and use this theorem to calculate the
appreciation or depreciation of a foreign currency.
LO 33 j: Describe the relationship between nominal and real interest rates.
LO 33 k: Describe how a non-arbitrage assumption in the foreign exchange markets leads to the
interest rate parity theorem, and use this theorem to calculate forward foreign exchange rates.
LO 33 l: Distinguish between covered and uncovered interest rate parity conditions.

QUESTIONS
1. Which of the following hedging instruments is the most effective instrument to manage
translation risk?
A. Forwards.
B. Futures.
C. Swaps.
D. Financing assets and liabilities in the same currency.
2. The following information is available on 31 December 2019:
What is the amount of the forward premium?

A. 16.48%
B. -16.48%
C. 0.3336
D. -0.3336
3. An entity is due a dividend from an overseas subsidiary in 2 months-time. What would the
entity be hoping for?
A. Foreign currency strength.
B. Foreign currency weakness.
C. No movement in the foreign currency.
D. Cannot be determined.
4. An entity is due to make a payment in 3 months-time to an overseas supplier. What would the
entity be hoping for?
A. Foreign currency strength.
B. Foreign currency weakness.
C. No movement in the foreign currency.
D. Cannot be determined.
5. Which type of option works on the average price of the underlying asset during the life of the
contract?
A. Asian option.
B. Knock-in option.
C. Basket option.
D. Exotic option.
6. Which theory works on the relationship between exchange rates and inflation rates
between the two countries?
A. Purchasing power parity.
B. Covered interest rate parity.

C. Uncovered interest rate parity.

D. Taylor rule.
7. Assume that an entity is exposed to three currencies, X, Y, and Z and implements the
following option strategy.
Buy an option on currency X
Buy on option on currency Y
Sell an option on currency Z
What type of option strategy us being used?
A. Asian option.
B. Knock-in option.
C. Basket option.
D. Exotic option.
8. Which of the following statements are not correct when dealing with the interest rate parity
theory?
9. Which of the following statements are correct regarding purchasing power parity?
I. There is a direct relationship between currencies and inflation rates, called the purchase
power parity theory.
II. This theory states that the difference between a spot and forward rate for a currency quote
can be attributed to the difference between the expected inflation rates (inflation rate
differential) of the two countries.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
10. Which of the following statements are correct when describing the relationship between
nominal and real interest rates? A base currency’s exchange rate is likely to increase if:
A. It’s short-term real exchange rate rises.
B. It’s real or nominal interest rates rise. This will attract foreign capital.
C. The foreign inflation rate increases. This will cause the foreign currency to depreciate.
D. The foreign risk premium increases. This will make foreign assets less attractive.

SOLUTIONS
1. D
The best way to mitigate translation risk is to finance the assets in a country with loans in that
country and currency.
2. C
Premium calculation
3. A
Foreign currency gains and losses occur as follows:
4. C
Foreign currency gains and losses occur as follows:

5. A
An Asian option works on the average price of the underlying asset during the life of
the contract.
6. A
Purchasing power parity (PPP)
7. C
Assume that an entity is exposed to three currencies, X, Y, and Z. A basket option involves the
following type of transaction:
Buy an option on currency X
Buy on option on currency Y
Sell an option on currency Z
8. A
 There is a direct relationship between currencies and interest rates, called the interest rate
parity theory.
 This theory states that the difference between the spot and the forward rates for a currency
quote can be attributed to the difference between the expected interest rates (interest rate
9. C
Purchasing power parity works as follows:
 There is a direct relationship between currencies and inflation rates, called the purchase
power parity theory.
 This theory states that the difference between a spot and forward rate for a currency quote
can be attributed to the difference between the expected inflation rates (inflation rate
10. A
A base currency’s exchange rate is likely to increase if:
 It’s long-term real exchange rate rises.
 It’s real or nominal interest rates rise. This will attract foreign capital.
 The foreign inflation rate increases. This will cause the foreign currency to depreciate.
 The foreign risk premium increases. This will make foreign assets less attractive.

Topic - 34
Pricing Financial Forwards and Futures [FMP - 10]
Learning Objectives
Pricing Financial Forwards and Futures
LO 34 a: Differentiate between investment and consumption assets.

LO 34 b: Define short-selling and calculate the net profit of a short sale of a dividend-paying stock.
LO 34 c: Describe the differences between forward and futures contracts and explain the
relationship between forward and spot prices.
LO 34 d: Calculate the forward price given the underlying asset’s spot price, and describe an
arbitrage argument between spot and forward prices.
LO 34 e: Distinguish between the forward price and the value of a forward contract.
LO 34 f: Calculate the value of a forward contract on a financial asset that does or does not provide
income or yield.
LO 34 g: Explain the relationship between forward and futures prices.
LO 34 h: Calculate a forward foreign exchange rate using the interest rate parity relationship.
LO 34 i: Calculate the value of a stock index futures contract and explain the concept of index
arbitrage.

QUESTIONS
1. Which of the following calculations regarding investment and consumption assets are correct?
I. An example of an investment asset would be a fixed income security.
II. An example of a consumption asset would be oil or gas.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
2. Which of the following are not steps in the short selling process?
A. The investor buys the security from a broker
B. The investor then sells the security.
C. The investor will keep a potion of the sale proceeds on deposit with the broker as collateral
to guarantee the final repurchase of the security.
D. The investor returns the borrowed security when the sale is closed out.
3. Which of the following statements is not a characteristic of a futures contract?

A. More transparent
B. More liquid
C. High default risk
D. Value at inception = 0
4. Assume that the calculated forward price is $5,000, straight after the inception of the contract
the stock is priced at $6,000. The risk-free rate is 6%. The continuously compounded dividend
yield is 3%. The forward expires in 6 months time.
What is the value of the forward contract?
A. $5,910.67
B. $4,852,22
C. $1,058.44
D. $1,000.00
5. Which of the following relationships between forward and futures prices are correct?
I. A big difference between forwards and futures is that in futures contracts they are
marked-to-market daily and margin payments are made.
II. In the event that the interest rate is known and the T is small there is a significant
difference between the pricing of forward and futures contracts.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.


The domestic currency is the US dollar and the foreign currency is the Swiss franc.
The spot rate is $0.5987.
The contract is set to mature in 180 days.
US interest rate = 5.5%
Swiss interest rate = 4.75%
What is the price of the currency forward?
A. 0.5987
B. 0.5994
C. 0.6034
D. 0.5980
7. Which of the following statements regarding the futures price incorporating storage costs is
correct?
8. The current price of an asset is $100 and the continuously compounded interest rate is 5%. An
interim cash flow of $10 is received after 6-months into the contract. What is the price of a 9-
month forward contract?
A. $9.75
B. $93.69
C. $100.00
D. $10.00
9. Assume that the index is currently trading at 3,000 points. The risk-free rate is 6% and the
dividend yield is 3%. The term of the contract is for six months. What Is the price of the index
futures contract?
A. 3,043 points
B. 3,000 points
C. 3,045 points
D. 3,089 points
10. A risk manager deciding between buying a futures contract on exchange and buying a forward
contract directly from a counterparty on the same underlying asset. Both contracts would have
the same maturity and delivery specifications. The manager finds that the futures price is less
than the forward price. Assuming no arbitrage opportunity exists, what single factor acting
alone would be a realistic explanation for this price difference?
A. The futures contract is more liquid and easier trade.
B. The forward contract counterparty is more likely to default.
C. The asset strongly negatively correlated with interest rates.
D. The transaction costs on the futures contract are less than on the forward contract.

SOLUTIONS
1. C
An investment asset is held for the purposes of investing. Examples of such assets
include, equities, bonds, derivatives and alternative investments.
A consumption asset is held for the purpose of being consumed. An example of such an asset
may be a commodity that is consumed in a production process (such as metal) or a commodity
that is consumed as part of our daily lives (such as oil or gas).
2. A
 The investor borrows the security from a broker and then sells the security.
 The investor will keep a potion of the sale proceeds on deposit with the broker as collateral
to guarantee the final repurchase of the security.
 The investor returns the borrowed security when the sale is closed out or the
lender requests the security back. The manner in which the security is returned to the
lender is by the investor buying the security back on the market.
3. C
Futures contract characteristics:
More transparent
More liquid
Clearinghouse limits risk
Value at inception = 0
4. C
5. A
A big difference between forwards and futures is that in futures contracts they are marked-to-
market daily and margin payments are made.
In the event that the interest rate is known and the T is small there is no significant difference
between the pricing of forward and futures contracts.
6. B
Price of a currency forward:
F0 = 0.5987e(0.05 – 0.0475)0.4932
F0 = 0.5994

7. A
F0 = (S0 + U)erT
This means that the futures price equals the spot price compounded over the life of the futures
contract at the risk free rate plus the value of the storage costs over the life of the contract.
We could express the storage costs in terms on a continuous yield as follows:
F0 = S0e(r+u)T
8. B
The price of a 9-month forward contract can be calculated as follows:
I = the present value of the interim cash flows
9. A
10. C
When an asset is strongly negatively correlated with interest rates, futures prices will tend to be
slightly lower than forward prices. When the underlying asset increases in price, the immediate
gain arising from the daily futures settlement will tend to be invested at a lower than average
rate of interest due to the negative correlation. In this case futures would sell for slightly less
than forward contracts, which are not affected by interest rate movements in the same manner
since forward contracts do not have a daily settlement feature.
The other three choices would all most likely result in the futures price being higher than the
forward price.

Topic - 35
Commodity Forwards and Futures [FMP - 11]
Learning Objectives
Commodity Forwards and Futures
LO 35 a: Explain the key differences between commodities and financial assets.

LO 35 b: Define and apply commodity concepts such as storage costs, carry markets, lease rate, and
convenience yield.
LO 35 c: Identify factors that impact prices on agricultural commodities, metals, energy, and
weather derivatives.
LO 35 d: Explain the basic equilibrium formula for pricing commodity forwards.
LO 35 e: Describe an arbitrage transaction in commodity forwards, and compute the potential
arbitrage profit.
LO 35 f: Define the lease rate and explain how it determines the no-arbitrage values for commodity
forwards and futures.
LO 35 g: Describe the cost of carry model and illustrate the impact of storage costs and convenience
yields on commodity forward prices and no-arbitrage bounds.
LO 35 h: Compute the forward price of a commodity with storage costs.
LO 35 i: Compare the lease rate with the convenience yield.
LO 35 j: Explain how to create a synthetic commodity position, and use it to explain the relationship
between the forward price and the expected future spot price.
LO 35 k: Explain the relationship between current futures prices and expected future spot prices,
including the impact of systematic and nonsystematic risk.
LO 35 l: Define and interpret normal backwardation and contango.

QUESTIONS
1. Which of the following areas regarding costs of carry in a commodities forward contract are not
correct?
A. Storage costs and carrying costs are a function of the physical characteristics of the
underlying asset. Some assets are easy to store and others are more difficult.
B. The costs of storage need to be deducted from the price of the contract.
C. The lease rate is the rate that the lessor of the asset will earn from leasing out the unused
asset.
D. A nonmonetary benefit is called a convenience yield.
2. Which of the following areas regarding costs of carry in a commodities forward contract are not
correct?
A. The basic formula used to price commodity forwards assumes a no arbitrage position.
B. The forward price must equal the current spot price plus the costs of carry.
C. The costs of carry include interest costs, storage costs and the convenience yield.
D. The forward price of a commodity will equal: F0,T = Soe-rT
3. Which of the following is not a step in the reverse cash and carry arbitrage process?
A. Buy the asset
B. Sell the asset
C. Lend money
D. Buy the forward contract
4. Assume that the current spot price per ounce of silver is $14.25. The annual lease rate is 6% and
the risk- free rate is 10%. Time to maturity on the contract is 6 months. What is the price of a
forward contract?
A. $14.25
B. $14.54
C. $14.83
D. $13.97
5. Assume that the current spot price per ounce of silver is $14.25. The monthly cost of storage is
$0.15 and the effective monthly risk-free rate is 1%. Time to maturity on the contract is 2
months. Assume discrete compounding for the storage cost component. What is the price of a
forward contract?
A. $14.54
B. $0.3015
C. $14.84
D. $14.25

6. When assessing the range of forward arbitrage prices present in the market (including costs of
carry), which of the following statements are correct?
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
7. Which of the following statements regarding convenience yields and lease rates are not correct?
A. The lease rate is earned when the commodity is purchased and lent out.
B. The lease rate = Convenience yield – storage costs.
C. There is a negative relationship between the lease rate and the storage costs.
D. It is not possible to get a negative lease rat.
8. Which of the following commodities has the shortest storage period?

A. Gold
B. Corn
C. Oil
D. Electricity
9. Assume the following crack spread 6-4-2 applies to crude oil, gasoline and heating oil. We are
planning to produce gasoline and heating oil from the crude oil in one-month time. The 1-
month forward prices are as follows:
Crude oil = $30 per barrel
Gasoline = $60 per barrel
Heating oil = $45 per barrel
What is the crack spread per barrel?
A. $180
B. $150
C. $25
D. $30
10. Which of the following is not a reason for basis risk when dealing with commodity futures?
A. The hedging instrument is exactly the same as the underlying instrument.
B. The hedge may need to be extended post the initial hedge period.
C. The hedge may need to be liquidated prior to the end of the initial hedge period.
D. When calculating the number of contracts needed to be bought or sold, this number is often
rounded off.
11. A commodity producer is looking for a hedge for his production. Assuming that one of his
main requirements is that the hedge be cheap, which of the following hedges are most likely to
be used?
A. Stack hedge

B. Strip hedge
C. Zero cost collar
D. Caplet
12. When looking to make use of a cross-hedge for a commodity transaction, which of the
following is not a factor that needs to be considered?
A. The term and maturity of the futures contract being used.
B. The correlations between the underlying and the contract.
C. The liquidity of the contract
D. The price risk of the commodity
13. When creating a synthetic commodity position which of the following statements are correct?
I. A synthetic commodity forward price can be created by a combination of: Long
commodity forward (F0,T)) + Zero coupon bond (paying F0,T)) at T.
II. No money changes hands at the outset of the contract.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
14. A risk analyst at a commodities trading firm is examining the supply and demand conditions
for various commodities and is concerned about the volatility of the forward prices for silver in
the medium term. Currently, silver is trading at a spot price of USD 20.35 per troy ounce and
the six- month forward price is quoted at USD 20.50 per troy ounce. Assuming that after six
months the lease rate rises above the continuously compounded interest rate, which of the
following statements is correct about the shape of the silver forward curve after six months?
A. The forward curve will be downward sloping.
B. The forward curve will be upward sloping.
C. The forward curve will be flat.
D. The forward curve will be humped.

SOLUTIONS
1. B
Storage costs and carrying costs are a function of the physical characteristics of the underlying
asset. Some assets are easy to store and others are more difficult.
The costs of storage need to be added to the price of the contract.
The lease rate is the rate that the lessor of the asset will earn from leasing out the unused asset.
A nonmonetary benefit is called a convenience yield.
2. D
The basic formula used to price commodity forwards assumes a no arbitrage position. Based
on this, the forward price must equal the current spot price plus the costs of carry. The costs of
carry include interest costs, storage costs and the convenience yield.
Keeping the above in mind, the forward price of a commodity will equal:
F0,T = SoerT
3. A
Reverse cash and carry arbitrage
Borrow the asset
Sell the asset
Lend money
Buy the forward contract
4. B
Price of a forward contract:
5. C
Assume that the current spot price per ounce of silver is $14.25. The monthly cost of storage is
$0.15 and the effective monthly risk-free rate is 1%. Time to maturity on the contract is
2 months.
Price of a forward contract:
Step 1: Compute the future value of the storage costs

6. C
Range of arbitrage free prices that are present in the market:
7. D
The lease rate is earned when the commodity is purchased and lent out.
The lease rate = Convenience yield – storage costs
There is a negative relationship between the lease rate and the storage costs.
It is possible to get a negative lease rate, when storage costs are very high.
8. D
Electricity is not storable and will go to waste if not consumed.
9. C
10. A
Reasons for basis risk include:
 The hedging instrument is not exactly the same as the underlying instrument. For example,
a commodity producer may hedge his commodity with a futures contract that does not
match his commodity perfectly, for example, a New York producer may hedge his
commodity with a NYMEX future (that specifies delivery in Oklahoma) that are not an
exact matches.
 The hedge may need to be extended post the initial hedge period.
 The hedge may need to be liquidated prior to the end of the initial hedge period.
 When calculating the number of contracts needed to be bought or sold, this number is
often rounded off.
11. A
A stack hedge uses near-dated futures that are often more liquid and cheap than a strip hedge.

12. D
The following factors need to be considered when looking at a cross-hedge:
 The term and maturity of the futures contract being used.
 The correlations between the underlying and the contract.
 The liquidity of the contract (to be able to unwind quickly if need be).
13. C
A synthetic commodity forward price can be created by a combination of: Long
commodity forward (F0,T))+ Zero coupon bond (paying F0,T)) at T. No money changes hands at
the outset of the contract.
14. A
The forward price is computed as: F0,T = Soe(r + λ - c)T And the commodity lease rate () is
computed as  = c - λ. So, the forward price can alternatively be expressed in terms of lease rate
and risk-free rate as: F0,T = Soe(r - δ)T.
Therefore, as the risk-free rate falls below the lease rate (r <  = c - ), we can see from the
forward price formula above that F < S, and the forward curve will be in backwardation.

Topic - 36
Options Markets [FMP - 12]
Learning Objectives
Options Markets
LO 36 a: Describe the types, position variations, payoffs and profits, and typical underlying assets of
options.
LO 36 b: Explain the specification of exchange-traded stock option contracts, including that of
nonstandard products.
LO 36 c: Explain how dividends and stock splits can impact the terms of a stock option.
LO 36 d: Describe how trading, commissions, margin requirements, and exercise typically work for
exchange-traded options.
LO 36 e: Define and describe warrants, convertible bonds, and employee stock options.

QUESTIONS
1. Which of the following statements regarding the principles of option pricing are correct?
A. An option has a positive value at the start.
B. The buyer of the option will pay the option premium and the seller will receive this
premium in order to initiate the contract.
C. Options have symmetrical payoffs.
D. The maximum loss to the buyer (long) is the option premium.
2. Which of the following statements regarding the value of a call option at expiry are correct?
I. At expiry the call option is worth the greater of: Zero, Or the difference between the
underlying price and the exercise price.
II. At expiry the value of the call can be denoted as follows: cT = Max(0, ST – X)
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following statements regarding the value of a put option at expiry are correct?
I. At expiry the put option is worth the greater of: Zero, Or the difference between the
exercise price and the underlying price
II. At expiry the value of the put option can be denoted as follows: pT = Max(0, X - ST)
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. Assume that the call option exercise price on the S&P index is trading at 1900 for a June
contract. The contract multiplier is 200.
The price of the option is $3000. The S&P was trading at 1950 at the date of expiry of the
contract. What is the gain on the option?
A. $10,000
B. $7,000
C. $50
D. $1,950
5. Consider a bond on a 10-year Treasury bond. The current coupon is 2.0%, the yield is 2.70%.
The price per $1 of par value is equal to $0.9394.
Assume that a call option is issued on this bond at a price of $0.96.
The price of the bond at the expiry of the option is equal to $0.99.
The options contract covers $10m face value of bonds and is cash settled.
What is the gain on the bond option?
A. $99,000
B. $96,000

C. $300,000
D. $3,000
6. Which of the following options best describe the following option “They are predominantly
standardized however do have some customizable options. These include, changing the strike
price, changing the expiry date, European or American options.”
A. Index options
B. FLEX options
C. ETF options
D. DOOM options
7. Which of the following options best describe the following option “if the price is above the
strike price it pays out a certain amount and if not it does not pay out at all.”
A. CEBO options
B. FLEX options
C. ETF options
D. Binary options
8. Which of the following statements regarding options and dividends and stock splits are
correct?
I. Options are not adjusted for dividends.
II. Options are adjusted for stock splits.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
A. $4,000
B. $330
C. $150

D. $50
A. $6,000
B. $5,250
C. $5,070
D. $10,000
11. Company XYZ operates in the US. On April 1, 2016, it has a net trade receivable of EUR
5,000,000 from an export contract to Germany. The company expects to receive this amount on
Oct. 1, 2016. The CFO of XYZ wants to protect the value of this receivable. On April 1, 2016, the
EUR spot rate is 1.14, and the 6-month EUR forward rate is 1.13. The CFO can lock in an
exchange rate by taking a position in the forward contract. Alternatively, the CFO can sell a 6-
month EUR 5,000,000 call option with strike price of 1.14. The CFO thinks that selling an option
is better than taking a forward position because if the EUR goes up, XYZ can take delivery of
the USD at 1.14, which is better than the outright forward rate of 1.13. If the EUR goes down,
the contract will not be exercised. Therefore, XYZ will pocket the premium obtained from
selling the call option. What can be concluded about the CFO’s analysis?
A. The CFO’s analysis is correct. The company is better off whichever way the EUR rate goes.
B. The CFO’s analysis is not correct. The company will suffer if the EUR goes up sharply.
C. The CFO’s analysis is not correct. The company will suffer if the EUR moves within a
narrow range.
D. The CFO’s analysis is not correct. The company will suffer if the EUR goes down sharply.

SOLUTIONS
1. C
An option has a positive value at the start. The buyer of the option will pay the option premium
and the seller will receive this premium in order to initiate the contract. Based on this we can see
that options have asymmetric payoffs. The maximum loss to the buyer (long) is the option
premium.
2. C
At expiry the call option is worth the greater of:
iii) Zero, Or
iv) The difference between the underlying price and the exercise price
cT = Max(0, ST – X)
3. C
At expiry the put option is worth the greater of:
iii) Zero, Or
iv) The difference between the exercise price and the underlying price
pT = Max(0, X - ST)
4. B
The gain on the option will be:
Value of index at expiry 1,950
Less: contract price (1,900)
Gain on the contract 50
X multiplier $200
Gain = $10,000
Less: price paid for option ($3,000)
Net gain $7,000
5. C
Assume that a call option is issued on this bond at a price of $0.96.
The price of the bond at the expiry of the option is equal to $0.99.
The options contract covers $10m face value of bonds and is cash settled.
Gain on the bond option =
($0.99 – $0.96) X $10,000,000
= $300 000
6. B
FLEX options – FLEX options trade on an exchange with the underlying being an equity or
equity index. They are predominantly standardized however do have some customizable
options. These include, changing the strike price, changing the expiry date, European or
American options. The minimum contract size is 100 contracts.

7. D
Binary options – A binary option is an option that only has one payoff profile. For example if the
price is above the strike price it pays out a certain amount and if not it does not pay out. This is
different to normal options that continue to increase as the price moves above the strike price.
8. C
Dividends and stock splits
Options are not adjusted for dividends but are adjusted for stock splits.
9. C
Calculate the cost of the contract
Cost of the call = $40 x 100 shares
= $4,000
Cost of commission = $50 + ($4,000 x 0.7%)
= $330
The commission is limited to a maximum of $150.
10. B
Step 1: Calculate the cost of the contract
Cost of the call = $40 x 100 shares = $4,000
Cost of commission = $50 + ($4,000 x 0.7%) = $330
The commission is limited to a maximum of $150.
Step 2: Calculate the profit on the contract
($600 - $500) x 100 shares = $10,000
($600 - $500) x 100 shares = $10,000
Less commission:
On purchase = ($150)
On sale ($600 x 100 x 1%) = ($600)
Total profit = $5,250
11. D
The CFOs analysis is incorrect because there is unlimited downside risk. The option premium
received is a fixed amount, and if the EUR declines sharply, the value of the underlying
receivable goes down as well. If instead the EUR moves in a narrow range, that would be good,
but there is no guarantee of course that this will occur.

Topic 37
Properties of Options [FMP - 13]
Learning Objectives
Properties of Options
LO 37 a: Identify the six factors that affect an option’s price.

LO 37 b: Identify and compute upper and lower bounds for option prices on non-dividend and
dividend paying stocks.
LO 37 c: Explain put-call parity and apply it to the valuation of European and American stock
options, with dividends and without dividends, and express it in terms of forward prices.
LO 37 d: Explain and assess potential rationales for using the early exercise features of American
call and put options.

QUESTIONS
1. Which of the following statements regarding the vega of option pricing are not correct?
A. Volatility is the standard deviation of the continuously compounded return on the stock.
B. Volatility is an easy measure to calculate.
C. The relationship between the option price and volatility is called vega.
D. Vega is positive on both calls and puts, which means that if the volatility increases so to
will the prices of call and put options.
2. Which of the following statements regarding the rho of an option are correct?
I. Call options increase in value as the risk-free rate increases.
II. Put options decrease in value as the risk-free rate increases..
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following statements regarding the dividend of an option are correct?
I. The higher the exercise price – the lower the call option price.
II. The higher the exercise price – the higher the put option price.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. When looking at the minimum values for calls and puts for European and American options,
which of the following statements are not correct?
A. European call = c0≥max(0, S0 - Xe-rT)
B. American call = C0≥ max(0, S0 - Xe-rT)
C. European put = p0≥ max(0, Xe-rT - S0)
D. American put = P0≥ max(0, S0 - X)
5. When looking at the maximum values for calls and puts for European and American options,
A. European call = c0<=So
B. American call = C0<=So
C. European put = p0<= Xe-Rt
D. American put = P0<= Xe-rT
6. Assume the following:

X = 100
Risk free rate = 5%
T = 180 days
S = 90

What is the maximum value for a European call option?

A. 0
B. 90
C. 7.53
D. 97.53
7. Which of the following statements regarding the strategy of fiduciary calls are correct?
I. Buying a European call option
II. Selling a risk-free bond
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. When working with the put call parity relationship, which of the following equations are not
correct?
A. c0 + Xe-rT = p0 + S0
B. c0 = p0 + S0 - Xe-rT
C. p0 = c0 - S0 + Xe-rT
D. p0 - S0 = c0 + Xe-rT
9. When assessing early exercise of an American option, which of the following statements are
correct?
I. When the underlying makes no cash payments, C0 = c0
II. When the underlying makes cash payments during the life of the option, early exercise
may be worthwhile and C0 may be higher than c0.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
10. When assessing the affect of a dividend on a European option, which of the following
statements are correct?
I. c0 ≥ Max [0, [S0 – PV(D,0,T)] – Xe-rT]
II. p0 ≥ Max [0, Xe-rT + PV(D,0,T - S0]
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
11. The price of a six-month, USD 25.00 strike, European put option on a stock is USD 3.00. The
stock price is USD 26.00. A dividend of USD 1.00 is expected in three months. The
continuously compounded risk-free rate for all maturities is 5% per year. Which of the

following is closest to the value of a call option on the same underlying stock with a strike
price of USD 25.00 and a time to maturity of six months?
A. USD 1.63
B. USD 2.40
C. USD 3.63
D. USD 4.62
SOLUTIONS
1. B
Volatility is the standard deviation of the continuously compounded return on the stock.
Volatility is a difficult measure to calculate. The relationship between the option price and
volatility is called vega. Vega is positive on both calls and puts, which means that if the
volatility increases so to will the prices of call and put options.
2. C
Call options increase in value as the risk-free rate increases.
Put options decrease in value as the risk-free rate increases.
3. C
Dividends
The higher the exercise price – the lower the call option price.
The higher the exercise price – the higher the put option price.
4. D
Minimum values
European call = c0≥max(0, S0 - Xe-rT) American call = C0≥ max(0, S0 - Xe-rT) European put =
p0≥ max(0, Xe-rT - S0) American put = P0≥ max(0, X - S0)
5. D
Maximum values
European call = c0<=So American call = C0<=So European put = p0<= Xe-rT American put =
P0<=X
6. A
c0 ≥ Max [0, S0 – Xe-rT] c0 ≥ Max [0, 90 –100e-0.05(0.5)] c0 ≥ Max [0, 90 – 97.53] c0 ≥ Max [0, -
7.53]
7. A
Fiduciary calls:
This strategy involves:
 Buying a European call option

 Buying a risk-free bond (that matures on the options’ expiration date and has a face value
that is equal to the exercise price of the call)
8. D
c0 + Xe-rT = p0 + S0 c0 = p0 + S0 - Xe-rT p0 = c0 - S0 + Xe-Rt
9. A
When will it be better to exercise the American call option early and lose the “time value” of the
option? An obvious case would be when early exercise would result in a cash payment. An
example would be to exercise just before a stock goes ex-div.
Based on this we could say:

 When the underlying makes no cash payments, C0 = c0
 When the underlying makes cash payments during the life of the option, early exercise
may be worthwhile and C0 may be higher than c0.
10. C
The effect of cash flows on the underlying asset
When cash flows are generated on the underlying this must be taken into account. Just like
with Forwards and futures we assume that we know the cash flows attributable to the
underlying at inception and make a present value adjustment to the price – so to by options we
need to do the same.
Based on this our equations will change slightly to take into account the cash flows on the
underlying asset:
European options – lower bounds:
c0 ≥ Max [0, [S0 – PV(D,0,T)] – Xe-rT]
p0 ≥ Max [0, Xe-rT + PV(D,0,T - S0]
11. C
From the equation for put-call parity, this can be solved by the following equation: c = S0 + p -
PV (K) - PV (D)
where PV represents the present value, so that PV (K) = K x e-rT and PV(D) = D e-rT
Where:
p represents the put price, c is the call price,
K is the strike price of the put option, D is the dividend,
S0 is the current stock price.
T is the time to maturity of the option, and t is the time to the next dividend distribution.
Calculating PV(K), the present value of the strike price, results in a value of 25.00 ∗ e-0.05 x 0.5
or 24.38, while PV (D) is equal to 1.00 ∗ e-0.05 x 0.25, or 0.99. Hence c = 26.00 + 3.00 – 24.38 –
0.99 = USD 3.63

Topic 38
Trading Strategies [FMP - 14]
Learning Objectives
Trading Strategies
LO 38 a: Explain the motivation to initiate a covered call or a protective put strategy.

LO 38 b: Describe principal protected notes (PPNs) and explain necessary conditions to create a
PPN.
LO 38 c: Describe the use and calculate the payoffs of various spread strategies.
LO 38 d: Describe the use and explain the payoff functions of combination strategies.

QUESTIONS
1. Which of the following statements regarding a covered call strategy are not correct?
A. The investor writes a covered call when he believes that the market will not move too far
away from where it is trading at present.
B. The strategy involves selling an out-of-the-money call against the current stock.
C. The sale of the option generates revenue from the premium.
D. In the event that stock prices move up, this will cause a gain on the call.
2. Which of the following statements regarding a protective put strategy are correct?
I. The potential upside on the stock is maintained.
II. The investor’s initial position is equal to: Short stock + Long put option.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. A Oct bull call spread is trading at Oct 25/30 for Bully Inc.
The option premiums are as follows:
$4.00 for the $25 call.
$1.50 for the $30 call.
Assume that the price of the stock closed at $32 – what is the profit / loss on the trade?
A. Gain $2.50
B. Loss $2.50
C. Gain $5.00
D. Gain $5.00
4. Which of the following statements regarding a bear call and a bear put spread are correct?
I. A bear put trade is constructed as follows: Long a put option with a high exercise price +
Selling a put option with a low exercise price.
II. A bear call spread is constructed as follows: Selling a call option with a low exercise price +
Long a call option with a high exercise price.
A. I only
B. II only
C. Both I and II
D. Neither I or II.
5. Jon Vick is a derivatives specialist at Derive Bank. He has constructed a butterfly call spread for
Wings Inc. when the call options are trading as follows:
Call price = $5.00 at an X of $30
Assume that the price of the stock closed at $33 – what is the profit / loss on the trade?
A. Gain $2.00

B. Loss $2.00
C. Loss $1.00
D. Loss $3.00
6. The following options strategy has been suggested:

A long call at the lower strike price (XL)
A short call at the higher strike price (XH)
A long put at the lower strike price (XH)
A short put at the higher strike price (XL)
What type of strategy is this?
A. Diagonal spread
B. Box spread
C. Calendar spread
D. Bull call spread
7. Which of the following structures best describes a long straddle?

A. Long an at-the-money put option + Long an at-the-money call option.
B. Short an at-the-money put option + Short an at-the-money call option
C. Long an at-the-money x 2 put options + Long an at-the-money call option
D. Long an at-the-money x 1 put option + Long an at-the-money 2 x call options.
8. Which of the following structures best describes a short straddle?

A. Long an at-the-money put option + Long an at-the-money call option.
B. Short an at-the-money put option + Short an at-the-money call option
C. Long an at-the-money x 2 put options + Long an at-the-money call option
D. Long an at-the-money x 1 put option + Long an at-the-money 2 x call options.
9. Which of the following statements regarding collars as an option strategy are not correct?
A. A collar can be used to reduce the cost of the hedge.
B. A collar is when options are written or sold and the income received can be used to reduce
the cost of the hedge.
C. A collar strategy would be to sell an out-of-the-money (OTM) put option (protective put)
and to buy an out-of-the-money call option (covered call).
D. The risk of a collar is that it cuts off a part of the upside return in order to secure downside
protection.
10. A borrower needs to use an interest rate option to hedge the risk on a floating rate loan with
several payments he may need to use several interest rate options to hedge this risk. In other
words, a separate option for every payment date. What is this strategy an example of?
A. Interest rate cap
B. Interest rate floor
C. Zero-cost collar
D. Floorlet

11. Jacqui Jones sells a March 2010 call on XYZ stock with an exercise price of $45 for a $3
premium. She also buys a March 2010 call on the same stock with an exercise price of $40 for a
$5 premium. Identify this option strategy and the maximum profit and loss for the investor.
A. Bear call spread, maximum profit is $3, maximum loss is $2.
B. Bull call spread, maximum profit is $3, maximum loss is unlimited.
C. Bear call spread, maximum profit is unlimited, maximum loss is $2.
D. Bull call spread, maximum profit is $3, maximum loss is $2.

SOLUTIONS
1. D
Covered call
The investor writes a covered call when he believes that the market will not move too far away
from where it is trading at present. The strategy involves selling an out-of-the-money call
against the current stock. The sale of the option generates revenue from the premium. In the
event that stock prices move up, this will cause a loss on the call. However, that gain on the
stock will offset his loss on the call option. In addition, he can use the premium written, to
offset a part of his loss.
2. A
Protective puts
A protective put is a risk-management strategy that investor can use to guard against the loss of
unrealized gains. The put option acts like an insurance policy - it costs money, which reduces
the investor's potential gains from owning the bond, but it also reduces his risk of losing money
if the stock declines in value. The potential upside on the stock is maintained. In the event that
stock prices fall, the protective put will be exercised.
The investor’s initial position is equal to:
Long stock + Long put option.
3. A
The net cost of the spread is:
$4.00 - $1.50 = $2.50.
Assume that the price of the stock closed at $32. Let us analyze the situation:
As you can see from the table, a gain of $2.50 has been made.
4. A
Bear call spread
A bear spread is a spread trade, which limits the amount of upside, when the stock, also called
the bear, falls, and also limits the downside.
The trade is constructed as follows:
Selling a call option with a low exercise price. Long a call option with a high exercise price.
Bear put spread

A bear put trade is constructed as follows: Long a put option with a high exercise price. Selling
a put option with a low exercise price.

5. A
The net cost of the spread is: $5.00 + $3.00 - $7.00 ($3.50 x 2) = $1.00
Assume that the price of the stock closed at $33. Let us analyze the situation:
6. B
Box spreads
A box spread is a combination of a bull spread and a bear spread on the same asset. Only two
strike prices will be used – in other words a high strike price (XH) and a low strike price (XL).
A bull spread = A long call at the lower strike price (XL) A short call at the higher strike price
(XH)
A bear spread = A long put at the lower strike price (XH) A short put at the higher strike price
(XL)
7. A
Long straddle
A straddle is a simple volatility trade. A long straddle strategy =
 Long an at-the-money put option +
 Long an at-the-money call option
8. B
Short straddle
A short straddle strategy =
 Short an at-the-money put option +
 Short an at-the-money call option
9. C
A collar can be used to reduce the cost of the hedge. A collar is when options are written or sold
and the income received can be used to reduce the cost of the hedge.
A collar strategy would be to buy an out-of-the-money (OTM) put option (protective put) and
to write an out-of-the-money call option (covered call). The investor is selling a call option, in
other words some of the upside potential and is using the money to pay for the long put option.
This collar protects against the downside but limits the upside to the exercise price on the call.
The risk of a collar is that it cuts off a part of the upside return in order to secure downside
protection.

10. A
When a borrower needs to use an interest rate option to hedge the risk on a floating rate loan
with several payments he may need to use several interest rate options to hedge this risk. In
other words, a separate option for every payment date. This is called an interest rate cap or
sometimes just a cap.
11. D
Bull call spread, maximum profit is $3, maximum loss is $2.
In a bull call spread, the buyer of the spread purchases a call option with a low exercise price,
XL, and subsidizes the purchase price of the call by selling a call with a high exercise price, XH.
The maximum profit will occur at any stock price over the high exercise price. For example, at a
stock price of $50: Maximum profit: 10 - 5 - 5 + 3 = $3.
The maximum loss will occur at any stock price below the low exercise price. For example, at a
stock price of $35: Maximum loss: 0 - 0 - 5 + 3 = -$2.

Topic 39
Exotic Options [FMP - 15]
Learning Objectives
Exotic Options
LO 39 a: Define and contrast exotic derivatives and plain vanilla derivatives.

LO 39 b: Describe some of the factors that drive the development of exotic derivative products.
LO 39 c: Explain how any derivative can be converted into a zero-cost product.
LO 39 d: Describe how standard American options can be transformed into nonstandard American
options.
LO 39 e: Identify and describe the characteristics and pay-off structure of the following exotic
options: gap, forward start, compound, chooser, barrier, binary, lookback, Asian, exchange, and
basket options.
LO 39 f: Describe and contrast volatility and variance swaps.
LO 39 g: Explain the basic premise of static option replication and how it can be applied to hedging
exotic options.

QUESTIONS
1. Which of the following areas are exotic options not more uncertain than versus vanilla options?
A. Value of the option
B. Payment dates of the option
C. Payment amounts of the option
D. Term of the option
2. When evaluating an exotic derivative strategy – which of the following questions is not
normally addressed:
A. Cost of the strategy.
B. Is a specific pricing model required? Does the user have the necessary model required to
assess costs and calculate exotic derivative values?
C. Does the exotic option provide an effective hedge?
D. Has market risk been adequately addressed?
3. Which of the following statements regarding a collar are correct?

I. A collar is when options are written or sold and the income received can be used to reduce
the cost of the hedge.
II. The risk of a collar is that it cuts off a part of the upside return in order to secure downside
protection.
A. I only.
B. II only.
C. Both I and II
D. Neither I or II.
4. Which of the following features will turn a standard American option into a nonstandard
American option?
I. A ‘lock out’ clause.
II. The option’s strike price may change during the life of the option.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
5. Assuming that we are dealing with a gap call option with the following details:
X2 = 110 (X2 is the trigger price)
X1 = 120
ST = 115
What is the payoff on this option?
A. 5
B. -5
C. 10
D. -10

6. What type of option is best described by the following statement? An option that only comes
into existence after a certain amount of time.
A. A gap option
B. A forward option
C. A barrier option
D. An Asian option
7. What type of option is best described by the following statement? The option allows the owner
to decide, after a period of time, whether the option is a call or put option.
A. A gap option
B. A forward option
C. A chooser
D. An Asian option
8. What type of option is best described by the following statement? The option has payoffs that
depend on the maximum and minimum prices of the underlying asset during the term of the
option contract.
A. A lookback option
B. A forward option
C. A chooser
D. An Asian option
9. Which of the following statements regarding a variance swap are not correct?
A. A variance swap is the swap of a pre-determined fixed variance rate for the actual realized
variance rate based on a notional principal amount.
B. The variance rate is calculated as the square of the volatility rate.
C. Variance swaps are easily hedged with the use of call and put options.
D. This swap is a bet on volatility as apposed to a bet on the volatility of an underlying asset’s
price.
10. Which of the following statements regarding a dynamic options replication strategy are
correct?
I. The process is often very expensive as it requires frequent trading and rebalancing.
II. The position in exotic options is hedged at the outset and remains in place for the duration
of the hedge.
A. I only
B. II only.
C. Both I and II.
D. Neither I or II.

11. A trader writes the following 1-year European-style barrier options as protection against large
movements in a non-dividend paying stock that is currently trading at EUR 40.96.
All of the options have the same strike price. Assuming the risk-free rate is 2% per annum,
what is the common strike price of these options?
A. EUR 39.00
B. EUR 40.00
C. EUR 41.00
D. EUR 42.00

SOLUTIONS
1. D
Exotic options contain uncertainty in the following areas:
 Cost of the option
 Value of the option
 Payment dates of the option
 Payment amounts of the option
 Cost of exiting the option
2. D
When evaluating an exotic derivative strategy – the following questions should be addressed:
 Cost of the strategy
 Is a specific pricing model required? Does the user have the necessary model required to
assess costs and calculate exotic derivative values?
 Does the exotic option provide an effective hedge?
 Has credit / default risk been adequately addressed?
 How would the investor exit his exotic position?
3. C
A collar can be used to reduce the cost of the hedge. A collar is when options are written or sold
and the income received can be used to reduce the cost of the hedge. The risk of a collar is that
it cuts off a part of the upside return in order to secure downside protection.
4. C
A standard American option is an option that is exchange-traded and contains standard terms
and conditions. There are certain features that will turn a standard American option into a
nonstandard American option. These features are:
 A ‘lock out’ clause. In other words the American option cannot be exercised for a certain
period of the option’s life. For example, the first three months.
 Fixed trading dates. In other words the American option cannot be exercised at any point
in time, rather at fixed periods of the option’s life. For example, the end of every month
only. This transforms the option from being an American option to a Bermudan option.
 The option’s strike price may change during the life of the option.
5. B
Case 3: X2 = 110 (X2 is the trigger price) X1 = 120 ST = 115
In such a case the payoff = (115 – 110) + (110 – 120) = -5
6. B
A forward start option is an option that only comes into existence after a certain amount of
time.

7. C
A chooser option allows the owner to decide, after a period of time, whether the option is a call
or put option.
8. A
A lookback option has payoffs that depend on the maximum and minimum prices of the
underlying asset during the term of the option contract.
9. D
A variance swap is the swap of a pre-determined fixed variance rate for the actual realized
variance rate based on a notional principal amount. The variance rate is calculated as the square
of the volatility rate. Variance swaps are easily hedged with the use of call and put options.
10. A
Dynamic options replication is the frequent adjusting of the holdings to ensure adequate
hedging. This process is often very expensive as it requires frequent trading and rebalancing.
Static options replication is when the position in exotic options is hedged at the outset and
remains in place for the duration of the hedge.
11. B
The sum of the price of an up-and-in barrier call and an up-and-out barrier call is the price of an
otherwise equivalent European call. The price of the European call is EUR 3.52 + EUR 1.24 =
EUR 4.76. The sum of the price of a down-and-in barrier put and a down-and-out barrier put is
the price of an otherwise equivalent European put. The price of the European put is EUR 2.00 +
EUR 1.01 = EUR 3.01.
Using put-call parity, where C represents the price of a call option and P the price of a put
option, C + Ke-rt = P + S K = ert (P + S – C) Hence, K = e0.02*1 * (3.01 + 40.96 – 4.76) = 40.00

Topic 40
Properties of Interest Rates [FMP - 16]
Learning Objectives
Properties of Interest Rates
LO 40 a: Describe Treasury rates, LIBOR, Secured Overnight Financing Rate (SOFR), and repo rates
and explain what is meant by the “risk-free” rate.
LO 40 b: Calculate the value of an investment using different compounding frequencies.
LO 40 c: Convert interest rates based on different compounding frequencies.
LO 40 d: Calculate the theoretical price of a bond using spot rates.
LO 40 e: Calculate the duration, modified duration, and dollar duration of a bond.
LO 40 f: Evaluate the limitations of duration and explain how convexity addresses some of them.
LO 40 g: Calculate the change in a bond’s price given its duration, its convexity, and a change in
interest rates.
LO 40 h: Derive forward interest rates from a set of spot rates.
LO 40 i: Derive the value of the cash flows from a forward rate agreement (FRA).
LO 40 j: Calculate zero-coupon rates using the bootstrap method.
LO 40 k: Compare and contrast the major theories of the term structure of interest rates.

QUESTIONS
1. Which of the following is not a characteristic of a repurchase agreement?

A. A repurchase agreement is the sale of a security by a dealer to an investor with a
commitment by the dealer to buy the same security back from the investor at a specified
price at a specified future date.
B. The seller of the bond will receive cash for selling the bond and will agree to buy it back at a
lower price at a certain date in the future.
C. The rate of the transaction (10% in this case) is called the repo rate.
D. Institutional investors in the bond market use this type of a transaction as a form of
financing.
2. If the nominal/stated interest rate is 8%, what is the effective annual rate assuming monthly
compounding?
A. 8.00%
B. 8.24%
C. 8.30%
D. 8.15%
3. Which of the following calculations regarding discrete and continuous rates are correct?
I. Assume that the continuous rate was 9.53%. The discrete rate would be = 10%.
II. Assume that the discrete rate was 12%. The continuous rate would be = 11.3%
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. Consider the following information about Bond P:

Coupon payments: semi-annual
Maturity: One and a half years
Annual coupon: $5
Annual spot yields:
Period 1 7%
Period 2 8%
Period 3 ?
Price of the bond: $94.2777.
What is the spot rate for Bond P in period 3?
A. 7%
B. 9%
C. 9.5%
D. 10%

5. A bond has a coupon rate of 5% and a maturity value of $100 in two years time. Assume that
the appropriate spot rates are:
Year 1 6.7%
Year 2 7.1%
What is the one-year forward rate one year from now?
A. 7.2%
B. 7.5%
C. 8.0%
D. 6.2%
6. Assume that the 6-month spot rate for LIBOR is 5% and the 9-month spot rate for LIBOR is 6%.
An investor enters into a FRA agreement to earn 9% on her principal of $10m between the 6
and 9-month period.
What is the value of the FRA?
A. $194,000
B. $46,366
C. $900,000
D. $55,789
7. Which of the following calculations regarding duration calculations are correct?

I. The reason that there is a negative sign in front of the price change duration calculation is
that there is an positive relationship between price changes and yield changes.
II. The approximate dollar price change for a 100 basis point change in yield is called money
duration or dollar duration.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. Which of the following statements regarding convexity are not correct?

A. The relationship between the bond’s price and its yield is a linear one.
B. The convexity adjustment is is used to approximate the change that is not explained by
duration.
C. The longer the maturity and the lower the coupon and yield, the greater the convexity.
D. The shorter the maturity and the higher the coupon and yield, the lower the convexity.
9. Consider a 10% coupon bond. The current price is $98 with a YTM of 12%.
Assume a 50 basis points increase in yields
Duration is 12 and convexity is 80.
What is the percentage price change for the bond?
A. -6.0%
B. 0.1%
C. 5.9%
D. 0.50%

10. Which of the major theories of the term structure of interest rates would state the following
“The market wants to be compensated for the interest rate risk when holding longer term
bonds”?
A. The pure expectations theory
B. The liquidity preference theory
C. The market segmentation theory
D. The preferred habitat theory
11. Which of the following statements regarding SOFR is least likely correct?
A. SOFR is the rate on a secured overnight loan.
B. SOFR is very close to the risk-free rate.
C. SOFR is higher than both USD LIBOR and the effective federal funds rate (EFFR).
D. SOFR is derived from a universe of actual overnight Treasury repo transactions.
12. A portfolio manager controls USD 88 million par value zero-coupon bonds maturing in 5 years
and yielding 4%. The portfolio manager expects that interest rates will increase. To hedge the
exposure, the portfolio manager wants to sell part of the 5-year bond position and use the
proceeds from the sale to purchase zero-coupon bonds maturing in 1.5 years and yielding 3%.
What is the market value of the 1.5-year bonds that the portfolio manager should purchase to
reduce the duration on the combined position to 3 years?
A. USD 41.17 million
B. USD 43.06 million
C. USD 43.28 million
D. USD 50.28 million

SOLUTIONS
1. B
A repurchase agreement is the sale of a security by a dealer to an investor with a commitment
by the dealer to buy the same security back from the investor at a specified price at a specified
future date. The seller of the bond will receive cash for selling the bond (e.g. $100) and will agree
to buy it back at a higher price (e.g. $110) at a certain date in the future (assume 1 year). The rate
of the transaction (10% in this case) is called the repo rate.
Institutional investors in the bond market use this type of a transaction as a form of financing.
2. C
3. C
Assume that the continuous rate was 9.53% The discrete rate would be =
r d = erd - 1 r d = e0.0953 - 1 r d = 1.10 – 1 r d = 10% r c = 9.53%
Assume that the discrete rate was 12% The continuous rate would be =
rc = ln(1 + r) r c = ln(1 + 12%) r c = ln(1.12) r c = 11.3%
4. B
By applying the bootstrapping methodology we are able to work out the spot rate for period 3.
Keep in mind that we know the price of the three-period bond as well as the spot rates for
period 1 and period 2. By substituting X for period 3’s spot rate we can work out the spot rate
for that period, as follows:

5. B
The one year rate one year from now =
6. B
Assume that the 6-month spot rate for LIBOR is 5% and the 9-month spot rate for LIBOR is 6%.
An investor enters into a FRA agreement to earn 9% on her principal of $10m between the 6 and
9-month period.
The value of the FRA is equal to:
Step 1: Calculate the forward rate:
Step 2: Apply quarterly compounding to the forward rate
7. B
The reason that there is a negative sign in front of the price change duration calculation is that
there is an inverse relationship between price changes and yield changes.
The approximate dollar price change for a 100 basis point change in yield is called money
duration or dollar duration.

8. A
The relationship between the bond’s price and its yield is a convex one. Based on this we need
to add another approximation to the duration measure – this is called the convexity adjustment.
This is used to approximate the change that is not explained by duration. The longer the
maturity and the lower the coupon and yield, the greater the convexity. The shorter the
maturity and the higher the coupon and yield, the lower the convexity.
9. C
Duration effect = - modified duration (Δy) = - 12 X 0.005 = -0.06 = - 6% Convexity effect = 1 2
(Convexity) (Δy) 2 = 1 2 (80) (0.005)2 = 0.0010 = 0.1% Total % price change: = -6% + 0.1% = -5.9%
10. B
Liquidity preference theory The problem with the pure expectations theory is that it does not
consider the risks associated with investing in bonds. This theory states that the market wants to
be compensated for the interest rate risk when holding longer term bonds. The longer the
maturity the greater the price volatility when interest rates change.
11. C
SOFR is the rate on a secured overnight loan and as such it is very close to the risk-free rate. It is
lower than both USD LIBOR and the effective federal funds rate (EFFR). SOFR is derived from a
universe of actual overnight Treasury repo transactions.
12. A
In order to find the proper amount, we first need to calculate the current market value of the
portfolio (P), which is: P = 88 * exp (-0.04 * 5) = 72.05 million. The desired portfolio duration
(after the sale of the 5-year bond and purchase of the 1.5 year bond) can be expressed as: [5 * (P-
X) + 1.5* X]/P = 3 where X represents the market value of the zero-coupon bond with a
maturity of 1.5 years. This equation holds true when X = (4/7) * P, or 41.17 million.

Topic 41
Corporate Bonds [FMP - 17]
Learning Objectives
Corporate Bonds
LO 41 a: Describe features of bond trading, and explain the behavior of bond yield.
LO 41 b: Describe a bond indenture and explain the role of the corporate trustee in a bond
indenture.
LO 41 c: Define high-yield bonds, and describe types of high-yield bond issuers and some of the
payment features unique to high yield bonds.
LO 41 d: Differentiate between credit default risk and credit spread risk.
LO 41 e: Describe event risk and explain what may cause it in corporate bonds.
LO 41 f: Describe the different classifications of bonds characterized by issuer, maturity, interest
rate, and collateral.
LO 41 g: Describe the mechanisms by which corporate bonds can be retired before maturity.
LO 41 h: Define recovery rate and default rate, differentiate between an issue default rate and a
dollar default rate, and describe the relationship between recovery rates and seniority.
LO 41 i: Evaluate the expected return from a bond investment and identify the components of the
bond’s expected return.

QUESTIONS
1. When assessing a bond’s indenture which of the following is not an example of a positive
covenant? Co
A. To pay interest and principal on a timely basis
B. To pay all taxes and other claims when due
C. A restriction on the borrower’s ability to incur further debt
D. To maintain all properties used useful in the borrower’s business in good working order
2. When assessing a bond’s maturity date and how it impacts bond retirements. which of the
I. Bonds with maturities of less than 1 year are called money market securities.
II. Bonds with maturities of greater than 1 year are called capital market securities.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. James Jack, FRM, is participating in a fixed income conference. The speaker describes a bond
using the following description “The coupon on this type of bond can be paid by increasing the
principal amount owing on the bond”. What type of bond is the speaker describing?
A. A PIK bond
B. A reset bond
C. A participating bond
D. A fixed payment bond
4. Which of the following statements are not correct when describing a zero-coupon bond?
A. A zero-coupon (ZC) bond pays the face-value of the bond at maturity – no coupon
payments are made on the bond.
B. Original issue discount (OID) = Face value of the bond less the price of the bond
C. The rate of interest will grow based on time to maturity and the size of the OID.
D. A disadvantage of the ZC bond is that it does not contain any reinvestment risk as there are
no coupons that are received.
5. Which of the following statements are not correct when describing a Equipment trust
certificates (ETCs)?
A. Equipment trust certificates (ETCs) are when a specific piece of equipment underlies the
bond issue.
B. The effective transaction is that the trustee purchases the equipment from the proceeds of
the bond issue and then leases it to the user.
C. The user pays rent to the trustee who passes this rental income on to the ETC holder.
D. ETC are bonds are issues that rank behind secured debt and after debenture bonds.

6. Which of the following mechanisms is not a mechanism to retire a bond issue?

A. Call option
B. Sinking fund provision
C. Tender offer
D. Put option
7. When dealing with the yield on a bond, which of the following statements are correct?
The yield on a bond is made up of two components:
I. The yield on a default-free bond (i.e. the yield on a U.S. Treasury), and
II. A premium above the yield on the default-free bond to compensate the holder for the
increased risk associated with this specific issue.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. Which of the following is not an example of an event risk?

A. A natural disaster or industrial accident
B. A takeover or corporate restructuring
C. A regulatory change
D. A corporate default
9. Jacqui Jack, FRM, is participating in a fixed income conference. The speaker describes a bond
using the following description “a high yield bond that initially had an investment grade rating
but due to certain circumstances has their rating has fallen to non investment grade”. What
type of bond is the speaker describing?
A. A story bond
B. A fallen angel
C. A reset bond
D. A restructured bond
10. When dealing with credit risk and defaults, which of the following statements is not correct?
A. Loss given default is the risk that the issuer will fail to satisfy the terms of the obligation
with respect to the timely payment of interest and principal.
B. The estimated percentage out of a group of bonds that is likely to default is called the
default rate.
C. The issuer default rate is the number of issuers that have defaulted over a year by the total
number of issuers (at the beginning of the year).
D. The dollar default rate is the par value of the defaulted bonds that have defaulted over a
year by the total par value of bonds (at the beginning of the year).
11. Which of the following equations dealing with loss given default and expected loss is correct?
A. Loss given default = 1 + recovery rate.
B. Expected loss = Probability of default - loss given default.

C. Expected loss = Probability of default X loss given default.

D. Loss given default = Probability of default - recovery rate.
12. The following details relate to Bond P:

 Credit spread over the risk-free rate = 2%.
 Default probability = 0.5% per annum.
 Recovery rate = 40%
What is the expected return on Bond P?
A. 1.7%
B. 1.6%
C. 2.0%
D. 1.5%
13. Which of the following statements regarding the trustee named in a corporate bond indenture
is correct?
A. The trustee has the authority to declare a default if the issuer misses a payment.
B. The trustee may action beyond the indenture to protect bondholders.
C. The trustee must act at the request of a sufficient number of bondholders.
D. The trustee is paid by the bondholders or their representatives.

SOLUTIONS
1. C
Affirmative covenants – these set out what the borrower promises to do, and will include:
 To pay interest and principal on a timely basis
 To pay all taxes and other claims when due
 To maintain all properties used useful in the borrower’s business in good working order
 To submit reports to the trustee stating that the borrower is in compliance with the loan
agreement
A restriction on the borrower’s ability to incur further debt is an example of a negative
covenant.
2. C
Bonds with maturities of less than 1 year are called money market securities. Bonds with
maturities of greater than 1 year are called capital market securities.
3. A
A payment-in-kind (PIK) bond
The coupon on this type of bond can be paid by increasing the principal amount owing on the
bond. i.e. paying coupon interest with principal.
4. D
Zero-coupon bonds
A zero-coupon (ZC) bond pays the face-value of the bond at maturity – no coupon payments
are made on the bond. Original issue discount (OID) = Face value of the bond less the price of
the bond The rate of interest will grow based on time to maturity and the size of the OID. One
advantage of the ZC bond is that it does not contain any reinvestment risk as there are no
coupons that are received.
5. D
Equipment trust certificates (ETCs) are when a specific piece of equipment underlies the bond
issue. The effective transaction is that the trustee purchases the equipment from the proceeds of
the bond issue and then leases it to the user. The user pays rent to the trustee who passes this
rental income on to the ETC holder.
6. D
Put option
7. C
The yield on a bond is made up of two components:
 The yield on a default-free bond (i.e. the yield on a U.S. Treasury), +
 A premium above the yield on the default-free bond to compensate the holder for the
increased risk associated with this specific issue.

8. D
 A natural disaster or industrial accident
 A takeover or corporate restructuring
 A regulatory change
9. B
A fallen angel is a high yield bond that initially had an investment grade rating but due to
certain circumstances has their rating has fallen to non investment grade.
10. A
Credit risk is the risk that the issuer will fail to satisfy the terms of the obligation with respect to
the timely payment of interest and principal. The estimated percentage out of a group of bonds
that is likely to default is called the default rate. The issuer default rate is the number of issuers
that have defaulted over a year by the total number of issuers (at the beginning of the year).
The dollar default rate is the par value of the defaulted bonds that have defaulted over a year
by the total par value of bonds (at the beginning of the year).
11. C
The loss given default is the amount that the investor stands to lose in the event of default by
the issuer. This can be calculated as follows: Loss given default = 1 – recovery rate. The
expected loss is the amount that the investor expects to lose as a result of the default. This can
be calculated as follows: Expected loss = Probability of default X loss given default.
12. A
Expected loss rate = 0.5% x (1 – 0.40) Expected loss rate = 0.3% Expected bond return = Risk-
free rate + credit spread – expected loss rate. Expected bond return = 2% – 0.3% Expected bond
return = 1.7%.
13. A
According to the Trust Indenture Act, if a corporate issuer fails to pay interest or principal, the
trustee may declare a default and take such action as may be necessary to protect the rights of
bondholders.
Trustees can only perform the actions indicated in the indenture, but are typically under no
obligation to exercise the powers granted by the indenture even at the request of bondholders.
The trustee is paid by the debt issuer, not by bond holders or their representatives.

Topic 42
Mortgages and Mortgage-Backed Securities [FMP - 18]
Learning Objectives
Mortgages and Mortgage-Backed Securities
LO 42 a: Describe the various types of residential mortgage products.

LO 42 b: Calculate a fixed rate mortgage payment, and its principal and interest components.
LO 42 c: Describe the mortgage prepayment option and the factors that influence prepayments.
LO 42 d: Summarize the securitization process of mortgage backed securities (MBS), particularly
formation of mortgage pools including specific pools and to-be-announceds (TBAs).
LO 42 e: Calculate weighted average coupon, weighted average maturity, single monthly mortality
rate (SMM), and conditional prepayment rate (CPR) for a mortgage pool.
LO 42 f: Describe the process of trading of pass-through agency MBS.
LO 42 g: Explain the mechanics of different types of agency MBS products, including collateralized
mortgage obligations (CMOs), interest-only securities (IOs), and principal-only securities (POs).
LO 42 h: Describe a dollar roll transaction and how to value a dollar roll.
LO 42 i: Explain prepayment modeling and its four components: refinancing, turnover, defaults,
and curtailments.
LO 42 j: Describe the steps in valuing an MBS using Monte Carlo simulation.
LO 42 k: Define Option Adjusted Spread (OAS), and explain its challenges and its uses.

QUESTIONS
1. When describing the various types of residential mortgage products which of the following is
not a characteristic of a prime loan?
A. FICO score of 660 and below
B. Low rates of default.
C. Borrowers have a strong repayment history.
D. Borrowers have stable and sufficient income
2. When assessing a fixed rate mortgage repayments which of the following statements are not
correct?
A. In the early years of the loan, the majority of the monthly payments consist of interest.
B. In the later years of the loan, the majority of the monthly payments consist of principal.
C. The point at which the interest and principal components of the monthly payment are equal
is called the crossover point.
D. The longer the amortization period, the greater the principal component as a portion of the
total monthly payment in the early period.
3. When assessing the factors that influence prepayments which of the following is not a factor
that will influence prepayments?
A. Current interest rates
B. Size of the mortgage pool
C. Housing prices
D. Seasonality
4. Which of the following statements regarding the securitization process of mortgage backed
securities (MBS) is not correct?
A. MBS are pass-through mortgage securities.
B. The weighted average coupon (WAC) is the weighted average of all the coupon rates in the
pool.
C. In order to be included in the agency pool, the mortgages must meet certain criteria.
D. The mortgages in the pool are called conforming loans.
5. What is the CPR and SMM for month 10 for 200 PSA?
A. 2% and 0.0017
B. 2% and 0.0034
C. 4% and 0.0017
D. 4% and 0.0034
6. When assessing a bond’s maturity date and how it impacts bond retirements. which of the
I. The motivation for creating a CMO is to distribute the prepayment risk among the different
classes of bonds.

II. A sequential pay CMO will seek to pay off the entire principal on the ‘first’ tranche before
any principal is repaid on the ‘other’ tranches.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
7. When modeling prepayments and specifically refinancing due to refinancing, which of the
following statements are not correct?
A. Refinancing burnout is when the mortgage holder will not refinance since he has already
refinanced one time before when rates dropped previously.
B. In most cases, a 2% drop in rates will incentivize mortgage holders to refinance their debt.
C. When the value of the property increases substantially, the mortgage holder will refinance
his mortgage with a new provider at a much higher value to extract equity value.
D. Cash-out refinancing is when the mortgage holder will not refinance since he has already
refinanced one time before when rates dropped previously.
8. Which of the following is not a step in valuing an MBS using Monte Carlo simulation?
A. The interest rate and refinancing paths need to be simulated.
B. Cash flows for each path needs to be forecasted.
C. Calculate the present values for each path.
D. Calculate the value of the MBS by summing all the present values from step 3.
9. Which of the following statements is not a challenge to using the option adjusted spread (OAS)
measure?
A. Since OAS is effectively a by-product of MCS, it will suffer from the same modeling risk
that MCS suffers from.
B. OAS assumes that the OAS is dynamic over the entire time period of the model.
C. OAS is dependent on the prepayment model – which in and of itself is a difficult model to
predict.
D. When using MCS, the interest rate paths must be adjusted to make sure that all rates or
securities that make up the benchmark curve are correctly valued.
10. When assessing the OAS ’s which of the following statements are correct?
I. The option-adjusted spread (OAS) takes the dollar difference between the fair price and the
market price and converts it into a yield spread measure.
II. The OAS seeks to find a return (spread) that will equate the market price and the fair price
(value). It will do this via trial and error.
A. I only
B. II only.
C. Both I and II.
D. Neither I or II.

11. A fixed-income portfolio manager purchases a seasoned 4.5% agency mortgage-backed security
with a weighted average loan age of 60 months. The current balance on the loans is USD 24
million, and the conditional prepayment rate is assumed to be constant at 0.5% per year. Which
of the following is closest to the expected principal prepayment this month?
A. USD 1,000
B. USD 7,000
C. USD 10,000
D. USD 70,000
SOLUTIONS
1. A
Prime loans (A-grade)
 FICO score of 660 and above.
 Low rates of default.
 Borrowers have a strong repayment history.
 Borrowers have stable and sufficient income
 Low loan-to-value ratios
2. D
In the early years of the loan, the majority of the monthly payments consist of interest. In the
later years of the loan, the majority of the monthly payments consist of principal. The point at
which the interest and principal components of the monthly payment are equal is called the
crossover point. The shorter the amortization period, the greater the principal component as a
portion of the total monthly payment in the early period.
3. B
 Current interest rates – as rates move down, owners may be tempted to refinance at the
lower rates.
 Housing prices – as prices rise, owners may be tempted to prepay and refinance, in order
to get some of their equity out.
 Seasonality – as summer arrives, people tend to move and hence prepayments increase
 Age of the pool.
 Personal – peoples personal circumstances may cause them to refinance, for example a
divorce may prompt the sale of a house.
 Refinancing burnout – if there has been a lot of refinancing in the past, then the risk of
further prepayments is reduced.
4. D
MBS are pass-through mortgage securities. This means that each pass-through security that is
issued has a claim on the pool of mortgages. The mortgages in the pool are called securitized
mortgages. Since each mortgage in the pool has a different maturity, the mortgages are
weighted by their outstanding principal amount as a percentage of the total outstanding

principal of all the mortgages in the pool this is called the weighted average maturity (WAM).
The weighted average coupon (WAC) is the weighted average of all the coupon rates in the
pool.
In order to be included in the agency pool, the mortgages must meet certain criteria. e.g. certain
LTV ratios. If the mortgages meet these criteria, they can be included in the pool and are called
conforming loans.
5. D
Calculate the CPR and SMM for month 10 for 100 PSA and 200 PSA.
100 PSA: CPR – month 10 = 10 x 0.2% = 2% 100 PSA = 2% x 1 = 2% SMM = 1 – (1 – 0.02)1/12 =
0.0017
200 PSA: CPR – month 10 = 10 x 0.2% = 2% 200 PSA = 2% x 2 = 4% SMM = 1 – (1 – 0.04)1/12 =
0.0034.
6. C
The motivation for creating a CMO is to distribute the prepayment risk among the different
classes of bonds. A sequential pay CMO will seek to pay off the entire principal on the ‘first’
tranche before any principal is repaid on the ‘other’ tranches.
7. D
Refinancing. In the event that market interest rates fall, the mortgage holder is incentivized to
prepay his current mortgage and refinance a new mortgage at the lower rates. In most cases, a
2% drop in rates will incentivize mortgage holders to refinance their debt. The reason for this is
called the media effect – as the drop in rates was big enough to be reported in the media. As
part of the refinancing incentive, when the value of the property increases substantially, the
mortgage holder will refinance his mortgage with a new provider at a much higher value. This
is done in order to extract some of the equity as a result of the increased price. This is called
cash-out refinancing. Refinancing burnout is when the mortgage holder will not refinance since
he has already refinanced one time before when rates dropped previously.
8. D
The following steps are used when valuing an MBS using MCS:
 The interest rate and refinancing paths need to be simulated.
 Cash flows for each path needs to be forecasted.
 Calculate the present values for each path.
 Calculate the value of the MBS by summing all the present values from step 3 and dividing
by the total number of interest rate paths (N).
9. B
Challenges to OAS
Since OAS is effectively a by-product of MCS, it will suffer from the same modeling risk that
MCS suffers from. OAS assumes that the OAS is constant over the entire time period of the
model. OAS is dependent on the prepayment model – which in and of itself is a difficult model

to predict. When using MCS, the interest rate paths must be adjusted to make sure that all rates
or securities that make up the benchmark curve are correctly valued.
10. C
The option-adjusted spread (OAS) takes the dollar difference between the fair price and the
market price and converts it into a yield spread measure. The OAS seeks to find a return
(spread) that will equate the market price and the fair price (value). It will do this via trial and
error.
11. C
The expected principal prepayment is equal to: 24,000,000 * (1-((1-0.005)^(1/12))) = USD 10,023.

Topic 43
Interest Rate Futures [FMP - 19]
Learning Objectives
Interest Rate Futures
LO 43 a: Identify the most commonly used day count conventions, describe the markets that each
one is typically used in, and apply each to an interest calculation.
LO 43 b: Calculate the conversion of a discount rate to a price for a US Treasury bill.
LO 43 c: Differentiate between the clean and dirty price for a US Treasury bond; calculate the
accrued interest and dirty price on a US Treasury bond.
LO 43 d: Explain and calculate a US Treasury bond futures contract conversion factor.
LO 43 e: Calculate the cost of delivering a bond into a Treasury bond futures contract.
LO 43 f: Describe the impact of the level and shape of the yield curve on the cheapest-to-deliver
Treasury bond decision.
LO 43 g: Calculate the theoretical futures price for a Treasury bond futures contract.
LO 43 h: Calculate the final contract price on a Eurodollar futures contract, and compare Eurodollar
futures to FRAs.
LO 43 i: Describe and compute the Eurodollar futures contract convexity adjustment.
LO 43 j: Explain how Eurodollar futures can be used to extend the LIBOR zero curve.
LO 43 k: Calculate the duration-based hedge ratio and create a duration-based hedging strategy
using interest rate futures.
LO 43 l: Explain the limitations of using a duration-based hedging strategy.

QUESTIONS
1. Assume that the bonds in question pay interest semi-annually and that the payment dates are
end of June and December every year. Compute the accrued interest for each instrument type,
assuming that the bond was sold on the 14th of March and that the accrued interest for the six
months was $10,000. What is the accrued interest assuming that the bond is a corporate bond?
A. $3,978
B. $4,000
C. $6,000
D. $4,056
2. Assume that the annual rate of interest on a 180 day T-bill is 10% and the face value is $100.
What is the real rate of interest?
A. 5.00%
B. 10.00%
C. 5.26%
D. 10.52%
3. Assume that the full price of a bond is equal to $102 713.73 and was sold 60 days into the period
(semi - annual payments). Total coupon for the period was $3,000. What is the clean price of the
bond?
A. $101,724
B. $100,000
C. $102,713
D. $989
4. Which of the following statements regarding a bond futures conversion factor are correct?
I. The conversion factor can be obtained from the CBOT on a daily basis.
II. The conversion factor is calculated as follows: Conversion factor =
Bond price  accrued int erest
Face value of the bond
A. I only.
B. II only
C. Both I and II.
D. Neither I or II.
5. Assume that the short needs to deliver a bond to the long and the last quoted futures price was
$96. There are two bonds that are available for delivery:
Bond A: Bond price = 101, conversion factor = 1.05
Bond B: Bond price = 110, conversion factor = 1.10
Which bond is the cost to deliver of bond A?
A. 0.20
B. 4.40

C. 1.05
D. 1.10
6. Which of the following statements are not correct when dealing with CTD bonds?
A. If the yield curve is sloping upwards – CTD bonds have longer maturities.
B. If the yield curve is sloping downwards – CTD bonds have shorter maturities
C. If yield exceed 6% then CTD bonds are longer maturity and higher coupon bonds.
D. If yields are less than 6% then CTD bonds are shorter maturity and higher coupon bonds.
7. Which of the following statements regarding a Treasury bond futures contract are correct?
I. The present value of the interim cash flows will need to be deducted from the spot price
prior to working out the futures price.
II. The futures contract pricing equation that pays interim cash flows: F0 = (S0 – I)erT
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. Assume that the rate priced into a Eurodollar futures contract contract is 6.25%. What is the
futures price?
A. $937,500
B. $6.25
C. $1,000,000
D. $984,375
9. Which of the following statements regarding a Eurodollar futures contract is not correct?
A. This contract is based on the rate of a 90-day dollar denominated time deposit issued by a
London Bank.
B. The T-Bill is a discount instrument.
C. The rate is the 180-day forward LIBOR rate.
D. The futures contract is based on a 90-day $1m U.S. T-bill.
10. Which of the following statements regarding a Treasury bond futures contract are correct?
I. A LIBOR spot rate curve can be produced by using the convexity adjusted Eurodollar
futures numbers.
R forward T2  T1   R1 T1
II. To solve for the spot rate, the following equation could be used: R2 =
T2
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
11. Assume a 3-month hedging period. The value of the portfolio is equal to #200m. The 3-month
bond contract is quoted at 102. The size per contract is $100,000. The duration of the portfolio is

9 and the duration on the futures contract is 13. How many contracts are needed in order to
hedge this position?
A. Buy 1,357 contracts
B. Sell 1,357 contracts
C. Buy 2,832 contracts
D. Sell 2,832 contracts
12. Which of the following statements regarding the limitation of using a duration-based hedging
strategy are correct?
I. The duration measure implies that all yields are perfectly correlated.
II. When yield changes are large and non-parralel then the effect of a duration hedge is
minimized.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II

SOLUTIONS
1. D
Days Jan – 30 days Feb – 30 days March – 13 days Total – 73 days
Total days Jan – 30 days Feb – 30 days March – 30 days April – 30 days May – 30 days June- 30
days Total – 180 days
73
 $10,000  $4,055.56
180
2. C
The price of the t-bill, or Y, is calculated as follows:
Y = 100 – (100 x 10% x 180/360)
Y = 100 – 5 Y = 95
The t-bill discount rate is equal to 10%, but the real rate of interest is calculated by dividing by
the price of 95, as follows:
Real interest rate = 5 / 95
= 5.26%
3. A
We first need to calculate the accrued interest. The first step is to calculate the days in the
accrued interest period.
AI = Semi-annual coupon payment X 60/182
= $3,000 X 0.3297 = $989.01
Based on this the clean price of the bond will be:
= Dirty price – accrued interest = $102,713.73 - $989.01 = $101,724.72
4. C
The conversion factor can be obtained from the CBOT on a daily basis. The conversion factor is
calculated as follows:
Bond price  accrued interest
Conversion factor =
Face value of the bond
5. A
Cost of delivery of Bond A = 101 – (1.05 x 96) = 0.20 Cost of delivery of Bond B = 110 – (1.1 x 96)
= 4.40
6. C
A basic guideline that can be used when working with CTD bonds is as follows:
 If the yield curve is sloping upwards – CTD bonds have longer maturities.
 If the yield curve is sloping downwards – CTD bonds have shorter maturities.
 If yield exceed 6% then CTD bonds are longer maturity and lower coupon bonds.
 If yields are less than 6% then CTD bonds are shorter maturity and higher coupon bonds.

7. C
The present value of the interim cash flows will need to be deducted from the spot price prior
to working out the futures price.
The futures contract pricing equation that pays interim cash flows:
F0 = (S0 – I)erT
8. D
The quoted price will be: Z = 100 – 6.25 = 93.75. The futures price will be: $1,000,000 [1 –
0.0625(90/360)] = $984,375
9. C
This contract is based on the rate of a 90-day dollar denominated time deposit issued by a
London Bank. This deposit is called a Eurodollar time deposit and the rate is referred to as
LIBOR. The T-Bill is a discount instrument. The rate is the 90-day forward LIBOR rate. The
futures contract is based on a 90-day $1m U.S. T-bill.
10. C
A LIBOR spot rate curve can be produced by using the convexity adjusted Eurodollar futures
numbers. time periods If we wanted to solve for the spot rate, the equation could be rearranged
as follows:
R forward T2  T1   R1 T1
R2 =
T2
11. B
A duration hedge can be set up as follows:
P  DP
N
F  DF
200,000,000  9
N
100,000  102   13
N  1,357.47
12. B
The duration measure implies that all yields are perfectly correlated. As such, when yield
changes are large and non-parralel then the effect of a duration hedge is minimized.

Topic 44
Swaps [FMP - 20]
Learning Objectives
Swaps
LO 44 a: Explain the mechanics of a plain vanilla interest rate swap and compute its cash flows.
LO 44 b: Explain how a plain vanilla interest rate swap can be used to transform an asset or a
liability and calculate the resulting cash flows.
LO 44 c: Explain the role of financial intermediaries in the swaps market.
LO 44 d: Describe the role of the confirmation in a swap transaction.
LO 44 e: Describe the comparative advantage argument for the existence of interest rate swaps and
evaluate some of the criticisms of this argument.
LO 44 f: Explain how the discount rates in a plain vanilla interest rate swap are computed.
LO 44 g: Calculate the value of a plain vanilla interest rate swap based on two simultaneous bond
positions.
LO 44 h: Calculate the value of a plain vanilla interest rate swap from a sequence of forward rate
agreements (FRAs).
LO 44 i: Explain the mechanics of a currency swap and compute its cash flows.
LO 44 j: Explain how a currency swap can be used to transform an asset or liability and calculate the
resulting cash flows.
LO 44 k: Calculate the value of a currency swap based on two simultaneous bond positions.
LO 44 l: Calculate the value of a currency swap based on a sequence of forward exchange rates.
LO 44 m: Identify and describe other types of swaps, including commodity, volatility, credit default,
and exotic swaps.
LO 44 n: Describe the credit risk exposure in a swap position.

QUESTIONS

Notional principal = $10m
The dealer agrees to pay the floating rate and the end-user pays a fixed rate.
Floating rate = 6.25% (LIBOR) at the beginning of the period.
Fixed rate = 7.00%
Days per year in floating calculation = 360
Days per year in fixed calculation = 365
Days in the settlement period = 180
Calculate the net amount to be settled at the end of the settlement period.
A. $10,000,000
B. $312,500
C. $345,205
D. $32,705
2. Which of the following statements regarding a plain vanilla swap are correct?
I. A plain vanilla swap is an interest rate swap in which one party pays a fixed rate and the
other pays a floating rate.
II. In a plain vanilla swap both sets of payments are made in the same currency.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following statements regarding the role of financial intermediaries in the swaps
market are not correct?
A. The market is similar to that of the futures market.
B. It is made up of dealers (banks, investment banks) and counterparties (normally end-users
or other dealers).
C. The dealers make markets in swaps by quoting bid and ask prices and rates. In return, the
dealer or bank that acts as the intermediary will charge a spread for bringing the parties
together and taking on the risk.
D. The dealer will typically offset his risk by making transactions in other markets.
4. Which of the following statements regarding the role of financial intermediaries in the swaps
market are not correct?
A. When a swap is initiated neither party will pay the other party anything. Therefore at
inception the value of a swap is zero.
B. A swap is a customized instrument with very little regulation in the market. As such the
risk of default is high.
C. The majority of the participants in the market are small institutions.
D. An agreement by the International Swaps and Derivatives Association (ISDA) that provides
details of the swap arrangement and is called a confirmation.

5.
How much is the comparative advantage?

A. 200 bps
B. 110 bps
C. 400 bps
D. 90 bps
6. Which of the following statements regarding the discount rates in a plain vanilla interest rate
swap are correct?
I. A swap is just a series of future cash flows whose value we can determine by present
valuing them back to todays date.
 T1 
II. The formula to calculate the forward rates is: R f  R2    R2  R1   
 T1  T2 
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
7. Consider an interest rate swap with a notional principal of $100m. The swap is based on 6-
month LIBOR and is a one-year swap agreement. The fixed rate on the loan is 10%. We are 3
months into the swap.
The following spot LIBOR rates are applicable:
LIBOR at last payment date: 7%
LIBOR at the 6-month date: 8%
LIBOR at the 12-month date: 9%
What is the value the fixed payment?
A. $100,000,000
B. $103,047,404
C. $1,596,841
D. $101,450,563
8. Which of the following statements are not correct regarding calculating the value of a plain
vanilla interest rate swap from a sequence of forward rate agreements (FRAs)
 T1 
A. The forward rates will be calculated as follows: R f  R2    R2  R1   
 T1  T2 
B. Once we have the forward rate, we will use it to calculate the fixed cash flows.
C. These floating cash flows will be deducted from the fixed rate cash flows and present
valued to todays date.

D. The sum of these present values is equal to the value of the swap.
What is the value of the BZAR?

A. R101,341,791
B. R106,008,487
C. -R4,666,696
D. $101,341,791
10. The following two companies have two different rates that are available to these companies to
borrow at:
Company Y has a comparative advantage of bps

A. 200 bps
B. 100 bps
C. 400 bps
D. 300 bps

What is the value of the swap?

A. R101,341,791
B. R106,008,487
C. -R4,666,696
D. $101,341,791
12. Assume that the ZAR yield is 10% and the USD yield is 2%.
The current exchange rate is ZAR 15: USD 1.
Calculate the forward rate in one years time.
A. 15:1
B. 16.24:1
C. 13.84:1
D. 16.50:1
13. Which of the following statements regarding the credit risk exposure in a swap position are
correct?
I. The swap market is almost all over-the-counter (OTC) traded.
II. The OTC market reduces the issue of default risk.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
14. Which of the following statements are not correct regarding a swaption?
A. A swaption is an option to enter into a swap
B. The most common swaption is an interest rate swaption.
C. An interest rate swaption gives the option to pay the fixed rate and to receive the floating
rate or the other way round.
D. A receiver swaption allows the holder to enter to enter into a swap as the fixed-rate payer
and floating rate receiver.

15. Savers Bancorp entered into a swap agreement over a 2-year period on August 9, 2014, with
which it received a 4.00% fixed rate and paid LIBOR plus 1.2% on a notional amount of USD6.5
million. Payments were to be made every 6 months. The table below displays the actual annual
6-months Libor rates over the 2-year period:
Date 6 - month LIBOR
Aug 9,2014 3.11%
Feb 9, 2015 1.76%
Aug 9,2015 0.84%
Feb 9, 2016 0.39%
Aug 9,2016 058%
Assuming no default, how much did savers Bancorp receive on August 9, 2016
A. USD 72,150
B. USD 78,325
C. USD 117,325
D. USD 156,650

SOLUTIONS
1. A
Fixed rate payment: $10,000,000 X 7.00% X 180/365 = $345,205 Floating rate payment:
$10,000,000 X 6.25% X 180/360 = $312,500 The fixed rate payer will pay the floating rate payer
the net amount, = $345,205 - $312,500 = $32,705.
2. C
A plain vanilla swap is an interest rate swap in which one party pays a fixed rate and the
other pays a floating rate – with both sets of payments being in the same currency.
3. A
The market is similar to that of the forward and OTC options market. It is made up of dealers
(banks, investment banks) and counterparties (normally end-users or other dealers). The
dealers make markets in swaps by quoting bid and ask prices and rates. In return, the dealer
or bank that acts as the intermediary will charge a spread for bringing the parties together and
taking on the risk. The dealer will typically offset his risk by making transactions in other
markets.
4. C
When a swap is initiated neither party will pay the other party anything. Therefore at
inception the value of a swap is zero. A swap is a customized instrument with very little
regulation in the market. As such the risk of default is high. The majority of the participants in
the market are large institutions. An agreement by the International Swaps and Derivatives
Association (ISDA) that provides details of the swap arrangement and is called a
confirmation.
5. C
Good credit enjoys an absolute advantage in both fixed and floating borrowing rates.
However, on a comparative basis Cantgeta loan enjoys an advantage. The comparative
advantage is the difference in borrowing rates between the two companies in the fixed and
floating markets – in other words 200 bps less 110 bps = 90 bps.
6. A
A swap is just a series of future cash flows whose value we can determine by present valuing
them back to todays date.
The formula to calculate the forward rates is:
 T 
R f  R2    R2  R1   1 
 T1  T2 
7. B
Value the fixed payment BFIXED = PFIXED X e-r(t) BFIXED = 5,000,000 X e-0.08(0.25) +
105,000,000 X e-0.09(0.75) BFIXED = $4,900,993 + $98,146,411 BFIXED = $103,047,404.

8. C
 T 
R f  R2    R2  R1   1 
 T1  T2 
Once we have the forward rate, we will use it to calculate the floating cash flows. These
floating cash flows will be deducted from the fixed rate cash flows and present valued to
todays date. The sum of these present values is equal to the value of the swap.
9. A
BZAR = (12,000,000 + 100,000,000) x e-0.10(1)
BZAR = R101,341,791
10. B
Company X has absolute advantage on interest rates over Company Y. However, on a
comparative basis there is a 100 bps (200bps – 100 bps) advantage to be shares between the
parties.
11. C
BZAR = (12,000,000 + 100,000,000) x e0.10(1) BZAR = R101,341,791 BUSD = (210,000 +
7,000,000) x e0.02(1) BUSD = $7,067,232 Convert the BUSD of $7,067,232 to ZAR at the spot
rate of 15:1 = R106,008,487 VSWAP (X)= BZAR – (S0 X BUSD) VSWAP (X)= R101,341,791 –
R106,008,487 VSWAP (X)= -R4,666,696
12. B
Forward rate1 = 15e(0.10 – 0.02)1 Forward rate1 = R16.24: USD1
13. A
The swap market is almost all over-the-counter (OTC) traded. This raises the issue of default
risk.
14. D
Swaptions
A swaption is an option to enter into a swap. The most common swaption is an interest rate
swaption. This is a swaption to pay the fixed rate and to receive the floating rate or the other
way round.
Basic characteristics of swaptions
A payer swaption allows the holder to enter to enter into a swap as the fixed-rate payer and
floating rate receiver.
15. B
The proper interest rate to use is the 6-month LIBOR rate at February 9, 2016, since it is the 6-
month LIBOR that will yield the payoff on August 9, 2016. Therefore, the net settlement
amount on August 9th, 2016 is as follows:
Savers receives: 6,500,000 * 4.00% * 0.5 years, or USD 130,000 Savers pays 6,500,000 * (0.39% +
1.20%) * 0.5, or USD 51,675. Therefore, Savers would receive the difference, or 78,325.

FRM PART – I – VALUATION AND RISK MODELS
Topic 45
Measures of Financial Risk [VRM - 1]
Learning Objectives
Measures of Financial Risk
LO 45 a: Describe the mean-variance framework and the efficient frontier.

LO 45 b: Explain the limitations of the mean-variance framework with respect to assumptions about
return distributions.
LO 45 c: Compare the normal distribution with the typical distribution of returns of risky financial
assets such as equities.
LO 45 d: Define the VaR measure of risk, describe assumptions about return distributions and
holding period, and explain the limitations of VaR.
LO 45 e: Explain and calculate Expected Shortfall (ES), and compare and contrast VaR and ES.
LO 45 f: Define the properties of a coherent risk measure and explain the meaning of each property.
LO 45 g: Explain why VaR is not a coherent risk measure.
LO 45 h: Describe spectral risk measures, and explain how VaR and ES are special cases of spectral
risk measures.

QUESTIONS
1. When describing the mean-variance framework and the efficient frontier which of the
following statements is not correct?
A. Once we introduce the risk-free asset into our portfolio we will derive a linear formula for
the expected standard deviation of the portfolio.
B. The shape of the efficient frontier changes from being a straight line to being curved.
C. When a risk-free asset is combined with risky assets in a portfolio, the standard deviation
of a portfolio will be the linear proportion of the standard deviation of the risky asset
portfolio.
D. The standard deviation of the whole portfolio will be determined by the standard
deviation of the risky assets only since the standard deviation of the risk-free asset is equal
to zero
2. When assessing the limitations of the mean-variance framework with respect to assumptions
about return distributions. Which of the following statements are correct?
I. To the extent that the underlying distribution is non-normal then the use of the standard
deviation as a risk measure is not appropriate.
II. The mean-variance framework assumes a normal distribution and thus would not be
appropriate for a non-normal distribution.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following is not a limitation of VaR?

A. Underestimates the frequency of extreme events.
B. The estimation of VaR is an objective approach.
C. Liquidity is not taken into account.
D. Sensitive to correlation risk.
4. Which of the following properties of a coherent risk measure is best described by ρ(R1 + R2) ≤
ρ(R1) + ρ(R2)?
A. Monotonicity
B. Subadditivity
C. Positive homogeneity
D. Translation invariance
5. When defining the properties of a coherent risk measure, which of the following statements
are correct?
I. Subadditivity is the most important measure for coherent risk measures
II. Subadditivity assumes some form of diversification benefits when adding assets together
to form a portfolio or at the worst no added risks to the portfolio.
A. I only.

B. II only.
C. Both I and II.
D. Neither I or II.
6. Assuming that we were using the HS approach and we wanted to work out the 5% VaR.
Assume that the 5th percentile for the portfolio earned= -15%. Which of the following
A. The 5% VaR = -15%.
B. The VaR measure does not tell us much about what happens once -15% is breached, for
this we need to ES measure.
C. Based on this we see that the ES measure will equal a larger loss than the VaR measure.
D. VaR, unlike ES has the ability to satisfy the subadditivity property.
7. When describing expected shortfall, which of the following statements are not correct?
A. The conditional VaR (CVaR) is a measure that measures the average loss once the
minimum loss has been exceeded.
B. The CVaR is sometimes referred to as the expected shortfall (ES) or expected tail loss
(ETL),
C. ES measures how much can we expect to lose if the VaR is exceeded.
D. The best approach to calculating the CVaR is by using the parametric approach.
8. When describing expected shortfall, which of the following statements are not correct?
A. The ES measure is also more effective than the VaR measure when adjusting for the
holding period and the level of confidence at the same time.
B. The ES surface curve that details both adjustments is a convex curve and is better at
solving portfolio optimization cases.
C. ES is more restrictive regarding its assumptions than VaR regarding risk and return
decision rules.
D. ES satisfies all the properties of a coherent risk measure.
9. When describing spectral risk measures, which of the following statements are not correct?
1
A. The ES weighting function = for the tail losses.
1  confidence int erval
B. The ES weighting function suggests that investors are risk neutral regarding losses –
which is not correct as we treat investors as risk average.
C. VaR cannot be used as a risk spectral model.
D. Both methods seem to fall short because their weighting system is inconsistent with risk
averse investors.

SOLUTIONS
1. B
The efficient frontier and the risk-free rate
Once we introduce the risk-free asset into our portfolio we will derive a linear formula for the
expected standard deviation of the portfolio. The shape of the efficient frontier changes from
being curved to being a straight line.
When a risk-free asset is combined with risky assets in a portfolio, the standard deviation of a
portfolio will be the linear proportion of the standard deviation of the risky asset portfolio. In
other words, the standard deviation of the whole portfolio will be determined by the standard
deviation of the risky assets only since the standard deviation of the risk-free asset is equal to
zero.
2. C
To the extent that the underlying distribution is non-normal then the use of the standard
deviation as a risk measure is not appropriate. The reason for this is that since the underlying
return density function is not symmetrical then the standard deviation will not capture the
correct probability of getting undesirable return outcomes.
The mean-variance framework assumes a normal distribution and thus would not be
appropriate for a non-normal distribution.
3. B
Limitations of VaR
 Subjective. The estimation of VaR is a highly subjective approach as we saw when we
looked at the three approaches used to estimate VaR.
 Underestimates the frequency of extreme events. When we assume a normal distribution
(for the parametric approach and the MCS) this leads to an underestimation of the tail risk.
The reason for this is that actual return distributions have fatter tails than a normal
distribution.
 Liquidity is not taken into account. Liquidity is likely to fall as a result of downside events.
This decreased liquidity and likelihood of exiting positions at lower prices, is not taken into
account in the VaR calculation.
 Sensitive to correlation risk. As a result of downside events correlations tend to rise. This
increased correlation, in times of extreme events, is not taken into account in the VaR
calculation.
4. B
Subadditivity
5. C
Subadditivity is the most important measure for coherent risk measures. This property assumes
some form of diversification benefits when adding assets together to form a portfolio or at the
worst no added risks to the portfolio.

6. D
The 5% VaR = -15%. However, this does not tell us much about what happens once -15% is
breached. For this we need to ES measure. Based on this we see that the ES measure will equal
a larger loss than the VaR measure. ES, unlike VaR has the ability to satisfy the subadditivity
property.
7. D
The conditional VaR (CVaR) is a measure that measures the average loss once the minimum
loss has been exceeded. The CVaR is sometimes referred to as the expected shortfall (ES) or
expected tail loss (ETL), in other words how much can we expect to lose if the VaR is exceeded.
The best approach to calculating the CVaR is by using the historical simulation (HS) approach
or the MCS approach.
8. C
The ES measure is also more effective than the VaR measure when adjusting for the holding
period and the level of confidence at the same time. The ES surface curve that details both
adjustments is a convex curve and is better at solving portfolio optimization cases.
ES is less restrictive regarding its assumptions than VaR regarding risk and return decision
rules. ES satisfies all the properties of a coherent risk measure. VaR will only satisfy these in the
case of a normal distribution.
9. C
1
The ES weighting function = for the tail losses. The other quantiles have
1  confidence int erval
a weight of zero. The problem with this is that all losses are given equal weighting, which
suggests that investors are risk neutral regarding losses – which is not correct as we treat
investors as risk average.
VaR can also be used as a risk spectral model. In this case we set the probability to one such
that the p-value is equal to the level of significance. The probability for all other events = 0, or P
≠ α. VaR only assigns weights to losses when the p-value is equal to the level of significance.
However, greater losses are not assigned any weight at all. This suggests that investors are risk
seekers regarding losses – which is not correct as we treat investors as risk average.

Topic 46
Calculating and Applying VaR [VRM - 2]
Learning Objectives
Calculating and Applying VaR
LO 46 a: Explain and give examples of linear and non-linear derivatives.

LO 46 b: Describe and calculate VaR for linear derivatives.
LO 46 c: Describe and explain the historical simulation approach for computing VaR and ES.
LO 46 d: Describe the delta-normal approach for calculating VaR for non-linear derivatives.
LO 46 e: Describe the limitations of the delta-normal method.
LO 46 f: Explain the full revaluation method for computing VaR.
LO 46 g: Compare delta-normal and full revaluation approaches for computing VaR.
LO 46 h: Explain structured Monte Carlo and stress testing methods for computing VaR, and
identify strengths and weaknesses of each approach.
LO 46 i: Describe the implications of correlation breakdown for scenario analysis.
LO 46 j: Describe worst-case scenario (WCS) analysis and compare WCS to VaR.

QUESTIONS
1. When describing of linear and non-linear derivatives which of the following statements is not
correct?
A. A linear derivative is a derivative whose value changes are linear, in other words the
relationship between the underlying instrument and the derivative are linear in nature.
B. The delta for a linear derivative will therefore be dynamic for all levels of the underlying.
C. An example of a linear derivative would be a forward contract on a currency
D. A nonlinear derivative depends on the state of the underlying asset and is a function of the
change in the value of the underlying.
2. Assume that we are dealing with a call option with a delta of 6. The underlying asset has a
daily volatility of 2%. What is the daily 5% VaR of the derivative?
A. -0.02
B. -0.03
C. -0.06
D. -0.18
3. Which of the following statements used to describe the delta-normal approach for calculating
VaR for non - linear derivatives are not correct ?
 derivative price
A. Δ = The delta of the derivative =
 underlying spot price
B. The local delta is the slope of the line for a 1% change in the underlying’s spot price.
C. The delta is a good measure to use for approximating small changes in the price.
D. As price movements get larger, the gap between tangent line and option price widens
making the delta a good approximation of price changes.
4. When assessing the limitations of the delta-normal method which of the following statements
are correct?
I. The Taylor Series approximation is used takes into account the rate of change thus making
it a better approximation measure than the delta
II. The Taylor Series captures the convexity
A. I only
B. II only
C. Both I and II.
D. Neither I or II.
5. When comparing the delta-normal and full revaluation approaches for computing VaR which
of the following statements are correct?
I. The Delta-normal approach makes use of the delta approximation: VaRP = Δ VaRF
II. The delta-normal calculation is computationally easier to use than the full revaluation
method
A. I only.

B. II only
C. Both I and II.
D. Neither I or II.
6. When comparing the delta-normal and full revaluation approaches for computing VaR which
of the following statements are correct?
I. A calculation is done on the VaR of the derivative by valuing the derivative based on the
underlying value of the index after a decline, which corresponds to a certain % VaR of the
index.
II. This full revaluation approach is very accurate but time consuming in its computation.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
7. When assessing structured Monte Carlo, stress testing, and scenario analysis methods for
computing VaR which of the following statements are not correct?
A. We have seen in the past that correlations tend to move together in times of crisis.
B. Periods of extreme volatility are bad news for strategies that rely on low levels of
correlations among assets.
C. The concern when using the SMC approach is that it is unable to predict what will happen
in times of crisis if the modeling was done under normal circumstances.
D. In cases of extreme volatility it will help to increase the number of simulations in SMC as
this will not improve the predictability of the model.
8. When assessing structured Monte Carlo, stress testing, and scenario analysis methods for
computing VaR which of the following statements are not correct?
A. Scenario analysis provides an estimate as to what a change in a set of risk factors will have
on the value of the portfolio.
B. Basing a scenario analysis on a hypothetical set of risk changes is called a hypothetical
scenario approach.
C. A Monte Carlo simulation can be used to examine the effect that extreme negative stress
events will have on the portfolio and is closely related to scenario analysis.
D. The structured Monte Carlo (SMC) approach assumes normality by simulating several
thousand outcomes when valuing the underlying asset.
9. When describing the worst-case scenario approach, which of the following statements are not
correct?
A. The VaR approach makes the assumption that an unfavorable event will occur with
certainty.
B. WCS focuses on what the outcome will be in the event of the event occurring.
C. The VaR calculation just indicates that minimum loss that is to be expected at a certain %.
D. The WCS goes further than VaR in that it works out the extent of the loss given that the
negative event will occur.

10. Assume we are looking at a 1% WCS with a measure of -3.00 to -4.00. Which of the following
I. We expect losses to exceed 2.33 only 1% of the time
II. The losses are exceeded 1% of the time, the expected loss is going to be -3 with a 1%
probability that the loss will be -4 or worse.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
11. A portfolio manager bought 1,000 call options on a non-dividend-paying stock, with a strike
price of USD 100, for USD 6 each. The current stock price is USD 104 with a daily stock return
volatility of 1.89%, and the delta of the option is 0.6. Using the delta-normal approach to
calculate VaR, what is an approximation of the 1-day 95% VaR of this position?
A. USD 112
B. USD 1,946
C. USD 3,243
D. USD 5,406

SOLUTIONS
1. B
A linear derivative is a derivative whose value changes are linear, in other words the
relationship between the underlying instrument and the derivative are linear in nature. The
delta for a linear derivative will therefore be constant for all levels of the underlying.
An example of a linear derivative would be a forward contract on a currency. A nonlinear
derivative depends on the state of the underlying asset and is a function of the change in the
value of the underlying. An example of a nonlinear derivative are most option contracts. The
reason for this is that the value of the option does not move at a constant rate when the
underlying asset moves.
2. D
The first step is to calculate the VaR of the underlying: VaR(5%)DAILY = - 0.02 X 1.65
VaR(5%)DAILY = -0.03 The second step is to approximate the derivatives VaR as follows:
VaR(5%)CALL, DAILY = -0.03 X 6 (delta) VaR(5%)CALL, DAILY = -0.18
3. D
The delta of the derivative is a linear measure and is calculated as follows:
 derivative price
Δ = The delta of the derivative =
 underlying spot price
We have already seen how to calculate this change in the previous LO. The local delta is the
slope of the line for a 1% change in the underlying’s spot price. The delta is a good measure to
use for approximating small changes in the price. An option price is not linear and hence only
stays close to the tangent line (which is linear) for small movements in price. As the price
movements get larger, the gap between tangent line and option price widens making the delta
a poor approximation of price changes.
4. C
The Taylor Series approximation is used takes into account the rate of change thus making it a
better approximation measure than the delta (which only measures the slope of the line at any
given point). The Taylor Series captures the convexity.
5. C
The Delta-normal approach makes use of the delta approximation: VaRP = Δ VaRF This
calculation is computationally easier to use than the full revaluation method.
6. C
Full revaluation approach
A calculation is done on the VaR of the derivative by valuing the derivative based on the
underlying value of the index after a decline, which corresponds to a certain % VaR of the
index. This method is very accurate but time consuming in its computation.

7. D
We have seen in the past that correlations tend to move together in times of crisis. This is bad
news for strategies that rely on low levels of correlations among assets. The concern when
using the SMC approach is that it is unable to predict what will happen in times of crisis if the
modeling was done under normal circumstances. It will not help to increase the number of
simulations as this will not improve the predictability of the model.
8. C
Scenario analysis provides an estimate as to what a change in a set of risk factors will have on
the value of the portfolio. Basing a scenario analysis on a hypothetical set of risk changes is
called a hypothetical scenario approach. A stress test can be used to examine the effect that
extreme negative stress events will have on the portfolio and is closely related to scenario
analysis. The structured Monte Carlo (SMC) approach assumes normality by simulating several
thousand outcomes when valuing the underlying asset.
9. A
The worst-case scenario (WCS) approach makes the assumption that an unfavorable event will
occur with certainty. We then focus on what the outcome will be in the event of the event
occurring. The VaR calculation just indicates that minimum loss that is to be expected at a
certain %. The WCS goes further than VaR in that it works out the extent of the loss given that
the negative event will occur. The WCS compliments the VaR approach.
10. C
What this means is that we expect losses to exceed 2.33 only 1% of the time. What is important
in the WCS measure is the extent of the loss. A measure of 3 to 4 means that when the losses are
exceeded 1% of the time, the expected loss is going to be -3 with a 1% probability that the loss
will be -4 or worse.
11. B
The delta of the option is 0.6. The VaR of the underlying is: 1.89% * 1.65 * 104 = 3.24. Therefore,
the VaR of one option is: 0.6*3.24=1.946, and multiplying by 1,000 provides the VaR of the entire
position: USD 1,946.

Topic 47
Measuring and Monitoring Volatility [VRM - 3]
Learning Objectives
Measuring and Monitoring Volatility
LO 47 a: Explain how asset return distributions tend to deviate from the normal distribution.
LO 47 b: Explain reasons for fat tails in a return distribution and describe their implications.
LO 47 c: Distinguish between conditional and unconditional distributions.
LO 47 d: Describe the implications of regime switching on quantifying volatility.
LO 47 e: Evaluate the various approaches for estimating VaR.
LO 47 f: Compare and contrast different parametric and non-parametric approaches for estimating
conditional volatility.
LO 47 g: Calculate conditional volatility using parametric and non-parametric approaches.
LO 47 h: Evaluate implied volatility as a predictor of future volatility and its shortcomings.
LO 47 i: Explain long horizon volatility/VaR and the process of mean reversion according to an
GARCH(1,1) model.
LO 47 j: Calculate conditional volatility with and without mean reversion.
LO 47 k: Describe the impact of mean reversion on long horizon conditional volatility estimation.
LO 47 l: Describe an example of updating correlation estimates.

QUESTIONS
1. When describing how asset return distributions tend to deviate from the normal distribution
which of the following statements is not correct?
A. Fat-tails are when the probability of events occurring in the tails is higher than for the
normal distribution.
B. The first two moments, the mean and variance, is similar for a normal distribution as for a
fat-tail distribution.
C. In the case of fat-tails, more of the distribution will sit in the tail as apposed to the normal
distribution
D. In the case of a normal distribution, more of the distribution will sit in the tail as apposed to
the fat-tail distribution.
2. When describing a negative or left skewed distribution which of the following statements is not
correct?
A. The graph is negatively skewed
B. The mode occurs at the highest point because it is the value that occurs the most frequently
C. The median lies in the middle of the data set
D. There are large outliers to the left, causing the graph to have a long left tail. These outliers
pull the mean over to the left, causing it to be smaller than the median
3. When distinguishing between conditional and unconditional distributions which of the

I. To the extent that the mean and variance are constant over time – we call this an
unconditional distribution.
II. If the mean and variance vary over time due to various circumstances, then we call this a
conditional distribution.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
4. In a regime switching model, which of the following statements are not correct?
A. In a regime switching model we assume that different market regimes exist with each
regime having a different volatility estimate.
B. The conditional distribution is assumed to be normal with a constant mean but a different
variance – high or low. The model works to solve the issue of fat tails and other reasons for
deviations from normal.
C. When using this model, the probability of large deviations from normal are common. This
model results in a fat-tailed unconditional distribution.
D. Since our assumption is that the variance (volatility) varies with time + the returns are
conditionally normally distributed – we are able to deal with the fat-tail issue a little better.

5. Which of the following VaR approaches is not a historical-based approach?

A. Parametric approach
B. Nonparametric approach
C. Hybrid approach
D. MCS approach
6. Which of the following VaR approaches is not a parametric approach?

A. The Exponentially weighted moving average (EWMA) model
B. The GARCH model
C. The Delta-normal approach.
D. The Historical Simulation approach.

Number of observations (K) = 100
VaR = 5%
λ = 0.95
Calculate, using the hybrid approach, the VaR %:

A. 6.00%
B. 9.94%
C. 9.50%
D. 10.00%
8. When describing the process of return aggregation in the context of volatility forecasting
methods, which of the following statements are correct?
I. The strong law of large numbers states that an average of a large number of random
samples will converge to a normal random variable.
II. To use the strong law of large numbers method, a well diversified portfolio is required.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
9. Which of the following statements are not correct when describing implied volatility?
A. In an actively traded options market we can assume that the prices of the options accurately
reflect their fair values.
B. By setting the Black-Scholes-Merton (BSM) model equal to the market price of the option –
we can work backwards to infer the volatility.

C. This procedure is called the implied volatility

D. A disadvantage of this method is that it is forward looking.
10. When describing mean reversion, which of the following statements are correct?
I. Mean reversion is when the time-series tends to move towards its mean.
II. This means that if the time series is currently above its mean it will decline, and if the time-
series is below its mean it will fall.
A. I only
B. II only.
C. Both I and II.
D. Neither I or II.
11. When describing backtesting, which of the following statements are correct?
I. Backtesting can be used to test the reliability of VaR. This involves comparing actual losses
to those predicted by VaR.
II. Assuming that the model was accurate we would expect the number of times that VaR was
exceeded to be equal to the level of significance.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
12. When using a backtesting approach, which of the following attributes is not an attribute that
VaR that can be evaluated upon?
A. The VaR estimate should be unbiased
B. The VaR estimate should be linear
C. The VaR estimate should be adaptable.
D. The VaR estimate must be robust.
13. Assume that portfolio daily returns are independently and identically normally distributed. A
new quantitative analyst has been asked by the portfolio manager to calculate portfolio VaRs
for10-,15-,20-, and 25-day periods. The portfolio manager notices something amiss with the
analyst’s calculations displayed below. Which one of following VaRs on this portfolio is
inconsistent with the others?
A. VaR(10-day)=USD316M
B. VaR(15-day)=USD465M
C. VaR(20-day)=USD537M
D. VaR(25-day)=USD600M

SOLUTIONS
1. D
Fat-tails are when the probability of events occurring in the tails is higher than for the normal
distribution. What is interesting is that the first two moments, the mean and variance, is similar
for a normal distribution as for a fat-tail distribution. The difference is where the majority of the
distribution lies. In the case of fat-tails, more of the distribution will sit in the tail as apposed to
the normal distribution.
2. C
The following characteristics are present in a negative or left skewed distribution.
 The graph is negatively skewed
 The mode occurs at the highest point because it is the value that occurs the most frequently
 The median lies in the middle of the data set, but in this case, because there are far more
values in the second part of the graph, it is slightly to the right of center from a diagram
point of view
 There are large outliers to the left, causing the graph to have a long left tail. These outliers
pull the mean over to the left, causing it to be smaller than the median
3. C
To the extent that the mean and variance are constant over time – we call this an unconditional
distribution. If the mean and variance vary over time due to various circumstances, then we call
this a conditional distribution.
4. C
In a regime switching model we assume that different market regimes exist with each regime
having a different volatility estimate. The conditional distribution is assumed to be normal with
a constant mean but a different variance – high or low. The model works to solve the issue of
fat tails and other reasons for deviations from normal. When using this model, the probability
of large deviations from normal are not common. This model results in a fat-tailed
unconditional distribution. Since our assumption is that the variance (volatility) varies with
time + the returns are conditionally normally distributed – we are able to deal with the fat-tail
issue a little better.
5. D
HISTORICAL-BASED APPROACHES
When looking at historical-based approaches, we can break them down into three major
categories:
Parametric approach
Nonparametric approach
Hybrid approach

6. D
The following approaches are all parametric approaches:
 The Exponentially weighted moving average (EWMA) model.
 The GARCH model.
 The Delta-normal approach.
7. B
Number of observations (K) = 100
VaR = 5%
λ = 0.95
Assume of portfolio size of $10m. We collect the daily returns over the past 100 days. We rank
them, and arrive at the lowest returns over the period.
We will calculate the hybrid weight as well as the cumulative hybrid weight for the lowest
returns per the table:
We have only calculated the first two lowest returns to illustrate the hybrid calculation. We did
not need to go further since we can already see that the cumulative hybrid weight has breached
the 5% level and thus the number we are looking for sits in between these two numbers – since
we are looking at a 5% VaR.
To arrive at the correct number we need to interpolate, as follows:
Average return of the two points = −0.10 + −0.09 / 2 = 0.095
Average weight of the two points = 0.0478+ 0.0867 / 2 = 0.0673
To arrive at the correct return number we calculate as follows:
0.10 – (0.10 – 0.095) 0.05−0.0478 / 0.0673−0.0478
= 0.10 – 0.0006
= 0.0994
To calculate the VaR we would multiply the 0.0994 by the value of the portfolio.
8. C
Return aggregation - The final method works with the strong law of large numbers, which
states that an average of a large number of random samples will converge to a normal random
variable. To use this method, a well diversified portfolio is required.
9. D
In an actively traded options market we can assume that the prices of the options accurately
reflect their fair values. By setting the Black-Scholes-Merton (BSM) model equal to the market

price of the option – we can work backwards to infer the volatility. This procedure is called the
implied volatility. An advantage of this method is that it is forward looking.
10. A
Mean reversion is when the time-series tends to move towards its mean. This means that if the
time series is currently above its mean it will decline, and if the timeseries is below its mean it
will rise.
11. C
Backtesting can be used to test the reliability of VaR. This involves comparing actual losses to
those predicted by VaR. Assuming that the model was accurate we would expect the number of
times that VaR was exceeded to be equal to the level of significance.
12. B
When using a backtesting approach, there are three attributes of VaR that can be evaluated:
 The VaR estimate should be unbiased
 The VaR estimate should be adaptable.
 The VaR estimate must be robust
13. A
The calculations follow. Calculate VaR(1-day)from each choice:
VaR(10-day) = 316 → VaR( 1-day) = 316/√10 = 100
VaR(15-day)=465→VaR( 1-day)=465/√15 =120
VaR(20-day)=537→VaR( 1-day)=537/ √20 =120
VaR(25-day)=600→VaR( 1-day)=600/ √25 =120
VaR(1-day) from “a” is different from those from other answers.

Topic 48
External and Internal Credit Ratings [VRM - 4]
Learning Objectives
External and Internal Ratings
LO 48 a: Describe external rating scales, the rating process, and the link between ratings and
default.
LO 48 b: Describe the impact of time horizon, economic cycle, industry, and geography on external
ratings.
LO 48 c: Define and use the hazard rate to calculate unconditional default probability of a credit
asset.
LO 48 d: Define recovery rate and calculate the expected loss from a loan.
LO 48 e: Explain and compare the through-the-cycle and at-the-point internal ratings approaches.
LO 48 f: Describe alternative methods to credit ratings produced by rating agencies.
LO 48 g: Compare external and internal ratings approaches.
LO 48 h: Describe and interpret a ratings transition matrix and explain its uses.
LO 48 i: Explain the potential impact of ratings changes on bond and stock prices.
LO 48 j: Explain historical failures and potential challenges to the use of credit ratings in making
investment decisions.

QUESTIONS
1. Which of the following is not a step in ratings process?

A. A qualitative analysis is performed.
B. A quantitative analysis is performed.
C. Meetings with the entity’s accountants.
D. Rating agency committee meetings to decide on the rating.
2. Which of the following statements are not correct when dealing with ratings of a rating
agencies?
A. Once a rating has been assigned to a bond the rating agency will monitor the credit quality
of the issuer.
B. An improved rating over time is called an upgrade.
C. An inferior rating over time is called a downgrade.
D. An unanticipated downgrade of an issue will increase the credit spread and result in the
price of the issue declining - this is called ratings risk.
3. Which of the following statements are not correct when dealing with the impact of time
horizon, economic cycle, industry, and geography on external ratings?
A. A ratings agency’s initial rating and their estimation of the probability of default will
increase as the time horizon increases.
B. In addition, the lower the grade of the bond, the greater the increase in the probability of
default as time increases.
C. A rating agency will often use average cycle forecast for the term of the issue - this leads to
average or stable ratings for the period which may end up over or underestimating the
position.
D. The default rate for lower-grade bonds is not correlated with the economic cycle while the
default rate for higher-grade bonds is more stable.
4. When explaining the potential impact of ratings changes on bond and stock prices, which of the
A. There is strong evidence to suggest that a ratings downgrade will result in the decrease in
the price of a bond.
B. There is weak evidence to suggest that a ratings upgrade will result in the increase in the
price of a bond.
C. There is no evidence to suggest that a ratings downgrade will result in the decrease in the
price of a stock.
D. There is mixed evidence to suggest that a ratings upgrade will result in the increase in the
price of a bond.
5. Which of the following statements are not correct when dealing with external versus internal
ratings approaches?
A. An internal rating is for example what a bank will use to determine the creditworthiness of
their own lenders.

B. Internal ratings came about after the success of external ratings.

C. Initially internal ratings were over simplistic and lacked specificity.
D. Internal ratings have improved dramatically over time, due to making greater use of the
external ratings methodologies (which are very well developed).
6. Which of the following statements regarding the through-the-cycle and at-the-point internal
ratings approaches are correct?
I. An at-the-point approach. The goal of this approach is to predict the credit quality of an
entity of a short space of time – normally a year.
II. A through-the-cycle approach focuses on the longer term and includes forecasts of future
cycles.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
7. The following one-year rating transition matrix is presented:
What is the probability of the AAA bond still being rated as AAA at the end of the year?
A. 93.20
B. 6.00%
C. 0.60%
D. 0.12%
8. Which of the following statements are not correct when describing the process for and issues
with building, calibrating, and backtesting an internal rating system?
A. One way of constructing an internal rating system is to work on a system that resembles
one set by the external rating agencies.
B. Weights are assigned by the internal rating team to certain risk factors and financial ratios
that were used by the external rating agency.
C. The internal rating team will then construct a scoring system.
D. Backtesting should be for periods of between 1 and 2 years.
9. Which of the following is not a bias that may affect a rating system?
A. Homogeneity bias
B. Time-horizon bias
C. Information bias
D. Look-ahead bias

10. Which of the following biases is best described by the following statement “Consistent ratings
cannot be maintained’?
A. Homogeneity bias
B. Time-horizon bias
C. Information bias
D. Look-ahead bias
SOLUTIONS
1. C
The rating process usually consists of the following steps:
 A qualitative analysis is performed.
 A quantitative analysis is performed.
 Meetings with the entity’s management.
 Rating agency committee meetings to decide on the rating.
 Communicating the rating to the issuer / entity.
 Meetings between the parties to discuss the rating.
 Dissemination of the rating to the general public.
2. D
Once a rating has been assigned to a bond the rating agency will monitor the credit quality of
the issuer. This rating can change over time. An improved rating is called an upgrade. An
inferior rating is called a downgrade. An unanticipated downgrade of an issue will increase the
credit spread and result in the price of the issue declining. This is called downgrade risk.
3. D
A ratings agency’s initial rating and their estimation of the probability of default will increase
as the time horizon increases. In addition, the lower the grade of the bond, the greater the
increase in the probability of default as time increases. Other factors that impact the issue are
forecast economic and industrial cycles. Keeping this in mind, a rating agency will often use
average cycle forecast for the term of the issue. This leads to average or stable ratings for the
period which may end up over or underestimating the position. Keep in mind that this issue if
further exacerbated by correlations. The default rate for lower-grade bonds is highly correlated
with the economic cycle while the default rate for higher-grade bonds is more stable.
4. C
There is strong evidence to suggest that a ratings downgrade will result in the decrease in the
price of a bond. There is weak evidence to suggest that a ratings upgrade will result in the
increase in the price of a bond. The statistical significance of the above data is difficult to
measure as the downgrade or upgrade may come at the same time as other changes at the
entity. There is also a theory that the market anticipates a ratings change and as such when it
does actually occur there is little price impact. When moving across to stocks, the effect even
more asymmetric than for bonds: There is average evidence to suggest that a ratings

downgrade will result in the decrease in the price of a stock. There is mixed evidence to suggest
that a ratings upgrade will result in the increase in the price of a bond.
5. A
An internal rating is for example what a bank will use to determine the creditworthiness of
their own borrowers. Internal ratings came about after the success of external ratings. The
companies used the same successful methodologies used by external ratings agencies for their
own internal businesses. Initially internal ratings were over simplistic and lacked specificity.
For example, a bank could only tell if the borrower was a good or bad client, it could not work
out unique rates to charge each customer. Internal ratings have improved dramatically over
time, due to making greater use of the external ratings methodologies (which are very well
developed), as well as making use of the Basel II rules and their approach to calculating credit
risk capital.
6. C
An at-the-point approach. The goal of this approach is to predict the credit quality of an entity
of a short space of time – normally a year. A through-the-cycle approach focuses on the longer
term and includes forecasts of future cycles.
7. A
For a bond rated AAA at the beginning of the year – its probability of still being rated at the
end of the year at AAA is 93.20%. The probability of it being downgraded to AA is 6.00% etc.
8. D
One way of constructing an internal rating system is to work on a system that resembles one set
by the external rating agencies. Weights are assigned by the internal rating team to certain risk
factors and financial ratios that were used by the external rating agency. The internal rating
team will then construct a scoring system.
9. D
The following biases are present when dealing with an internal rating system:
 Homogeneity bias – Consistent ratings cannot be maintained.
 Time-horizon bias – Ratings are mixed from different approaches.
 Information bias – Ratings are often given despite insufficient information.
 Principal/agent bias – The agents may not always be acting in the best interest of the bank.
 Criteria bias – Unstable criteria are used to develop a rating.
 Scale bias – Ratings may be unstable over time.
 Backtesting bias – Defaults rates and internal ratings may be incorrectly linked.
 Distribution bias – An incorrect distribution may have been used to model the probability
of default.
10. A
The following biases are present when dealing with an internal rating system: Homogeneity
bias – Consistent ratings cannot be maintained.

Topic 49
Country Risk: Determinants, Measures, and Implications
[VRM - 5]
Learning Objectives
Country Risk: Determinants, Measures, and Implications
LO 49 a: Identify sources of country risk.

LO 49 b: Explain how a country’s position in the economic growth life cycle, political risk, legal risk,
and economic structure affect its risk exposure.
LO 49 c: Evaluate composite measures of risk that incorporate all major types of country risk.
LO 49 d: Compare instances of sovereign default in both foreign currency debt and local currency
debt, and explain common causes of sovereign defaults.
LO 49 e: Describe the consequences of sovereign default.
LO 49 f: Describe factors that influence the level of sovereign default risk; explain and assess how
rating agencies measure sovereign default risks.
LO 49 g: Describe characteristics of sovereign credit spreads and sovereign CDS, and compare the
use of sovereign spreads to credit ratings.

QUESTIONS
1. Which of the following is not a source of country risk?

A. Countries that are already developed.
B. Political risks.
C. The structure and efficiency of a country’s legal system.
D. Disproportionate reliance of one country on another for commodities or services.
2. When looking at political risk for a country, which of the following is not correct?
A. Corruption risk is present when corruption exists within government and is similar to
charging an explicit tax, which serves to reduce profits and returns.
B. Continuous versus discontinuous risk – A democratic system is viewed as a continuous
system.
C. Risk of expropriation and nationalization - The risk of expropriation and nationalization is
that successful companies may have their assets taken by government for no compensation
or for amounts that are below market prices.
D. Risk of violence – The costs of violence include physical costs such as harm to people as
well as economic costs such as increased costs of security and insurance.
3. Which of the following is not a service that evaluates country risk?

A. Political risk services (PRS)
B. The Newsweek
C. The World Bank
D. Euromoney
4. Which of the following statements regarding instances of sovereign default are correct?
I. Latin America accounts for a large portion of the foreign debt defaults during the survey
period.
II. Defaults are more likely to occur on funds borrowed from banks than on foreign bond
issues.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
5. When describing the consequences of sovereign default, which of the following statements are
not correct?
A. Ratings can drop by one or two grades when compared to a similar non-defaulting country.
B. Borrowing costs rise by 5% to 10%.
C. The effects decease over time.
D. There is a greater chance of a banking crisis following a sovereign default.

6. When describing the consequences of sovereign default, which of the following statements are
not correct?
A. GDP normally falls by approximately 0.5% to 2% within the first year of the default.
B. The decline in GDP is long-lived.
C. A trade war can ensue following a default.
D. Exports are known to drop by up to 8%.
7. Which of the following factors will not influence a country’s risk of sovereign default?
A. Level of indebtedness
B. Social services and pension funds
C. Stability of tax system
D. The banking system
8. Which of the following is not a risk of relying on rating agency reports?

A. Credit ratings are static.
B. Rating agencies are not infallible
C. Event risk is difficult to capture in the ratings
D. Ratings tend to lag the market pricing
9. Which of the following is not an advantage of default credit spreads?

A. Real-time changes
B. Granularity
C. New information
D. Accurate predictor of defaults
10. Which of the following is not a disadvantage of default credit spreads?

A. Risk-free security matching
B. Difficult to compare
C. Increased volatility
D. Granularity

SOLUTIONS
1. A
 Countries that are still in their economic growth cycle.
 Political risks.
 The structure and efficiency of a country’s legal system.
 Disproportionate reliance of one country on another for commodities or services.
2. A
Corruption – This risk is present when corruption exists within government and is similar to
charging an implicit tax, which serves to reduce profits and returns.
Continuous versus discontinuous risk – A democratic system is viewed as a continuous system
and albeit that the risk is generally low, the risk of the system changing due to elections,
government policies etc. is reasonably high. An autocratic system is viewed as a discontinuous
system as policies are locked in and predictable with a single leader making all the decisions.
When changes are made in a discontinuous system they can be severe and difficult to predict.
Risk of expropriation and nationalization - The risk of expropriation and nationalization is that
successful companies may have their assets taken by government for no compensation or for
amounts that are below market prices.
Risk of violence – The costs of violence include physical costs such as harm to people as well as
economic costs such as increased costs of security and insurance.
3. B
The following services evaluate country risk:
 Political risk services (PRS) – PRS ranks countries in terms of their country risk by using 22
key variables. The rankings are categorized into three areas: Political, economic and
financial risks.
 The Economist – The Economist assesses the following risks: currency, sovereign debt and
banking risk, in order to arrive at country risk. The lower the score the lower the country
risk.
 The World Bank – Risk measures are complied by the World bank focusing on the
following six key areas: corruption, government effectiveness, political stability, rule of law,
voice and accountability, and regulatory quality.
 Euromoney – 400 economists who assess country risk are surveyed and country risk is then
ranked based on the results of the survey.
4. C
 Latin America accounts for a large portion of the foreign debt defaults during the survey
period.
 Defaults are more likely to occur on funds borrowed from banks than on foreign bond
issues.

5. B
Ratings can drop by one or two grades when compared to a similar non-defaulting country.
Borrowing costs rise by 0.5% to 1.0%. The effects decease over time. There is a greater chance of
a banking crisis following a sovereign default.
6. B
GDP normally falls by approximately 0.5% to 2% within the first year of the default. The
decline in GDP is short-lived. A trade war can ensue following a default. Exports are known to
drop by up to 8%.
7. D
The following factors will influence a country’s risk of sovereign default:
Level of indebtedness – The amount of debt owed by the country is a key factor in determining
the risk of default. For the purposes of determining how much is owed both local and overseas
debt needs to be considered. Debt is normally measured as percentage of GDP. This is not the
only factor, as there are counties with high debt ratios such as France, but are considered to
have a high level of creditworthiness.
Social services and pension funds – Countries that have got higher health commitments and
social benefits have also got a greater chance of defaulting on their debt. Based on this,
countries with older populations and hence greater social commitments are more at risk.
Tax – The larger the tax base and the greater the amount of tax collected, the lower the risk of
default.
Stability of tax system – The tax base must be well diversified such that they can collect
constant amounts of taxes in both good and bad times.
8. A
Credit ratings are dynamic and tend to change over the term of the bond.
Rating agencies are not infallible, and can also make mistakes. There have been times when
assigned credit ratings were too high, and other times when fraud and misstatement when
undetected. In addition the information that they receive form governments may be incorrect.
The analysts at rating agencies may be overburdened with work.
Event risk is difficult to capture in the ratings, an example of this will be future litigation risk
for banks, environmental risks. These risks are difficult to anticipate in advance. These risks are
often not captured by the rating agencies
Ratings tend to lag the market pricing, and bond prices and credit spreads tend to change more
quickly than the ratings assigned to the bonds.
9. D
Advantages of default risk spreads
 Real-time changes – Sovereign default spread is calculated in real-time and as such is far
more dynamic than ratings from the ratings agencies.
 Granularity - Sovereign default spreads are far more granular as apposed to ratings by the
ratings agencies.

 New information - Sovereign default spreads react much or quickly to new information
than do ratings from the ratings agencies.
10. D
Disadvantages of default risk spreads
Risk-free security – A risk-free security that matches the sovereign debt in required. Both the
term and the currency need to match.
Difficult to compare – A local currency bond does not have a risk-free comparison. The reason
is that the difference in local currency bonds (between each other) merely reflects the
differences in expected inflation
Increased volatility – The sovereign default spread is very volatile and changes therein may not
only be as a result of default risks. Other risks may also be present, such as liquidity risk.

Topic 50
Measuring Credit Risk [VRM - 6]
Learning Objectives
Measuring Credit Risk
LO 50 a: Evaluate a bank’s economic capital relative to its level of credit risk.

LO 50 b: Explain the distinctions between economic capital and regulatory capital, and describe
how economic capital is derived. Identify and describe important factors used to calculate economic
capital for credit risk: probability of default, exposure, and loss rate.
LO 50 c: Define and calculate expected loss (EL).
LO 50 d: Define and explain unexpected loss (UL).
LO 50 e: Estimate the mean and standard deviation of credit losses assuming a binomial
distribution.
LO 50 f: Describe the Gaussian copula model and its application.
LO 50 g: Describe and apply the Vasicek model to estimate default rate and credit risk capital for a
bank.
LO 50 h: Describe the Credit Metrics model and explain how it is applied in estimating economic
capital.
LO 50 i: Describe and use the Euler’s theorem to determine the contribution of a loan to the overall
risk of a portfolio.
LO 50 j: Explain why it is more difficult to calculate credit risk capital for derivatives than for loans.
LO 50 k: Describe challenges to quantifying credit risk.

QUESTIONS
1. Which of the following statements regarding the bank’s economic capital are correct?
I. Economic capitalP = ULP x CM
II. Economic capitalP = ULP x LGD
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
2. Which of the following statements used to describe important factors used to calculate
economic capital for credit risk: probability of default, exposure, and loss rate, are not correct?
A. The probability of default (PD) can be defined as the probability that the issuer will not
make timely payment of interest and principal.
B. The loss given default (loss rate) is the full value of the loan outstanding.
C. Even in the event of default by the issuer of the bond this does not mean that the holder will
lose all his money – he may recover a portion of the investment – this is called the recovery
rate.
D. The exposure at default (EAD) is the loss exposure stated in dollar terms – for example, the
outstanding balance on the loan.
3. Which of the following statements used to describe important factors used to calculate
economic capital for credit risk: probability of default, exposure, and loss rate, are not correct?
A. The exposure at default (EAD) is the loss exposure stated in dollar terms – for example, the
outstanding balance on the loan
B. Loss given default = 1 + recovery rate.
C. The expected loss is the amount that the investor expects to lose as a result of the default.
D. Expected loss = Exposure at default X Probability of default X loss given default.

Total loan - $5,000,000 Loan outstanding = $4,000,000 Probability of default = 2% over the next
year Loss given default = 45% Standard deviation of PD = 12% Standard deviation of LGD =
32%
What is the expected loss?
A. $4,000,000
B. $36,000
C. $281,823
D. $45,000

Total loan - $5,000,000 Loan outstanding = $4,000,000 Probability of default = 2% over the next
year Loss given default = 45% Standard deviation of PD = 12% Standard deviation of LGD =
32%

What is the unexpected loss?

A. $4,000,000
B. $36,000
C. $281,823
D. $45,000
What is the portfolios expected loss?

A. $36,000
B. $16,000
C. $52,000
D. $100,000
What is the portfolios unexpected loss?

A. $281,823
B. $92,195
C. $329,712
D. $370,018
8. When describing how economic capital is derived, which of the following statements are not
correct?
A. Reserves are set aside for unexpected losses, however, the bank will also need to estimate
its expected losses and then set aside excess capital reserves to cover these losses.
B. This excess capital required to cover the estimated losses is called economic capital.
C. The amount required is equal to the difference between the unexpected outcome and the
expected outcome given a certain confidence level.
D. If we know the shape of the loss distribution of ELP and ULP, then the difference between
the expected outcome and the confidence interval can be estimated.

9. When explaining how the credit loss distribution is modeled, which of the following statements
is not correct?
A. When working with credit risk and economic capital our key concern is the tail of the
chosen distribution.
B. Credit risks are normally distributed and are also highly skewed.
C. In practice, we apply a beta distribution in credit risk modeling – the mass of the beta
distribution sits between zero and one.
D. When calculating the tail of the loss distribution we often combine the beta distribution
with a Monte Carlo simulation.
10. Which of the following is not correct when dealing with challenges to quantifying credit risk?
A. Other major risks, such as market and operational risk, are separated from credit risk and
managed separately within the bank.
B. Credit losses are measured as a percentage of their risk contribution to the total credit
portfolio and are not influenced by the correlation among risk factors.
C. Credit risk models normally only work with a one-year time horizon. In truth a longer
horizon is required.
D. When calculating the tail of the loss distribution we often combine the beta distribution

SOLUTIONS
1. A
Economic capitalP = ULP x CM
2. B
The probability of default (PD) can be defined as the probability that the issuer will not make
timely payment of interest and principal. Even in the event of default by the issuer of the bond
this does not mean that the holder will lose all his money – he may recover a portion of the
investment – this is called the recovery rate and is expressed as a percentage of the bond’s
value. The loss given default (loss rate) is the amount that the investor stands to lose in the
event of default by the issuer. The exposure at default (EAD) is the loss exposure stated in
dollar terms – for example, the outstanding balance on the loan.
3. B
The exposure at default (EAD) is the loss exposure stated in dollar terms – for example, the
outstanding balance on the loan. This can be calculated as follows: Loss given default = 1 –
recovery rate. The expected loss is the amount that the investor expects to lose as a result of the
default. This can be calculated as follows: Expected loss = Exposure at default X Probability of
default X loss given default.
4. B
Expected loss Expected loss = Exposure at default X Probability of default X loss given default.
EL = EAD x PD x LGD EL = $4,000,000 x 0.02 x 0.45 EL = $36,000
5. C
Unexpected loss
6. C
Expected loss Expected loss = Exposure at default X Probability of default X loss given default.
EL = EAD x PD x LGD Asset X: ELX = $4,000,000 x 0.02 x 0.45 ELX = $36,000 Asset Y: ELY =
$1,000,000 x 0.04 x 0.40 ELY = $16,000 Calculate the expected losses (EL) for the portfolio: ELP =
(ELX = $36,000) + (ELY = $16,000) ELP = $52,000

7. C
8. A
The expected loss is what we use to measure the loss in value of an asset. However, the
unexpected loss can often exceed the expected loss. Reserves are set aside for expected losses,
however, the bank will also need to estimate its unexpected losses and then set aside excess
capital reserves to cover these losses. This excess capital required to cover the estimated losses
is called economic capital. How much economic capital is needed? The amount required is
equal to the difference between the unexpected outcome and the expected outcome given a
certain confidence level. If we know the shape of the loss distribution of ELP and ULP, then the
difference between the expected outcome and the confidence interval can be estimated. This
difference is represented as a multiple of the ULP also referred to as the capital multiplier (CM).
9. B
When working with credit risk and economic capital our key concern is the tail of the chosen
distribution. However, credit risks are not normally distributed and are highly skewed. The
reason for this is that maximum gains are limited and extreme losses are rare. In practice, we
apply a beta distribution in credit risk modeling – the mass of the beta distribution sits between
zero and one. This defines losses between 0% and 100%. The distribution is very flexible and
can be symmetric or skewed depending on the value of the parameters. When the shape
parameters are equal, the distribution is symmetric and the mean = ELP and the variance =
ULP. When calculating the tail of the loss distribution we often combine the beta distribution
10. D
The following challenges are present when quantifying credit risk: Other major risks, such as
market and operational risk, are separated from credit risk and managed separately within the
bank. Credit losses are measured as a percentage of their risk contribution to the total credit

portfolio and are not influenced by the correlation among risk factors. Credit risk models
normally only work with a one-year time horizon. In truth a longer horizon is required.

Topic 51
Operational Risk [VRM - 7]
Learning Objectives
Operational Risk
LO 51 a: Describe the different categories of operational risk and explain how each type of risk can
arise.
LO 51 b: Compare the basic indicator approach, the standardized approach, and the advanced
measurement approach for calculating operational risk regulatory capital.
LO 51 c: Describe the standardized measurement approach and explain the reasons for its
introduction by the Basel committee.
LO 51 d: Explain how a loss distribution is derived from an appropriate loss frequency distribution
and loss severity distribution using Monte Carlo simulations.
LO 51 e: Describe the common data issues that can introduce inaccuracies and biases in the
estimation of loss frequency and severity distributions.
LO 51 f: Describe how to use scenario analysis in instances when data is scarce.
LO 51 g: Describe how to identify causal relationships and how to use Risk and Control Self-
Assessment (RCSA), Key Risk Indicators (KRIs), and education to measure and manage operational
risks.
LO 51 h: Describe the allocation of operational risk capital to business units.
LO 51 i: Explain how to use the power law to measure operational risk.
LO 51 j: Explain the risks of moral hazard and adverse selection when using insurance to mitigate
operational risks.

QUESTIONS
1. When making the following statement ‘Operational capital is based on the bank’s operational
VaR measure. Per Basel the current loss distribution is equal to a confidence interval of 99.9%
over a 1-year period” – which approach to calculating regulatory capital is this referring to?
A. The basic indicator approach
B. The standardized approach
C. The advanced measurement approach
D. The scenario analysis approach
2. Money laundering, intentional or unintentional failure to perform duties towards clients,

mishandling of confidential client information are examples of which category of operational
risk?
A. Damage to physical assets.
B. Clients, products, and business practices.
C. Execution, delivery, and process management.
D. External fraud.
3. When deriving a loss distribution from the loss frequency distribution and loss severity
distribution which of the following statements are not correct?
A. We make use of the Poisson distribution to model loss frequency.
T n
B. The probability of losses over a given time period = e  T 
n!
C. Loss severity is often modeled using the lognormal distribution.
D. The lognormal distribution is symmetrical and has fat-tails.
4. Assume that the data we have is from Bank X, whose losses equal $10m and revenue equals
$6m. Bank Y, whose losses we are attempting to estimate, has revenue of $4m. What is the
estimated loss for Bank Y?
A. $10,000,000
B. $9,109,594
C. $15,000,000
D. $6,666,667
5. Which of the following statements regarding scenario analysis are correct?

I. Scenario analysis is recommended by the regulators as it encourages management to be
proactive in assessing possible risks attributable to the bank.
II. A disadvantage of this approach is that it is expensive and time consuming.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

6. When describing how to use Risk and Control Self-Assessment (RCSA) and Key Risk Indicators
(KRIs) to measure and manage operational risks, which of the following statements are not
correct?
A. A downside of the RCSA approach is that it is unlikely that managers will disclose risks
that are not being well controlled.
B. When using the RCSA approach the manager’s perception of risk and that of the entity may
be different.
C. In order to have value as a KRI, the indicator must be able to predict losses, and be
accessible and measurable in a timely manner.
D. KRIs are able to predict losses before they occur.
7. When applying the scorecard approach, which of the following statements are not correct?
A. The scorecard approach can be used to allocate operational risk capital to business units.
B. Each manager will be surveyed regarding each of the various risks.
C. Each question and subsequent answer will be allocated scores.
D. Once totaled, the score represents the tail risk of that business unit.
8. Consider the following constants for the power law equation:

α=4K=9
What is the probability that the variable (V) will exceed a value of 4?
A. 4.00%
B. 9.00%
C. 3.52%
D. 1.00%
9. When explaining the risks of moral hazard, which of the following statements are not correct?
A. Moral hazard is a concept that people tend to take less risks when they are insured than
they would have taken had they not been insured.
B. Firms that insure against operational risk may be less inclined to control the risk of say a
rogue trader since they are anyway insured.
C. The potential upside in the case of operational risk may also prevent an insured firm from
taking due care.
D. Some of the ways to mitigate moral hazard is to include deductibles (in other words that the
insured person is responsible for a fixed part of the payment), limits on payments, and
coinsurance provisions (the insurance company will pay a % of the loss).
10. Which of the following statements regarding adverse selection are correct?
I. Adverse selection is when individuals who know that they are high-risk individuals are
more likely to be the ones applying for insurance.
II. Some of the ways to mitigate against adverse selection are greater initial due diligence as
well as ongoing due diligence reviews.
A. I only.
B. II only.
C. Both I and II.

D. Neither I or II.
11. Which of the following statements concerning the measurement of operational risk is correct?
A. Economic capital should be sufficient to cover both expected and worst-case operational
risk losses.
B. Loss severity and loss frequency tend to be modeled with lognormal distributions.
C. Operational loss data available from data vendors tend to be biased toward small losses.
D. The standardized approach used by banks in calculating operational risk capital allows for
different beta factors to be assigned to different business lines.

SOLUTIONS
1. C
The advanced measurement approach
2. B
Clients, products, and business practices. Any practice that fails to perform the obligation
towards a client is included in this category. Examples include, money laundering, intentional
or unintentional failure to perform duties towards clients, mishandling of confidential client
information etc. This category is where the majority of losses due to operational risk occur.
3. D
We make use of the Poisson distribution to model loss frequency. Remember from Topic 17 –
distributions, that the mean and variance are both equal to the parameter called the lambda λ.
The lambda measures the average loss over a given time period.
T n
The probability of losses over a given time period = e  T 
n!
Loss severity is often modeled using the lognormal distribution. The lognormal distribution is
asymmetrical and has fat-tails. We calculate the mean and the variance from the logarithm of
losses.
4. B
5. C
Scenario analysis can also be used when seeking additional risk data. This approach is
recommended by the regulators as it encourages management to be proactive in assessing
possible risks attributable to the bank. A disadvantage of this approach is that it is expensive
and time consuming.
6. D
The risk and control self-assessment (RCSA) program is also used to identify and measure
operational risk. As assumption that we make is that the managers of the various business lines
are the people that are closest to those operations and as such should the ones surveyed in
assessing and evaluating the risks. A downside of this approach is that it is unlikely that
managers will disclose risks that are not being well controlled. In addition, the manager’s
perception of risk and that of the entity may be different. As such, risk identification and
measurement need to be independently verified.

Key risk indicators (KRI) can also be used to identify operational risks. In order to have value as
a KRI, the indicator must be able to predict losses, and be accessible and measurable in a timely
manner. KRIs are designed to be able to predict losses before they occur. Examples of KRIs
include number of failed transactions, employee turnover etc.
7. D
The scorecard approach can be used for exercise. Each manager will be surveyed regarding
each of the various risks. Each question and subsequent answer will be allocated scores. This is
done so that the scores can be quantified. Once totaled, the score represents the risk of that
business unit.
8. C
P(V > X) = K x X-α P(V > 4) = 9 x 4-4 P(V > X) = 3.52%
9. A
would have taken had they not been insured. In the context of an insurance model, the insured,
knowing that they are insured anyway with car insurance, may not pay close attention to how
they drive. The same applies to operational risk. Firms that insure against operational risk may
be less inclined to control the risk of say a rogue trader since they are anyway insured. In
addition, the potential upside in this case may also prevent them from taking due care.
Some of the ways to mitigate moral hazard is to include deductibles (in other words that the
insured person is responsible for a fixed part of the payment), limits on payments, and
coinsurance provisions (the insurance company will pay a % of the loss).
10. C
Adverse selection is when individuals who know that they are high-risk individuals are more
likely to be the ones applying for insurance. Based on this the insurance company must
perform its underwriting correctly to avoid overestimating the level of mortality.
Some of the ways to mitigate against adverse selection are greater initial due diligence as well
as ongoing due diligence reviews.
11. D
In the standardized approach to calculating operational risk, a bank’s activities are divided up
into several different business lines, and a beta factor is calculated for each line of business.
Economic capital covers the difference between the worst-case loss and the expected loss. Loss
severity tends to be modeled with a lognormal distribution, but loss frequency is typically
modeled using a Poisson distribution. Operational loss data available from data vendors tends
to be biased towards large losses.

Topic 52
Stress Testing [VRM - 8]
Learning Objectives
Stress Testing
LO 52 a: Describe the rationale for the use of stress testing as a risk management tool.
LO 52 b: Identify key aspects of stress testing governance, including choice of scenarios, regulatory
specifications, model building, stress-testing coverage, capital and liquidity stress testing, and
reverse stress testing.
LO 52 c: Describe the relationship between stress testing and other risk measures, particularly in
enterprise - wide stress testing.
LO 52 d: Explain the importance of stressed inputs and their importance in stressed VaR and
stressed ES.
LO 52 e: Identify the advantages and disadvantages of stressed risk metrics.
LO 52 f: Describe the key elements of effective governance over stress testing.
LO 52 g: Describe the responsibilities of the board of directors and senior management in stress
testing activities.
LO 52 h: Identify elements of clear and comprehensive policies, procedures, and documentations
for stress testing.
LO 52 i: Identify areas of validation and independent review for stress tests that require attention
from a governance perspective.
LO 52 j: Describe the important role of the internal audit in stress testing governance and control.
LO 52 k: Describe the Basel stress testing principles for banks regarding the implementation of
stress testing.

QUESTIONS
1. Which of the following is not a key governance area?

A. Validation and review
B. Internal audit
C. Policies and procedures
D. External audit
2. When describing the responsibilities of the board of directors, which of the following
A. Stress testing is important as it gives the shareholders a sense of the risk appetite of the firm
as well as its future direction.
B. Stress testing can assist with future plans such as capital requirements and liquidity.
C. The stress test results should be viewed by the board with a fair measure of skepticism, in
order to properly test the assumptions.
D. In the event of any issues, the board can act early to correct these.
3. When describing the responsibilities of the management team, which of the following
A. The management team is responsible for the stress testing exercise and reporting the results
through to the board.
B. The reports should be clear, concise and well documented.
C. Sufficient staff must be retained for this exercise and must be adequately remunerated.
D. The stress testing must be kept confidential among the management team only.
4. When Identifying elements of clear and comprehensive policies, procedures, and

documentations on stress testing, which of the following is not correct?
A. The purpose of the stress test.
B. Roles and responsibilities of the stress test – internal roles only.
C. Determining consistent and effective stress testing practices.
D. Setting up the frequency and priority of the stress testing procedures.
5. When Identifying elements of clear and comprehensive policies, procedures, and

documentations on stress testing, which of the following is not correct?
A. Determining the use of the stress test.
B. Determining remedial actions as a result of the stress test.
C. Confidentiality regarding third parties regarding the stress test.
D. Determining the stress test process – including design and selection.
6. When identifying areas of validation and independent review for stress tests that require
attention from a governance perspective, which of the following statements are not correct?
A. Stress testing requires ongoing validation and independent and unbiased review.
B. In terms of validating the stress test, periods on nonstress should be used to test their
predictive power.

C. If non stressed tests perform well it is guaranteed that the test will perform well in stressed
periods.
D. When validating models, expert-based judgment, sensitivity analysis and simulations can
be used.
7. Which of the following statements regarding the role of the internal audit in stress testing
governance and control are correct?
I. The internal audit process will test and assess the integrity and reliability of the entity’s
policies and procedures.
II. The internal audit team should be independent and knowledgeable in the area of stress
testing.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. When identifying key aspects of stress testing governance, including stress-testing coverage,
stress-testing types and approaches, and capital and liquidity stress testing, which of the
A. Some stress testing results may not include all factors. As such it is important to document
the stress testing coverage to assess which factors are includes and which are excluded.
B. The coverage needs to be applied both on a long-term basis only.
C. The coverage can be applied to individual exposures, different levels within the entity or
the entire entity.
D. The relationship between the various risks and exposures should be incorporated. Risk
concentrations should also be addressed.
A. When using scenarios as part of the stress testing process, these should be robust enough to
be credible to all parties concerned.
B. The scenarios should consider firm factors only.
C. Historical as well as future expected scenarios should be looked at.
D. Cumulative as well as knock-on effects should be looked at.
A. The capital and liquidity stress test should fit in to the firm’s overall strategy.
B. The tests should test the impact on several risks, such as earnings risk, losses, cash flows,
capital and liquidity.
C. Subsidiaries and other group companies should be ignored in these tests.
D. All the necessary capital and liquidity objectives need to be stated.

11. When describing the differences in defining loss estimates between stress testing and VaR,
which of the following are not correct?
A. Stress testing defines losses from an accounting point of view. VaR defines losses from a
market point of view.
B. Stress testing loos a losses over a long time horizon. VaR looks at losses at a point in time –
normally shorter time horizons.
C. Stress testing uses ordinal rankings such as severe, very severe etc. VaR works with
probabilities when using the various VaR models – such as Monte Carlo simulation or
historical simulation. For example confidence levels of 99.9% are used for operational risk
VaR measures.
D. Stress testing uses unconditional scenarios, such as hypothetical scenarios. VaR makes use
of conditional scenarios.
12. When working with the revised Basel market risk capital framework, which of the following
A. The revised Basel market risk capital framework makes use of stressed inputs when
calculating credit risk for supervisory purposes.
B. The SVaR is meant to mimic a period of market stress and is calculated using a 10-day, 99%
confidence interval.
C. SVaR can be used to calculate the capital charge for a credit value adjustment (CVA).
D. In Basel III we see the mandated use of stressed parameters when calculating the default
risk charge for counterparty credit risk.
13. Which of the following statements regarding the advantages and disadvantages of stressed risk
metrics are correct?
I. An advantage of using stressed risk metrics are that they are a conservative measure, thus
allowing for more than sufficient capital to be provided for in the even of a stressed market
event.
II. A disadvantage of using stressed risk metrics is that they are stressed inputs and may not
necessarily respond to current market conditions.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
14. Which of the following statements regarding the rationale for the use of stress testing as a risk
management tool is not correct?
A. Stress testing is an important tool that can be used to identify sources of risk as well as the
size of the risk.
B. When assessing minimum capital adequacy requirements as per Basel II (Pillar 1), banks
will need to undergo stress testing to determine market risk (for the internal models
approach – IMA) and to determine credit risk (for the internal ratings-based approach -
IRB).

C. Pillar 2 of Basel II states that in terms of the supervisory review process (SRP) - banks are
required to undergo stress testing to assist in assessing their risks and ways to mitigate
these risks.
D. One of the keys in stress testing is the backward-looking nature of the tests.
15. Which of the following statements is not a weakness of stress testing and integration in risk
governance?
A. Board and senior management over involvement.
B. Stress testing not fully developed
C. Overview of the organization is lacking
D. Inadequate response to crisis
16. Which of the following statements is not a recommendation of stress testing methodologies?
A. More comprehensive testing – Testing should be comprehensive and should covered on an
individual as well as firm-wide basis. Shocks to the risk factors as well as feedback and
spillover effects should also be considered.
B. Risk concentration – Stress testing should allow the bank identify and control risk
concentrations. Stress testing should be comprehensive and firm-wide.
C. Multiple measures – In order to obtain a complete picture on the bank’s overall activities,
several measures can be used, such as looking at funding gaps, accounting and economic
profits, capital requirements, etc.
D. Effect of synergies – When developing future scenarios, the more expert opinions (both
internal and external) that can be included, the better.
17. The risk that bank may need to provide support for their off-balance sheet entities, is best
described by which of the following risks?
A. Basis risk
B. Counterparty credit risk
C. Pipeline risk
D. Contingent risk
18. Which of the following recommendations is not a recommendation for supervisors?

A. Assessment of testing methodology.
B. Assessment of contingent risk.
C. Assessment of contingent risk.
D. Evaluation of capital and liquidity needs
19. An implementation principle recommended by the Basel Committee to banks for the
governance of sound stress testing practices is that stress testing reports should:
A. Not be passed up to senior management without first being approved by middle
management.
B. Have limited input from their respective business areas to prevent biasing of the results.
C. Challenge prior assumptions to help foster debate among decision makers.
D. Be separated by business lines to help identify risk concentrations.

SOLUTIONS
1. D
Some of the key governance areas include; the governance structure, documentation, validation
and review, internal audit and policies and procedures.
2. A
Stress testing is important as it gives the board of directors a sense of the risk appetite of the
firm as well as its future direction. This will assist with future plans such as capital
requirements and liquidity. The stress test results should be viewed by the board with a fair
measure of skepticism, in order to properly test the assumptions. In the event of any issues, the
board can act early to correct these.
3. D
The management team is responsible for the stress testing exercise and reporting the results
through to the board. The reports should be clear, concise and well documented. Based on this,
the management team must set up policies and procedures for effective stress testing. These
policies must be adhered to and reviewed and corrected on a regular basis. Sufficient staff must
be retained and adequately remunerated. The stress testing must be transparent and get the
buy in of the organizations people.
4. B
Examples of what should be included are:
 The purpose of the stress test.
 Roles and responsibilities of the stress test – internal and external roles.
 Determining consistent and effective stress testing practices.
 Setting up the frequency and priority of the stress testing procedures.
 Validation and review processes.
5. C
Examples of what should be included are:
 Determining the use of the stress test.
 Determining remedial actions as a result of the stress test.
 Providing transparency to third parties regarding the stress test.
 Determining the stress test process – including design and selection.
 Determining updating and review procedures.
6. C
Stress testing requires ongoing validation and independent and unbiased review. In terms of
validating the stress test, periods on nonstress should be used to test their predictive power.
However, even if these non stressed tests perform well it is not guaranteed that the test will
perform well in stressed periods. This is due to various factors such as changing correlations in
times of stress. When validating models, expert-based judgment, sensitivity analysis and
simulations can be used

7. C
The internal audit firm is a critical part of the stress testing governance process. The internal
audit process will test and assess the integrity and reliability of the entity’s policies and
procedures. The internal audit team should be independent and knowledgeable in the area of
stress testing. The stress testing process should vigorous and any discrepancies should be
reported to management.
8. B
Stress testing coverage
 Some stress testing results may not include all factors. As such it is important to document
the stress testing coverage to assess which factors are includes and which are excluded.
 The coverage needs to be applied both on a long-term and short-term basis.
 The coverage can be applied to individual exposures, different levels within the entity or
the entire entity.
 The relationship between the various risks and exposures should be incorporated. Risk
concentrations should also be addressed.
9. B
Stress-testing types and approaches
 When using scenarios as part of the stress testing process, these should be robust enough to
be credible to all parties concerned.
 The scenarios should consider firm and system wide factors.
 Historical as well as future expected scenarios should be looked at.
 Cumulative as well as knock-on effects should be looked at.
 When looking at the entire firm – all business lines should be stressed according to the same
set of stress assumptions.
 Stress testing should extend beyond the normal set of assumptions. The entire viability of
the entity should be tested.
10. C
Capital and liquidity stress testing
 The capital and liquidity stress test should fit in to the firm’s overall strategy.
 The tests should test the impact on several risks, such as earnings risk, losses, cash flows,
capital and liquidity.
 Subsidiaries and other group companies should also be considered in these tests.
 All the necessary capital and liquidity objectives need to be stated.
11. D
The following differences in defining loss estimates can be identified between stress testing and
VaR:
 Stress testing defines losses from an accounting point of view. VaR defines losses from a
market point of view.
 Stress testing looks a losses over a long time horizon. VaR looks at losses at a point in time –
normally shorter time horizons.

 Stress testing uses ordinal rankings such as severe, very severe etc. VaR works with
probabilities when using the various VaR models – such as Monte Carlo simulation or
historical simulation. For example confidence levels of 99.9% are used for operational risk
VaR measures.
 Stress testing uses conditional scenarios, such as hypothetical scenarios. VaR makes use of
unconditional scenarios.
12. A
The revised Basel market risk capital framework makes use of stressed inputs when calculating
market risk for supervisory purposes. Such stressed inputs include stressed value at risk or the
SVaR measure. The SVaR is meant to mimic a period of market stress and is calculated using a
10-day, 99% confidence interval. SVaR can be used to analyze potential losses on an investment
portfolio. It can also be used to calculate the capital charge for a credit value adjustment (CVA)
– which is the expected value / price of counterparty credit risk. With the revised Basel market
risk capital framework stress testing is also mandated. This is achieved by using internal
models to calculate the necessary market risk. In Basel III we see the mandated use of stressed
parameters when calculating the default risk charge for counterparty credit risk.
13. C
Advantages of using stressed risk metrics are that they are a conservative measure, thus
allowing for more than sufficient capital to be provided for in the even of a stressed market
event. A disadvantage of using stressed risk metrics is that they are stressed inputs and may
not necessarily respond to current market conditions.
14. D
Stress testing is an important tool that can be used to identify sources of risk as well as the size
of the risk. Once this has been done, risk tolerance levels can be developed and methods can be
sought to mitigate the risk. When assessing minimum capital adequacy requirements as per
Basel II (Pillar 1), banks will need to undergo stress testing to determine market risk (for the
internal models approach – IMA) and to determine credit risk (for the internal ratings-based
approach - IRB). Moving on to Pillar 2 of Basel II – the supervisory review process (SRP) - banks
are required to undergo stress testing to assist in assessing their risks and ways to mitigate
these risks. One of the keys in stress testing is the forward-looking nature of the tests. This
allows banks to be better prepared for future risks.
15. A
Weaknesses of stress testing and integration in risk governance: Board and senior management
lack of involvement – Banks that had extensive involvement by senior management and the
board were better able to handle the recent financial crisis, while those that did not, handled the
crisis poorly. Stress testing not fully developed – Market risk stress testing is fairly developed.
This is not so for credit and operational risk. In addition, in the past there were no mechanisms
to assess the correlations among risks. Overview of the organization is lacking – Prior to the
crisis, each division within the bank managed their own risk – there was no overall view of risk.
Inadequate response to crisis – The original stress models were no flexible enough to enable a

swift response to the crisis. In addition, systems were not developed sufficiently to enable
timely reporting.
16. D
More comprehensive testing – Testing should be comprehensive and should covered on an
individual as well as firm-wide basis. Shocks to the risk factors as well as feedback and
spillover effects should also be considered. Risk concentration – Stress testing should allow the
bank identify and control risk concentrations. Stress testing should be comprehensive and firm-
wide. Multiple measures – In order to obtain a complete picture on the bank’s overall activities,
several measures can be used, such as looking at funding gaps, accounting and economic
profits, capital requirements, etc.
17. D
Banks are required to inject credit and liquidity in the special purpose entity (SPE) that is used
for securitization transactions. This support to these off-balance sheet entities increases the
bank’s risk exposure especially during difficult times. Prior to the crisis, banks did not take into
account this contingent risk.
18. B
Recommendations to supervisors
 Assessment of testing methodology.
 Corrective action.
 Challenging of scenarios.
 Evaluation of capital and liquidity needs.
 Increase stress scenarios.
 Bring in additional resources, if necessary.
19. C
The Basel Committee states “At banks that were highly exposed to the financial crisis and fared
comparatively well, senior management as a whole took an active interest in the development
and operation of stress testing… stress testing at most banks, however, did not foster internal
debate nor challenge prior assumptions…”Therefore, the Basel Committee recommends that
prior assumptions used in stress testing be challenged to ensure that the stress test best
captures the potential for extreme scenarios given current market conditions.

Topic 53
Pricing Conventions, Discounting and Arbitrage [VRM - 9]
Learning Objectives
Prices, Discount Factors, and Arbitrage
LO 53 a: Define discount factor and use a discount function to compute present and future values.
LO 53 b: Define the “law of one price,” explain it using an arbitrage argument, and describe how it
can be applied to bond pricing.
LO 53 c: Identify arbitrage opportunities for fixed income securities with certain cash flows.
LO 53 d: Identify the components of a US Treasury coupon bond, and compare the structure to
Treasury STRIPS, including the difference between P-STRIPS and C-STRIPS.
LO 53 e: Construct a replicating portfolio using multiple fixed income securities to match the cash
flows of a given fixed- income security.
LO 53 f: Differentiate between “clean” and “dirty” bond pricing and explain the implications of
accrued interest with respect to bond pricing.
LO 53 g: Describe the common day-count conventions used in bond pricing.

QUESTIONS
1. Assume that we have a one-year bond that has a 5% coupon attached to it and is currently
selling for $103. What is the discount factor for time period 1?
A. 1.0000
B. 0.9810
C. 1.0194
D. 1.0300
2. What is the price of a bond that is quoted at 98-8+ and has a par value of $1m?
A. $1,000,000
B. $982,500
C. $982,656
D. $985,000
3. Assume that we have been offered a one-year bond that has a 5% coupon attached to it and is
currently selling for $103. The rates in the market are currently 3%. What is the correct arbitrage
strategy?
A. Buy the offered bond and sell a bond at current market yields
B. See the offered bond and buy a bond at current market yields.
C. Buy both bonds.
D. There is no arbitrage opportunity available in this case
4. Assume that we have been offered a one-year bond that has a 5% coupon attached to it and is
currently selling for $103. The rates in the market are currently 3%. How much is the arbitrage
profit?
A. No profit
B. $1.06 upfront
C. $1.06 at the end
D. $1.00
5. Which of the following is not a disadvantage of Treasury strips?

A. Shorter-term C-STRIPS often trade rich.
B. Longer-term C-STRIPS often trade cheap
C. Strips tend to be illiquid.
D. Principal strips are often undervalued
6. Which of the following statements regarding a replicating portfolio are not correct ?
A. In the event that a bond is considered to be trading cheap or expensive relative to the
market or to other bonds, the bond will either be bought (if it is cheap) or sold (if it is
expensive) and a replicating portfolio will be bought or sold
B. The first step is to determine how much of each bond need transact in order to replicate the
portfolio.
C. The best way to replicate a portfolio this is to start at the beginning and work backwards.

D. A replicating portfolio will assist in creating an arbitrage profit
7. Which of the following statements are not correct when describing the concept of arbitrage?
A. Arbitrage occurs when two equivalent asset sell for two different prices.
B. Arbitrage presents an opportunity to profit for risk or for a cash outlay
C. This concept that no arbitrage opportunities should exist is called the law of one price.
D. It should be that “prices are set to eliminate the opportunity to profit at no risk with no
commitment of one’s own funds”
8. Which of the following statements regarding clean and dirty prices is not correct?
A. The interest earned by the seller from the last coupon payment date to the settlement date is
called the accrued interest.
B. The buyer needs to compensate the seller for this accrued interest, as the seller will receive
the full coupon on the next coupon date.
C. The full price is the price taking into account accrued interest (also referred to as the dirty
price). It is this price that the buyer pays the seller.
D. Dirty price = Clean price – accrued interest
end of June and December every year. Assuming that the bond was sold on the 14th of March
and that the accrued interest for the six months was $10,000. How much is he accrued interest
at the date of sale assuming the bond was a U.S. Treasury?
A. $3,9778
B. $4,055
C. $10,000
D. $4,000
end of June and December every year. Assuming that the bond was sold on the 14th of March
and that the accrued interest for the six months was $10,000. How much is he accrued interest
at the date of sale assuming the bond was a U.S. Corporate bond?
A. $3,9778
B. $4,055
C. $10,000
D. $4,000
11. An analyst has been asked to check for arbitrage opportunities in the Treasury bond market by
comparing the cash flows of selected bonds with the cashflows of combinations of other bonds.
If a 1-year zero-coupon bond is priced at USD 96.12 and a 1 – year bond paying a 10% coupon
semi – annually is priced at USD 106.20, what should be the price of a 1-year Treasury bond
that pays a coupon of 8% semi-annually?
A. $98.10
B. $101.23
C. $103.35
D. $104.18

SOLUTIONS
1. B
Present value (Price) = Future value (par value + coupon) x discount factor 103 = 105 x d(1)
d(1) = 103 / 105 = 0.9810.
2. C
8.5
A bond quoted at 98-8+ means that this bond trades at 98 % of its par value, in other
32
words, the price of the bond is 98.2656% of its par value. If the par value of the bond is $1m,
then the par value will be $982,656 ($1m x 98.2656%).
3. B
Assume that we have been offered a one-year bond that has a 5% coupon attached to it and is
currently selling for $103. The yield-to-maturity (yield) on this bond is calculated as follows:
Present value = 103
Future value = -100
Payment = -5
Period = 1
Rate = ?
Solve for the interest rate using your calculator = 1.94%
Assume that the one-year spot rate in the market is 3%. Based on the current market yield of
3% it is clear that the price offered to us on the bond of $103 is not correct as it yields a rate of
1.94% that is different to the current market price.
Let’s start off and work out the correct price of the bond:
Present value = ?
Future value = -100
Payment = -5
Period = 1
Rate = 3%
Solve for the present value (price) using your calculator = 101.94
As you can see the correct price of the bond is really 101.94, so the price being offered of 103 is
too high.
How do we take advantage of this?

Remember for arbitrage we always but the cheaper asset and sell the more expensive one.

4. B
5. D
Strips disadvantages:
 Shorter-term C-STRIPS often trade rich.
 Longer-term C-STRIPS often trade cheap.
 Strips tend to be illiquid.
6. C
In the event that a bond is considered to be trading cheap or expensive relative to the market
or to other bonds, the bond will either be bought (if it is cheap) or sold (if it is expensive) and
a replicating portfolio will be bought or sold.
The first step is to determine how much of each bond (A and B) we need transact in order to
replicate the portfolio. The best way to do this is to start at the end and work backwards.
7. B
We take a look at arbitrage. Arbitrage occurs when two equivalent asset sell for two different
prices. This presents an opportunity to profit for no risk or cash outlay. However it must be
kept in mind that in all likelihood the market would eventually close the gap between the two
prices and a single price would result. This concept that no arbitrage opportunities should
exist is called the law of one price. It should be that “prices are set to eliminate the
opportunity to profit at no risk with no commitment of one’s own funds” It might seem that
prices of an equivalent asset are differently priced in two locations but this may not be correct
as one would need to take transportation costs into account and these costs could offset such
price differences.
8. D
The interest earned by the seller from the last coupon payment date to the settlement date is
called the accrued interest. The buyer needs to compensate the seller for this accrued interest,
as the seller will receive the full coupon on the next coupon date.

Full price (dirty price) The full price is the price taking into account accrued interest (also
referred to as the dirty price). It is this price that the buyer pays the seller.
Clean price (flat price) This is the price excluding the accrued interest Clean price = Dirty
price – accrued interest.
9. A
10. B
11. D
The solution is to replicate the 1 year 8% bond using the other two treasury bonds. In order to
replicate the cashflows of the 8% bond, you could solve a system of equations to determine the
weight factors,F1 and F2, which correspond to the proportion of the zero and the 10% bond to
be held, respectively.

The two equations are as follows:

(100*F1)+(105*F2)=104(replicating the cashflow including principal and interest payments at
the end of 1 year), and (5* F2) =4(replicating the cash flow from the coupon payment in 6
months.)
Solving the two equations gives us F1 = 0.2 and F2 = 0.8. Thus the price of the 8% bond should
be 0.2 (96.12) + 0.8 (106.2) = 104.18.

Topic 54
Interest Rates [VRM - 10]
Learning Objectives
Interest Rates
LO 54 a: Calculate and interpret the impact of different compounding frequencies on a bond’s

value.
LO 54 b: Define spot rate and compute spot rates given discount factors.
LO 54 c: Interpret the forward rate, and compute forward rates given spot rates.
LO 54 d: Define par rate and describe the equation for the par rate of a bond.
LO 54 e: Interpret the relationship between spot, forward, and par rates.
LO 54 f: Assess the impact of maturity on the price of a bond and the returns generated by bonds.
LO 54 g: Define the “flattening” and “steepening” of rate curves and describe a trade to reflect
expectations that a curve will flatten or steepen.
LO 54 h: Describe a swap transaction and explain how a swap market defines par rates.

QUESTIONS
1. Assume a $100 investments was made at an annual rate of 12%, compounded semi-annually.
What is the value of the investment after five years?
A. $133.02
B. $179.08
C. $100.00
D. $112.36
2. Assume the following rates:
Assume a notional principal of $100.

What is the 1-year discount rate?
A. 0.9965
B. 0.9920
C. 1.0000
D. 0.9500
3. Assume that the price of 6-month zero-coupon bond is $99 and the par value is $100. What is
the 6-month annualized rate?
A. 1.01%
B. 1.00%
C. 2.00%
D. 2.02%
4. Assume that the 3-year zero-coupon bond trades at a price of $90. What is the 3 year
annualized rate?
A. 5.00%
B. 10.00%
C. 1.77%
D. 3.54%
the appropriate spot rates are:
What is the one-year rate one year from now?

A. 7.1%
B. 6.7%
C. 7.5%
D. 7.2%

6. Which of the following statements are not correct when describing the par rate?
A. The par bond curve works on a series of yield-to-maturities (YTM) where each YTM is
arrived at by making sure that the bond trades at par.
B. The par bond curve is derived from the spot rate curve.
C. The yield to maturity is the interest rate that will make the future value of the bond’s cash
flows equal its market price + accrued interest.
D. Another term for this is the Internal rate of return (IRR).
the appropriate discount rates are:
What is the yield-to-maturity of this bond?

A. 6.700%
B. 7.500%
C. 7.100%
D. 7.099%
8. When describing he relationship between spot, forward, and par rates, which of the following
I. A spot rate is just a package of short-term forward rates – therefore we can discount our
cash flows by either the spot rate or the forward rates.
II. The formula for valuation using forward rates will be = PV of $1 in T periods =
1
1  z1 1  1f1 1  1f2 1  1f31  1fT1 
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
9. When assessing the impact of maturity on the price of a bond and the returns generated by
bonds, which of the following statements are correct?
I. A bond prices increase with maturity when coupon rates are above the forward rates
II. A short-term investor that rolls over his investment (for example every 6 months) can
expect to do worse when short-term rates are above the forward rates than an investor who
invests in the longer - term investment.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

10. Which of the following statements is not a description of a yield curve change?
A. Change in level (a parallel shift).
B. Change in slope (flattening or steepening).
C. Change in curvature.
D. Change in convexity
11. Below is a chart showing the term structure of risk-free spot rates:
Which of the following charts presents the correct derived forward rate curve?

SOLUTIONS
1. B
Assume a $100 investments was made at an annual rate of 12%, compounded semi-annually.
The value of the investment after five years is equal to:
2. B
The first period discount rate is equal to:
3. D
The 6-month annualized rate is calculated as follows:
Present value = $99 Future value = $100 N = 1 Payment = 0 Rate = ?
By using your calculator and solving for r we arrive at 1.01%. This is the six-month rate, the
annualized rate is equal to 1.01% x 2 = 2.02%.
4. D
The 3 year annualized rate is calculated as follows:
Present value = $90 Future value = $100 N = 6 Payment = 0 Rate = ?
By using your calculator and solving for r we arrive at 1.7715%. This is a six-month rate, the
annualized rate is equal to 1.7715% x 2 = 3.5430%.
5. C
The one year rate one year from now =

6. C
The par bond curve works on a series of yield-to-maturities (YTM) where each YTM is arrived
at by making sure that the bond trades at par. The par bond curve is derived from the spot rate
curve. The yield to maturity is the interest rate that will make the present value of the bond’s
cash flows equal its market price + accrued interest. Another term for this is the Internal rate of
return (IRR).
7. D
Present value = 96.21 (we have calculated this already using spot or forward rates) Future value
= 100 Payment = 5 Number of periods = 2 Calculate the Interest rate = ? Interest rate = 7.099%
8. C
We know that a spot rate is just a package of short-term forward rates – therefore we can
discount our cash flows by either the spot rate or the forward rates. The formula for valuation
using forward rates will be:
9. A
When comparing coupon rates to their corresponding forward rates over time, we see that
bond prices increase with maturity when coupon rates are above the forward rates. On the
opposite side, bond prices decrease with maturity when coupon rates are below the forward
rates. By way of example, a short-term investor that rolls over his investment (for example
every 6 months) can expect to do better when short-term rates are above the forward rates than
an investor who invests in the longer-term investment.
10. D
Yield curve changes include changes in (1) level (a parallel shift), (2) slope (flattening or
steepening) and (3) curvature.
11. D
The forward curve will be above the spot curve when the spot curve is rising. The forward
curve will also cross the spot curve when the spot curve reaches its maximum (or extreme)
value. The forward curve will be below the spot curve when the spot curve is declining. The
only chart that reflects these three conditions is choice D.
VaRs for the various confidence levels that are greater than 96.5%. Therefore, ES = (272,317,500
+ 286,357,500 + 304,785,000 + 333,157,500)/4 = INR 299,154,375.

Topic 55
Bond Yields and Return Calculations [VRM - 11]
Learning Objectives
Bond Yields and Return Calculations
LO 55 a: Distinguish between gross and net realized returns, and calculate the realized return for a
bond over a holding period including reinvestments.
LO 55 b: Define and interpret the spread of a bond, and explain how a spread is derived from a
bond price and a term structure of rates.
LO 55 c: Define, interpret, and apply a bond’s yield-to-maturity (YTM) to bond pricing.
LO 55 d: Compute a bond’s YTM given a bond structure and price.
LO 55 e: Calculate the price of an annuity and a perpetuity.
LO 55 f: Explain the relationship between spot rates and YTM.
LO 55 g: Define the coupon effect and explain the relationship between coupon rate, YTM, and
bond prices.
LO 55 h: Explain the decomposition of the profit and loss (P&L) for a bond position or portfolio into
separate factors including carry roll-down, rate change, and spread change effects.
LO 55 i: Explain the following four common assumptions in carry roll-down scenarios: realized
forwards, unchanged term structure, unchanged yields, and realized expectations of short-term
rates; and calculate carry roll down under these assumptions.

QUESTIONS
1. A bond is currently trading at $110. The bond was purchased 5 months ago at $105. A coupon
of $3 has been paid. What is the holding period gross realized return?
A. 7.62%
B. 15.24%
C. 4.76%
D. 7.27%
2. A bond is currently trading at $110. The bond was purchased 12 months ago at $105. A coupon
of $3 has been paid. The bond purchase was financed with a loan at 3% per annum. What is the
holding period net realized return?
A. 7.62%
B. 15.24%
C. 4.62%
D. 9.24%
3. When describing the spread of a bond, which of the following statements are not correct?
A. There may be instances when the actual price of the bond differs from the calculated price.
B. The calculated price is worked out by using spot or forward rates.
C. This difference between the market price and the calculated price of the bond is called the
spread of the bond.
D. The spread is a fixed measure and will help identify which bonds are over or underpriced
relative to the yield curve.
4. Which of the following is not a limitation of the YTM measure?

A. The YTM considers ALL returns that the investor will earn by holding the bond to maturity
and not just the coupon receipts.
B. The YTM takes into account the timing of the cash flows.
C. The YTM assumes that the reinvested income is reinvested at the YTM rate
D. The YTM is equal to the IRR measure
5. Assume the following details:

 A 10-year Treasury bond
 Par value of the bond = $100
 An 8% coupon
 Coupon payments made semi-annually = $4 per period
 Price of the bond = $93.4960
What is the YTM on the bond?

A. 4.50%
B. 9.00%
C. 4.00%
D. 16.00%

6. A man is planning retirement at the end of 2018 and wishes to receive 20 annual payments of
$50,000. How much must he invest now so that this is possible if the interest he can earn is 9%
per annum?
A. $1,000,000
B. $456,427
C. $500,000
D. $250,000
7. When looking at the relationship between spot rates and the YTM, which of the following
statements is not correct?
A. When valuing a fixed-income security often the use of one discount rate, i.e. the yield-to-
maturity, to compute the future value of each cash flow, is used.
B. Using the YTM is not entirely correct, as interest rates are seldom flat over a number of
different maturities.
C. It is more correct to use a different discount (interest) rate for each different cash flow date.
D. The correct rate that we use is the spot rate.
8. When looking at how a bonds value changes as it moves closer to maturity, which of the
following statements is not correct?
A. It decreases over time if the bond is selling at a premium
B. It increases over time if the bond is selling at a discount
C. It is unchanged if the bond is selling at par value
D. A bond’s discount is amortized over the life of the bond
9. Which of the following is not a component of a bond’s price appreciation?

A. Carry-roll down
B. Changes in rate
C. Changes in spread
D. Reinvested coupon
10. The following statement was made at a recent bond conference, “The trader assumes that the
forward rates will equal the expected future spot rates. Based on this, it will make no difference
if an investor invests in a 10-year bond or in two five-year bonds (rolled over)”.
Which scenario does this represent?
A. Realized forward scenario
B. Unchanged term structure scenario
C. Unchanged yields scenario
D. Carry roll-down scenario
11. An investment advisor is advising a wealthy client of the company. The client would like to
invest USD500,000 in a bond rated at least AA. The advisor is considering bonds issued by
Company X, Company Y, and Company Z, and wants to choose a bond that satisfies the client’s
rating requirement, but also has the highest yield to maturity. The advisor has gathered the
following information:

Which bond should the investment advisor purchase for the client?
A. Y bond
B. X bond
C. Z bond
D. Either the Z bond or the Y bond

SOLUTIONS
1. A
HPY = 110− 105 + 3 / 105
HPY = 0.0762
HPY = 7.62%
2. C
HPY = 110− 105 + 3 / 105 − 0.03
HPY = 0.0762 – 0.03
HPY = 4.62%
3. D
There may be instances when the actual price of the bond differs from the calculated price.
Remember the calculated price is worked out by using spot or forward rates. This difference is
called the spread of the bond. The spread is a relative measure and will help identify which
bonds are over or underpriced relative to the yield curve.
4. D
Limitations of the YTM measure
 The YTM considers ALL returns that the investor will earn by holding the bond to maturity
and not just the coupon receipts.
 The YTM takes into account the timing of the cash flows
 The YTM assumes that the reinvested income is reinvested at the YTM rate.
5. B
Calculate the IRR: Cash flow 0 = -93.4960 Cash flow 1-19 = 4.00 Cash flow 20 = 104 IRR =
4.500% This IRR is for every 6 months. Therefore per annum = 4.500% X 2 Yield to maturity =
9.00%.
6. B
7. A
When valuing a fixed-income security often the use of one discount rate, i.e. the yield-
tomaturity, to compute the present value of each cash flow, is used. This is not entirely correct,
as interest rates are seldom flat over a number of different maturities. Thus, it is more correct to
use a different discount (interest) rate for each different cash flow date. The rate that we use is
the spot rate.

8. D
How a bond’s value changes as it moves closer to maturity
The changes to a bond’s value over time is as follows:

 It decreases over time if the bond is selling at a premium (decreases towards par)
 It increases over time if the bond is selling at a discount (increases towards par)
 It is unchanged if the bond is selling at par value (it is already at par)
 A bond’s discount is accreted over the life of the bond
9. D
 Carry-roll down – the bond price changes as a result of changes in the interest rate from the
original term structure to the expected term structure.
 Changes in rate – the bond price changes as a result of changes in the interest rate from the
original term structure.
 Changes in spread– the bond price changes as a result of changes in the bond’s spread from
the original term structure.
10. A
Realized forward scenario – The trader assumes that the forward rates will equal the expected
future spot rates. Based on this, it will make no difference if an investor invests in a 10-year
bond or in two five-year bonds (rolled over).
11. B
To reach the correct answer, find the bond with the highest yield to maturity (YTM) that
qualifies for inclusion in the client’s portfolio. Although we can calculate the YTM for each
bond using a modern business calculator, it is unnecessary to do so in this case. Of the three
bonds, the Y bond does not qualify for the portfolio as its rating of A+ is below the AA rating
required by the client. This leaves the X bond and the Z bond. Comparing the two bonds, the X
bond pays a higher coupon than the Z bond, yet it is cheaper as well.
Therefore, the yield on the X bond is higher. To formally calculate the yield, you could also use
the following equation describing the relationship between price and yield:

Topic 56
Applying Duration, Convexity, and DV01 [VRM - 12]
Learning Objectives
Applying Duration, Convexity, and DV01
LO 56 a: Describe a one-factor interest rate model and identify common examples of interest rate
factors.
LO 56 b: Define and compute the DV01 of a fixed income security given a change in yield and the
resulting change in price.
LO 56 c: Calculate the face amount of bonds required to hedge an option position given the DV01 of
each.
LO 56 d: Define, compute, and interpret the effective duration of a fixed income security given a
change in yield and the resulting change in price.
LO 56 e: Compare and contrast DV01 and effective duration as measures of price sensitivity.
LO 56 f: Define, compute, and interpret the convexity of a fixed income security given a change in
yield and the resulting change in price.
LO 56 g: Explain the process of calculating the effective duration and convexity of a portfolio of
fixed income securities.
LO 56 h: Describe an example of hedging based on effective duration and convexity.
LO 56 i: Construct a barbell portfolio to match the cost and duration of a given bullet investment,
and explain the advantages and disadvantages of bullet versus barbell portfolios.

QUESTIONS
1. When describing an interest rate factor, the ability to correctly measure interest rate sensitivity
will help the certain people. Which of the following people is it least likely to help?
A. Hedgers
B. Traders
C. Investors
D. Portfolio Managers
2. Assume that the price of the bond moved up from $100 to $100.20 and rates moved down by 1
basis point. What is the DV01?
A. -$0.20
B. $0.20
C. 1.00
D. $2.00
3. An investor has made a $50m investment in 20-year coupon bonds. The 20-year coupon bond’s
price moved up from $100 to $100.20 as rates moved down by 1 basis point. The hedging
instrument used to hedge this long position will be a 10-year coupon bond with a DV01 of
$0.15. How much face value of the 10-year bond is required to hedge the 20-year bond?
A. $0.20
B. $66,666,667
C. $37,500,000
D. $50,000,000

Bond: 20-year bond Coupon: 9% Price: 134.6722 Duration: 10.66
What is the approximate % price change for a 10 basis points move?
A. -1.066%
B. 1.066%
C. 1.00%
D. 10.66%
5. When comparing the DV01 and effective duration as measures of price sensitivity, which of the
A. The DV01 measure looks at the change in dollar value per basis point change in yield.
B. The duration measure looks at the % change in the value of the bond per each unit change
in yields.
C. Duration is a more commonly used measure as it alerts investors to how the value of the
bond will change in relation to changes in yields.
D. The DV01 measure is a very useful when looking at bullet portfolios.

6. Consider a 10% coupon bond.

The current price is $98 with a YTM of 12%.
Assume a 50 basis points increase in yields. Duration is 12 and convexity is 80.
What is the percentage price change for the bond?
A. 6.00%
B. 0.100%
C. 5.90%
D. -5.90%
7. The following portfolios have been presented:
What is the portfolio duration?

A. 6.47
B. 1.61
C. 3.54
D. 2.16
8. When explaining the impact of negative convexity on the hedging of fixed income securities,
A. Convexity measures the exposure to volatility.
B. As long as interest rates move, the bond returns increase when convexity is positive.
C. When convexity is negative, then a movement in rates (either direction) will reduce bond
returns.
D. Convexity measures parallel shifts in the yield curve
9. The following three bonds have been presented:
Assuming a barbell portfolio, what is the % allocation to the short-term and long-term bonds?
A. Short-term = 70.95%
B. Short-term = 29.05%
C. Long-term = 70.95%
D. Long-term = 80.00%

10. The following three bonds have been presented:
What is the convexity of the barbell portfolio?

A. 23.4
B. 389.7
C. 206.6
D. 129.8
11. A risk manager is evaluating the price sensitivity of an investment-grade callable bond using
the firm’s valuation system. The table below presents information on the bond as well as on the
embedded option. The current interest rate environment is flat at 5%.
Value in USD per USD 100 face value
The DV01 of a comparable bond with no embedded options having the same maturity and
coupon rate is closest to:
A. 0.0185
B. 0.2706
C. 0.2891
D. 0.3077

SOLUTIONS
1. B
The ability to correctly measure interest rate sensitivity will help the following people:
 Hedgers – When hedging it is important to know the impact of rates on the fixed income
security as well as on the hedging instrument.
 Investors – When investing the impact of interest rats on the value of the fixed income
security is very important.
 Portfolio managers – Managers need to know how rate changes affect the portfolio as well
as the level of volatility on the portfolio.
 Asset/liability managers – AL managers need to match their assets and liabilities and as
such need to know the sensitivity of each instrument before they can match properly.
2. B
Assume that the price of the bond moved up from $100 to $100.20 and rates moved down by 1
basis point.
The calculation is as follows:
3. B
Step 1: Calculate the DV01 of the 20-year bond
4. A
The approximate % price change for a 10 basis points move is:
% Price change = - duration X Δy* X 100
% Price change = - 10.66 X 0.001 X 100
% Price change = - 1.066%

5. D
The DV01 measure looks at the change in dollar value per basis point change in yield. The
duration measure looks at the % change in the value of the bond per each unit change in yields.
Duration is a more commonly used measure as it alerts investors to how the value of the bond
will change in relation to changes in yields. The DV01 measure is a very useful when looking at
hedging of instruments.
The DV01 measure can be calculated if we have the duration measure, as follows: DV01 =
Duration x 0.0001 x value of the bond.
6. D
Duration effect = - modified duration (Δy) = - 12 X 0.005 = -0.06 = - 6%
Convexity effect = 1/2 (Convexity) (Δy) 2
= 1/2 (80) (0.005)2 = 0.0010 = 0.1%
Total % price change: = -6% + 0.1% = -5.9%.
7. A
Calculation of the portfolio duration
8. D
Convexity measures the exposure to volatility. As long as interest rates move, the bond returns
increase when convexity is positive. On the reverse side, when convexity is negative, then a
movement in rates (either direction) will reduce bond returns.
9. A
Step 1: Set the costs of both portfolios to be equal to each other
Let us assume a $100,000,000 investment will be made
Value5 + Value30 = $100,859,000
Step 2: Set the durations of both portfolios to be equal to each other

Let us assume a $100,000,000 investment will be made.
Let us solve these equations to work out the proportion of each bond to purchase.
(P x 4.520) + (1 – P) x 16.611 = 8.033
Where:
P = Proportion of bond 5

4.520P + 16.611 – 16.611P = 8.033

-12.09P = -8.578
P = 70.95%
Based on this we would purchase 70.95% of Bond 5 and 29.05% of Bond 30
10. D
The barbell convexity measure will equal:
23.4 x 70.95% + 389.7 x 29.05%
= 16.60 + 113.21
= 129.80
11. D
The call option reduces the bond price, therefore the bond with no embedded options will be
the sum of the callable bond price and the call option price. Therefore, the price of the bond
with no embedded options at a rate of 4.98% would be 104.1657 and the price at a rate of 5.02%
would be 102.9351.
DV01 is a measure of price sensitivity of a bond. To calculate the DV01, the following equation
is used:
Where ∆P is the change in price and ∆y is the change in yield. Therefore

Topic 57
Modeling Non-Parallel Term Structure Shifts and Hedging
[VRM - 13]
Learning Objectives
Modeling Non-Parallel Term Structure Shifts and Hedging
LO 57 a: Describe and assess the major weakness attributable to single-factor approaches when
hedging portfolios or implementing asset liability techniques.
LO 57 b: Describe the principal components analysis and explain its use in understanding term
structure movements.
LO 57 c: Define key rate exposures and know the characteristics of key rate exposure factors
including partial ‘01s and forward-bucket ‘01s.
LO 57 d: Describe key-rate shift analysis.
LO 57 e: Define, calculate, and interpret key rate ‘01 and key rate duration.
LO 57 f: Describe the key rate exposure technique in multi-factor hedging applications; summarize
its advantages and disadvantages.
LO 57 g: Calculate the key rate exposures for a given security, and compute the appropriate
hedging positions given a specific key rate exposure profile.
LO 57 h: Relate key rates, partial ‘01s and forward-bucket ‘01s, and calculate the forward-bucket ‘01
for a shift in rates in one or more buckets.
LO 57 i: Apply key rate and multi-factor analysis to estimating portfolio volatility.

QUESTIONS
1. When describing and assessing the major weakness attributable to single-factor approaches
when hedging portfolios or implementing asset liability techniques, which of the following
statements is not correct?
A. One of the major weaknesses of the DV01 approach is that it assumes that all rate changes
occur as a result of a single factor – parallel changes in rates.
B. This DV01 approach was effective and useful as it is easy to compute and understand for
hedging purposes.
C. A more realistic approach is to say that rates at different points along the yield curve are not
correlated and will change at different rates – in other words non-parallel yield curve shifts.
D. When rates change at different rates along the yield curve - This is called spread risk.
2. When defining key rate exposures including partial ‘01s and forward-bucket ‘01s. Which of the
I. Partial ‘01s – These are used to measure the hedging risk for a swap portfolio. They are
derived from the most liquid money market and swap instruments.
II. Forward bucket ‘01s – These are used to measure the risk given changes in the shape of the
yield curve. We can understand the portfolios yield curve risk from forward-bucket ‘01s.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following statements is not an advantage of the key rate approach?
A. The key rates are affected by the other key rates closest to them.
B. The key rates effects do not jump across maturities (they are smooth).
C. A parallel shift across the curve will result.
D. The approach is easy to calculate.
4. The following key rate ‘01s and durations of a C-STRIP are presented:
What is the key rate duration for a 2 year shift?

A. -0.38
B. -1.35
C. -0.0010
D. -0.0035

5. The following key rate ‘01s and durations of a C-STRIP are presented:
What is the key rate for a 2 year shift?

A. -0.38
B. -1.35
C. -0.0010
D. -0.0035
6. When describing key rate ‘01 and key rate duration, which of the following statements are not
correct?
A. For every shift of one basis point in the key rate – the key rate ’01 provides the dollar
change in the bond’s value.
B. The key rate duration works off 100 basis point changes in key rates.
C. From the key rate duration numbers we can assess the bond sensitivity to changes in the
yield curve.
D. One of the downsides of the key rate methodology is that it assumes that each rate is only
affected by those rates that surround it when in reality these shifts are not always linear.
7. It is important to remember that using key rates as a method of immunization is not 100%
guaranteed, which of the following statements are correct reasons for this?
I. In the event that rates change more than what was anticipated then the immunization
strategy will no work as indicated. The larger the changes in rates the worse the hedge.
II. In the event that rates do not change in the same manner or path as was indicated by the
key rate method, then the immunization strategy will not work as indicated.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
8. When describing the partial ’01 method, which of the following statements is not correct?
A. For the partial ’01 the starting point will be to fit a swap rate curve by using observable par
rates and short-term money market or futures rates.
B. The change in the value of the portfolio as a result of a one basis point change will be
measured and the curve will be refitted.
C. This results in yield curve shifts being fitted more accurately due to the constant fitting of
securities.
D. For the partial ‘01s the forward bucket ‘01s are calculated by moving forward rate over
several parts of the term structure, one part at a time.

9. When constructing an appropriate hedge for a position across its entire range of forward-
bucket exposures, which of the following statements are correct?
I. Assuming that the forward bucket ’01 overall is negative this would mean rates are
dropping.
II. When looking to hedge – the best option to select would be the hedge that neutralizes the
risk in each of the forward buckets – in other words, the hedge with the lowest net position.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II
10. When applying key rate and multi-factor analysis to estimating portfolio volatility, which of the
A. The benefit of using key rates and bucket analysis allows the manager the use of more than
just a single - factor when managing the interest rate risk on his po
B. An added benefit of using key rates and bucket analysis is that they also estimate volatility
well.
C. Key rates and bucket analysis make use of the correlations between the various interest rate
assumptions.
D. The key difference is that when using the forward bucket approach the number of inputs
and correlation pairs will decrease as it is based on estimated forward rate effects.
11. You are using key rate shifts to analyze the effect of yield changes on bond prices. Suppose that
the 10-year yield has increased by ten bps and that this shock decreases linearly to zero for the
20-year yield. What is the effect of this shock on the 14-yearyield?
A. Increase of zero bp
B. Increase of four bps
C. Increase of six bps
D. Increase of ten bps

SOLUTIONS
1. D
One of the major weaknesses of the DV01 approach is that it assumes that all rate changes occur
as a result of a single factor – parallel changes in rates. This approach was effective and useful
as it is easy to compute and understand for hedging purposes.
However, a more realistic approach is to say that rates at different points along the yield curve
are not correlated and will change at different rates – in other words non-parallel yield curve
shifts. This is called yield curve risk.
2. C
Partial ‘01s – These are used to measure the hedging risk for a swap portfolio. They are derived
from the most liquid money market and swap instruments.
Partial ‘01s – These are used to measure the hedging risk for a swap portfolio. They are derived
from the most liquid money market and swap instruments.
3. D
Advantages of the key rate approach
 The key rates are affected by the other key rates closest to them.
 The key rates effects do not jump across maturities (they are smooth).
 A parallel shift across the curve will result.
4. A
0.0010
Key rate duration =  10,000  0.38
26.22311
5. C
26.22411  26.22311
DV 01  
10,000  0.01
DV 01  0.0010
6. B
For every shift of one basis point in the key rate – the key rate ’01 provides the dollar change in
the bond’s value. The key rate duration works off 100 basis point changes in key rates. From
these numbers we can assess the bond sensitivity to changes in the key rates. This in turn will
allow us to hedge our bond portfolio more effectively. When all the key rates are summed we
assume a parallel shift across all maturities. One of the downsides of the key rate methodology
is that it assumes that each rate is only affected by those rates that surround it when in reality
these shifts are not always linear.

7. C
It is important to remember that using key rates as a method of immunization is not 100%
guaranteed due to the following reasons:
 In the event that rates change more than what was anticipated then the immunization
strategy will no work as indicated. The larger the changes in rates the worse the hedge.
 In the event that rates do not change in the same manner or path as was indicated by the
key rate method, then the immunization strategy will not work as indicated.
8. D
For the partial ’01 the starting point will be to fit a swap rate curve by using observable par
rates and short-term money market or futures rates. The change in the value of the portfolio as
a result of a one basis point change will be measured and the curve will be refitted. This results
in yield curve shifts being fitted more accurately due to the constant fitting of securities.
For the forward-bucket ‘01s the forward bucket ‘01s are calculated by moving forward rate over
several parts of the term structure, one part at a time.
9. B
Assuming that the forward bucket ’01 overall is negative this would mean rates are rising and
so to is the value of the option to pay a fixed rate of 5%.
There may be several ways presented to hedge this payer swaption – the best option to select
would be the hedge that neutralizes the risk in each of the forward buckets – in other words,
the hedge with the lowest net position.
10. D
The benefit of using key rates and bucket analysis allows the manager the use of more than just
a single-factor when managing the interest rate risk on his portfolio. An added benefit of these
models is that they also estimate volatility well because they make use of the correlations
between the various interest rate assumptions. The key difference is that when using the
forward bucket approach the number of inputs and correlation pairs will increase as it is based
on estimated forward rate effects.
11. C
The 10bp shock to the 10 – year yield is supposed to decline linearly to zero for the 20 - year
yield. Thus, the shock decreases by one basis point per year and will result in an increase of six
bps for the 14-year yield.

Topic 58
Binomial Trees [VRM - 14]
Learning Objectives
Binomial Trees
LO 58 a: Calculate the value of an American and a European call or put option using a one-step and
two-step binomial model.
LO 58 b: Describe how volatility is captured in the binomial model.
LO 58 c: Describe how the value calculated using a binomial model converges as time periods are
added.
LO 58 d: Define and calculate delta of a stock option.
LO 58 e: Explain how the binomial model can be altered to price options on stocks with dividends,
stock indices, currencies, and futures.

QUESTIONS
1. When calculating the value of an American and a European call or put option using a one-step
binomial model which of the following statements is not correct?
S
A. Using a discreet calculation – the up move is equal to u 
S
s
B. Using a discreet calculation – the down move is equal to d 
s
C. Using a continuous calculation – the up move is equal to u = e t
1
D. Using a continuous calculation – the down move is equal to u =  t
e
2. When calculating the value of an American and a European call or put option using a one-step
binomial model and considering the risk-neutral probability which of the following statements
is not correct?
A. Using a discreet calculation – the risk neutral probability of an upwards move is equal to
πU = 1+r−d / u – d
B. Using a discreet calculation – the risk neutral probability of an downwards move is equal to
πD = 1 – πU
C. Using a continuous calculation – the risk neutral probability of an upwards move is equal to
πU = e rt−d / u−d
D. The risk-neutral probability is the probability of an up or down move.
3. A stock is currently trading at $100. It can either go up by 25% or down by 20%. Assume an
exercise price of $100 and a risk free rate of 7%. Assume a call option is being considered.
Using the replicating portfolio model, how many options will need to be purchased?
A. 1.00
B. 0.55
C. 1.80
D. 2.00
4. A stock is currently trading at $100. It can either go up by 25% or down by 20%. Assume an
exercise price of $100 and a risk free rate of 7%. Assume a call option is being considered.
Using the one-period binomial options pricing model, what is the value of a call option?
A. 15.01
B. 20
C. 14.01
D. 100
5. When describing how volatility is captured in the binomial model. Which of the following
I. The greater the volatility or standard deviation, the bigger the difference between the up
and down movements in the stock price.

II. Assuming a standard deviation of zero, there would be no difference between the stock
price in an up and down state.
A. I only
B. II only.
C. Both I and II.
D. Neither I or II.
6. When describing how the value calculated using a binomial model converges as time periods
are added, which of the following statements are correct?
I. The binomial model works on large intervals between the points. If we shorten these
periods, we will need to increase the number of branches to consider.
II. Assume that we shorten the intervals so extensively until they become arbitrarily small we
start to approach continuous timing and the Black-Scholes-Merton model.
A. I only.
B. II only
C. Both I and II.
D. Neither I or II.
7. When describing how the binomial model can be altered to price options on stocks with
dividends, which of the following statements are correct?
A. The binomial model cannot be changed to incorporate a continuous dividend yield.
B. Capital gains on a stock will equal = risk-free rate less the dividend yield.
C. Incorporating the dividend yield into the risk-neutral probability calculation will result in
the following upward move calculation: πU = e (r−q)t−d / u−d
D. Incorporating the dividend yield into the risk-neutral probability calculation will result in
the following downward move calculation: πD = 1 – πU
8. When describing how the binomial model can be altered to price options on currencies and
futures, which of the following statements are correct?
A. The risk neutral probability of an upwards move on a currency option is calculated
continuously as follows: πU = e (rDC−rFC)t−d / u−d
B. The risk neutral probability of an downward move on a currency option is calculated as
follows: πD = 1 – πU
C. The risk neutral probability of an upwards move on a futures option is calculated
continuously as follows: πU = 1−r / u−d
D. The risk neutral probability of an downwards move on a futures option is calculated
continuously as follows: πD = 1 – πU
9. Which of the following statements regarding the delta of a stock option are not correct?
A. Delta or h = Change in the options price / Change in the underlying price
B. Delta or h = C +−C − / S+−S−
C. N(d1) = delta for calls
D. N(d2) = delta for puts

10. A stock is currently trading at $100.

It can either go up by 25% or down by 20%.
S + = Su = 100(1.25) = 125
S - = Sd = 100(0.80) = 80
c + = Max(0, S+ - X) =Max(0, 125 - 100) = 25.00
c - = Max(0, S- - X) = Max(0, 0,80 - 100) = 0
Exercise price = $100
Risk free rate of 7%.
c = 14.0187
Which of the following statements are correct?
I. The hedge ratio = 0.5556.
II. Assuming a short position of 1000 options – 555.6 shares will be purchased to hedge this
transaction.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
11. A risk manager for Bank XYZ is considering writing a 6-month American put option on a non-
dividend paying stock ABC. The current stock price is USD 50, and the strike price of the
option is USD 52. In order to find the no-arbitrage price of the option, the manager uses a two-
step binomial tree model. The stock price can go up or down by 20% each period. The
manager’s view is that the stock price has an 80% probability of going up each period and a
20% probability of going down. The annual risk - free rate is 12% with continuous
compounding.
What is the risk-neutral probability of the stock price going up in a single step?
A. 34.5%
B. 57.6%
C. 65.5%
D. 65.5%

SOLUTIONS
1. D
Discreet calculation
Let us now look at how the underlying moves:
We define a move upwards as ‘u’.
We define a move downwards as ‘d’.
Therefore:
u = S+ / S
d = S -/ S
Continuous manner
Up move = e 𝜎√t
Down move = e −𝜎√t = 1 / e 𝜎√t = 1 / Up move
2. D
Discreet calculation
The risk neutral probability of an upwards move is calculated as follows:
πU = 1+r−d / u – d
The risk neutral probability of an downwards move is calculated as follows:
πD = 1 – Πu
Continuous calculation
The risk neutral probability of an upwards move is calculated continuously as follows:
πU = e rt−d / u−d
The risk-neutral probability is NOT the actual probability of an up or down move but rather the
risk-neutral probabilities assuming investors were risk-neutral.
3. C
The minimum value of the stock in one years time = $80.
The present value of this is = $80 / 1.07 = $74.77. We borrow this amount and invest $25.23
($100 - $74.77) in the stock. Let us see why this is called the bankruptcy-free portfolio:
 If the stock goes down to $80 – We can use the proceeds of the stock of $80 to repay our
loan of $80. The net proceeds will equal 0.
 If the stock goes up to $125. We can use the proceeds of the stock of $125 to repay our loan
of $80. The net proceeds will equal $45.
The future return is equal to zero or $45. Looking at the future returns on the option:
c + = Max(0, S+ - X) =Max(0, 125 - 100) = 25.00
c - = Max(0, S- - X) = Max(0, 80 - 100) = 0
Based on this we would need to purchase $45 / $25 = 1.80 call options in order to replicate the
future return.

4. C
The stock is currently trading at $100. It can either go up by 25% or down by 20%.
Therefore:
u = S+ / S u = 125 / 100 u = 1.25 d = S- / S d = 80 / 100 d = 0.80 S + = Su = 100(1.25) = 125 S - =
Sd = 100(0.80) = 80
Assume an exercise price of $100 and a risk free rate of 7%. The value of a European call option
can therefore be expressed as follows: c + = Max(0, S+ - X) =Max(0, 125 - 100) = 25.00 c - =
Max(0, S- - X) = Max(0, 80 - 100) = 0
Calculation of π:
π = 1+r−d / u−d
π = 1+0.07−0.80 / 1.25−0.80
π = 0.60
Now we can calculate the price of the call option:
c = 0.60(25) + 0.40(0) / 1+0.07
c = 14.0187
5. C
The greater the volatility or standard deviation, the bigger the difference between the up and
down movements in the stock price. Assuming a standard deviation of zero, there would be no
difference between the stock price in an up and down state.
6. C
The binomial model works on large intervals between the points. If we shorten these periods,
we will need to increase the number of branches to consider. Assume that we shorten the
intervals so extensively until they become arbitrarily small we start to approach continuous
timing and the Black-Scholes-Merton model.
7. A
The binomial model can be changed to incorporate a continuous dividend yield – denoted ‘q’.
Capital gains on a stock will equal = risk-free rate less the dividend yield.
Incorporating the dividend yield into the risk-neutral probability calculation will result in the
following calculation:
The risk-neutral probability – with a dividend yield

πU = e (r−q)t−d / u−d
The risk neutral probability of an downward move is calculated as follows:
πD = 1 – Πu
8. C
Currencies
πU = e (rDC−rFC)t−d / u−d
The risk neutral probability of an downward move is calculated as follows:

πD = 1 – Πu
Futures
πU = 1−d / u−d
The risk neutral probability of an downwards move is calculated as follows:
πD = 1 – πU
9. D
Delta or h = Change in the options price / Change in the underlying price
This can be expanded to:
Delta or h = C +−C − / S+−S−
Keep in mind that an approximation for delta can be found by:
N(d1) = delta for calls
N(d1) – 1 = delta for puts
10. C
Delta or h = 25−0 / 125−80
h = 0.5556
Hedge = 1000 options X 0.5556
= 555.6 shares
11. B
Calculation follows:

Topic 59
The Black-Scholes-Merton Model [VRM - 15]
Learning Objectives
The Black-Scholes-Merton Model
LO 59 a: Explain the lognormal property of stock prices, the distribution of rates of return, and the
calculation of expected return.
LO 59 b: Compute the realized return and historical volatility of a stock.
LO 59 c: Describe the assumptions underlying the Black-Scholes-Merton option pricing model.
LO 59 d: Compute the value of a European option using the Black-Scholes-Merton model on a non-
dividend - paying stock.
LO 59 e: Define implied volatilities and describe how to compute implied volatilities from market
prices of options using the Black-Scholes-Merton model.
LO 59 f: Explain how dividends affect the decision to exercise early for American call and put
options.
LO 59 g: Compute the value of a European option using the Black-Scholes-Merton model on a
dividend - paying stock, futures, and exchange rates.
LO 59 h: Describe warrants, calculate the value of a warrant, and calculate the dilution cost of the
warrant to existing shareholders.

QUESTIONS
1. Assume the following numbers.

 Initial price $50
 Expected annual return 10%
 Annualized standard deviation 25%
What is the mean and standard deviation in six months time?
A. Mean = 3.94 and Standard deviation = 0.1768
B. Mean = 0.1768 and Standard deviation = 3.94
C. Mean = 0.25 and Standard deviation = 0.10
D. Mean = 0.50 and Standard deviation = 0.25
2. Assume the following numbers.

 Initial price $50
 Expected annual return 10%
 Annualized standard deviation 25%
 Return period = 9 month years
What is the expected price at time period T?

A. $50.00
B. $53.89
C. $55.26
D. $55.00
3. Which of the following assumptions is not an assumption of the BSM model?

A. The underlying price follows a geometric lognormal diffusion process.
B. The risk-free rate is known and constant.
C. The volatility of the underlying asset is unknown.
D. There are no taxes or transaction costs.

Underlying price = 52.75
Volatility = 0.35
Continuously compounded risk-free rate = 4.88%
Option expires in 9 months (T) = 0.75
Exercise price = 50
What is the value of a call option on this stock?

A. 0.5596
B. 0.6736
C. 8.5580
D. 4.0110


Underlying price = 52.75
Volatility = 0.35
Continuously compounded risk-free rate = 4.88%
Option expires in 9 months (T) = 0.75
Exercise price = 50
What is the value of a put option on this stock?

A. 0.5596
B. 0.6736
C. 8.5580
D. 4.0110
6. A company has got 2,000,000 shares outstanding at a current market price of $100 each. The
company is going to issue 1,000,000 warrants that allow the holder to purchase each share at a
price of R125 in two years time. Assuming that this was a regular call option transaction with
similar terms – the price of the call would be $10.
What is the value of the warrant?
A. $10
B. $6.67
C. $3.33
D. $96.67
7. A company has got 2,000,000 shares outstanding at a current market price of $100 each. The
company is going to issue 1,000,000 warrants that allow the holder to purchase each share at a
price of R125 in two years time. Assuming that this was a regular call option transaction with
similar terms – the price of the call would be $10.
What is the expected price of the stock after the warrant has been issued?
A. $10
B. $6.67
C. $3.33
D. $96.67
8. When describing the process of implied volatilities, which of the following statements are
correct?
I. In an actively traded options market we can assume that the prices of the options accurately
reflect their fair values.
II. By setting the BSM models equal to the market price of the option – we can work
backwards to infer the volatility.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

9. When assessing how dividends affect the decision to exercise early for American call and put
options, which of the following statements are correct?
I. When the underlying makes no cash payments, C0 = c0
II. When the underlying makes cash payments during the life of the option, early exercise may
be worthwhile and C0 may be higher than c0.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
10. When computing the value of a European option using the Black-Scholes-Merton model on a
dividend - paying stock, which of the following statements are not correct?
A. Cash flows in the price of the underlying will affect the price of the option.
B. In the BSM model we need to adjust for the present value of the cash flows on the
underlying.
C. When using S0 in the BSM model we now need to deduct in the continuous effect of the
cash flows.
D. In the case of stocks S0 will = S0e – δcT
11. A non-dividend-paying stock is currently trading at USD 40.00 and has an expected return of
12% per year. Using the Black-Scholes-Merton (BSM) model, a 1-year, European-style call
option on the stock is valued at USD 1.78. The parameters used in the model are:
N(d1) = 0.29123 N(d2) = 0.20333
The next day, the company announces that it will pay a dividend of USD 0.50 per share to
holders of the stock on an ex-dividend date 1 month from now and has no further dividend
payout plans for at least 1 year. This new information does not affect the current stock price,
but the BSM model inputs change, so that:
N(d1) = 0.29928 N(d2) = 0.20333
If the risk-free rate is 3% per year, what is the new BSM call price?
A. USD1.61
B. USD1.78
C. USD1.95
D. USD2.11

SOLUTIONS
1. A
The six-month probability distribution is:
2. B
3. C
Assumptions of the model
 The underlying price follows a geometric lognormal diffusion process.
 The risk-free rate is known and constant.
 The volatility of the underlying asset is known and constant.
 There are no taxes or transaction costs.
 There are no cash flows on the underlying.
4. C
Now we use the probability table to arrive at:

N(d1) = N(0.45) – we round up to two digits (therefore 0.4488 becomes 0.45)
The next step is to look up these numbers on the table and we arrive at:
N(0.45) = 0.6736
N(0.15) = 0.5596
c = S0N(d1) – Xe-rcT N(d2)
c = 52.75(0.6736) – 50e-0.0488(0.75)(0.5596)

c = 35.5324 – 50(0.9641)(0.5596)
c = 35.5324 – 26.9744
c = 8.5580
The value of a call will be $8.5580
5. D
Now we use the probability table to arrive at:

The next step is to look up these numbers on the table and we arrive at:
N(0.45) = 0.6736
N(0.15) = 0.5596
6. B
7. D

8. C
In an actively traded options market we can assume that the prices of the options accurately
reflect their fair values. By setting the BSM models equal to the market price of the option – we
can work backwards to infer the volatility.
9. C
American options
 When the underlying makes no cash payments, C0 = c0
 When the underlying makes cash payments during the life of the option, early exercise may
be worthwhile and C0 may be higher than c0.
10. C
Cash flows in the price of the underlying will affect the price of the option.
In the BSM model we need to adjust for the present value of the cash flows on the underlying.
When using S0 in the BSM model we now need to add in the continuous effect of the cash
flows. In the case of stocks S0 will become:
S0e – δcT.
11. C
The value of a European call is equal to S*N(d1)–Ke-rT*N(d2), where S is the current price of
the stock. In the case that dividends are introduced, S in the formula is reduced by the present
value of the dividends.
Furthermore, the announcement would affect the values of S,d1 and d2. However, since we are
given the new values, and d2is the same, the change in the price of the call is only dependent
on the term S *N(d1). Previous S * N(d1) = 40 * 0.29123 = 11.6492 New S *N(d1)=(40–(0.5* exp(-
3%/12)) * 0.29928=11.8219 Change = 11.8219 – 11.6492 = 0.1727.
So, the new BSM call price would increase in value by 0.1727,which when added to the
previous price of 1.78 equals 1.9527.

Topic 60
Option Sensitivity Measures: The “Greeks” [VRM - 16]
Learning Objectives
Option Sensitivity Measures: The “Greeks”
LO 60 a: Describe and assess the risks associated with naked and covered option positions.
LO 60 b: Describe the use of a stop loss hedging strategy, including its advantages and
disadvantages, and explain how this strategy can generate naked and covered option positions.
LO 60 c: Describe delta hedging for an option, forward, and futures contracts.
LO 60 d: Compute the delta of an option.
LO 60 e: Describe the dynamic aspects of delta hedging and distinguish between dynamic hedging
and hedge-and-forget strategy.
LO 60 f: Define and calculate the delta of a portfolio.
LO 60 g: Define and describe theta, gamma, vega, and rho for option positions, and calculate the
gamma and vega for a portfolio.
LO 60 h: Explain how to implement and maintain a delta-neutral and a gamma-neutral position.
LO 60 i: Describe the relationship between delta, theta, gamma, and vega.
LO 60 j: Describe how portfolio insurance can be created through option instruments and stock
index futures.

QUESTIONS
1. Which of the following statements are not correct when dealing with a covered call strategy?
A. The investor writes a covered call when he believes that the market will not move to far
away from where it is trading at present.
B. The strategy involves buying an out-of-the-money call against the current stock.
C. The sale of the option generates revenue from the premium.
D. In the event that stock prices move up, this will cause a loss on the call. However, that gain
on the stock.
2. When assessing a stop loss strategy, which of the following statements are correct regarding
how the stop loss position works?
I. Purchasing the underlying asset when the asset prices rises above the strike price.
II. Selling the asset as soon as the price falls below the strike price.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
3. Which of the following statements are not correct when dealing with an option’s delta?
A. The relationship between the option price and the underlying price is called the options
delta.
B. The delta can be defined as Delta = Change in the options price / Change in the underlying
price
C. Call option delta = positive, this is because as the price of the underlying increases, so to
does the value of the call option.
D. N(d2) = delta for puts
4. Assume that you own 100,000 shares in Deltaco. The current price is $125 per share. A call
option on Deltaco shares with an exercise price of $125 is trading at $10 and has a delta of 0.75.
How many call options do we need to buy/sell in order to create a delta-neutral portfolio.
A. Buy 133,333 call options
B. Sell 133,333 call options
C. Buy 75,000 call options
D. Sell 75,000 call options
5. Assume that our underlying position is 500,000 shares in Hedge me at a price of $100. A put
option is selling at $10 with a delta of 0.45. How many put options are required to hedge this
position?
A. Buy 111,111 put option contracts
B. Sell 111,111 put option contracts
C. Buy 11,111 put option contracts
D. Sell 11,111 put option contracts

6. When describing the delta of a portfolio, which of the following statements are correct?
I. The delta of a portfolio is the delta of each individual position multiplied by the weighting
of that position.
II. The portfolio delta cannot be calculated accurately.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.
7. Which of the following statements regarding theta are not correct?

A. The greater the uncertainty, the greater the time value of the option.
B. As the option price moves towards the payoff value of the option this is called the time
value decay.
C. The rate at which the time value decays is called the option’s theta.
D. If the option price decreases as time moves forward then we say that the theta is positive.
8. Which of the following statements regarding gamma are not correct?

A. When the gamma is large this means that the delta changes rapidly and cannot provide a
good approximation of how much the option moves in response to changes in movement of
the underlying.
B. The gamma is larger when there is greater uncertainty about whether the option will expire
in or out of the money.
C. The gamma will be large when the option is at the money and close to expiration.
D. The delta will be a good approximation for the options price sensitivity when it is at the
money and close to expiry.
9. Which of the following statements regarding vega are not correct?

A. Volatility is the standard deviation of the continuously compounded return on the stock.
B. The relationship between the option price and volatility is called vega.
C. Vega is positive on both calls and puts, which means that if the volatility increases so to will
the prices of call and put options.
D. The closer the option gets to in-the-money, the smaller the vega.
10. When attempting to create positions that are neutral to the Greeks this may be more difficult to
achieve than it may seem, which of the following statements are correct regarding the reasons
for this?
I. It is expensive to keep rebalancing the portfolio to ensure that it is Greek neutral.
II. It is often difficult to find instruments that create Greek neutral portfolios.
A. I only.
B. II only.
C. Both I and II.
D. Neither I or II.

11. Which of the following statements are not correct with respect to portfolio insurance?
A. Portfolio insurance involves: The underlying asset + Cash or a derivative that contains a
ceiling.
B. An example of portfolio insurance is to purchase a put option on the underlying portfolio.
C. Other examples of portfolio insurance include selling futures indexes that to the equivalent
value of the portfolio adjusting for the required delta.
D. Use of futures contracts is often he preferred method, as they are often cheaper and more
liquid than put options.
12. If the current market price of a stock is USD 60, which of the following options on the stock has
the highest gamma?
A. Call option expiring in 5 days with strike price of USD 30
B. Call option expiring in 5 days with strike price of USD 60
C. Call option expiring in 30 days with strike price of USD 60
D. Put option expiring in 30 days with strike price of USD 30

SOLUTIONS
1. B
Covered call:
The investor writes a covered call when he believes that the market will not move to far away
from where it is trading at present. The strategy involves selling an out-of-the-money call
against the current stock. The sale of the option generates revenue from the premium. In the
event that stock prices move up, this will cause a loss on the call. However, that gain on the
stock.
2. C
A stop loss strategy is meant to limit losses when call option contracts have been written in the
case of a naked position.
The strategy is as follows:
 Purchasing the underlying asset when the asset prices rises above the strike price.
 Selling the asset as soon as the price falls below the strike price.
3. D
The relationship between the option price and the underlying price is called the options delta.
The delta is also the hedge ratio, which we discussed previously. The delta can be defined as:
Delta = Change in the options price / Change in the underlying price
This can be expanded to:
Delta or h = C +−C − / S+−S−
Call option delta = positive, this is because as the price of the underlying increases, so to does
the value of the call option. Put option delta = negative, this is because as the price of the
underlying increases, the value of the put option falls. Keep in mind that an approximation for
delta can be found by: N(d1) = delta for calls N(d1) – 1 = delta for puts.
4. B
The formula used to calculate the number of call options to sell is:
5. C

6. A
The delta of a portfolio is the delta of each individual position multiplied by the weighting of
that position.
7. D
Theta:
The time towards expiry moves constantly towards zero. The greater the uncertainty, the
greater the time value of the option. As the option price moves towards the payoff value of the
option this is called the time value decay. The rate at which the time value decays is called the
option’s theta. If the option price decreases as time moves forward then we say that the theta is
negative.
8. D
Gamma:
When the gamma is large this means that the delta changes rapidly and cannot provide a good
approximation of how much the option moves in response to changes in movement of the
underlying. The gamma is larger when there is greater uncertainty about whether the option
will expire in or out of the money. This means that the gamma will be large when the option is
at the money and close to expiration. In other words, the delta will be a poor approximation for
the options price sensitivity when it is at the money and close to expiry.
9. D
Vega:
Volatility is the standard deviation of the continuously compounded return on the stock.
Volatility is a difficult measure to calculate. The relationship between the option price and
volatility is called vega. Vega is positive on both calls and puts, which means that if the
volatility increases so to will the prices of call and put options. The closer the option gets to in-
the-money, the larger the vega.
10. C
Albeit that it may be advantageous to create positions that are neutral to the Greeks, this may
be more difficult to achieve than it may seem. The reasons for this are:
 It is expensive to keep rebalancing the portfolio to ensure that it is Greek neutral.
 It is often difficult to find instruments that create Greek neutral portfolios.
11. A
Portfolio insurance involves:
3. The underlying asset +
4. Cash or a derivative that contains a floor (in the event of the asset dropping value) – but also
allows for upside on the underlying position.
An example of portfolio insurance is to purchase a put option on the underlying portfolio.
Other examples of portfolio insurance include selling futures indexes that to the equivalent
value of the portfolio adjusting for the required delta. This is often he preferred method as
futures are often cheaper and more liquid than put options.

12. B
Gamma is defined as the rate of change of an option’s delta with respect to the price of the
underlying asset, or the second derivative of the option price with respect to the asset price.
Therefore. the highest gamma is observed in shorter maturity and at-the-money options, since
options with these characteristics are much more sensitive to changes in the underlying asset
price. The correct choice is a call option both at-the-money and with the shorter maturity.

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FRM PART – I – FOUNDATION OF RISK MANAGEMENT

The Building Blocks of Risk Management

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3. The 5% VaR of a portfolio over a one-month period is $10m

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9. Investalot Inc recently made an investment in a venture capital business called

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B. Business risk and Strategic risk.

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How Do Firms Manage Financial Risk?

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1. Which of the following statements regarding hedging is least likely correct?

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C. Board of directors, Management team.

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The Governance of Risk Management

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3. Which of the following statements is a reason to appoint a risk advisory director?

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Comment 2: Business strategy is more important than risk tolerance.

7. Which of the following statements relating to the compensation committee is incorrect?

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10. Which of the following is not a responsibility of the audit committee?

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Credit Risk Transfer Mechanisms

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2. Which of the following credit derivatives acts as a form of insurance?

3. Jacqui Jones, FRM, is giving a presentation to a group of risk analysts. In the

4. What type of syndication will guarantee an obligor a fixed loan amount?

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 Faulty origination practices.

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7. An analyst gathers the following data:

9. An analyst developed the following data on Stock A and the market:

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What is the beta of Stock A?

10. Which of the following statements relating to beta are correct?

11. Data relating to Fund A is presented below for appraisal purposes:

Jensen’s alpha is equal to:

12. Data relating to Fund A is presented below for appraisal purposes:

The Fund’s Sharpe ratio is equal to:

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13. Data relating to Fund A is presented below for appraisal purposes:

The Fund’s Treynor ratio is equal to:

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17. Data relating to Fund A is presented below for appraisal purposes:

The Fund’s Sortino ratio is equal to:

18. Data relating to Fund A is presented below for appraisal purposes:

The Fund’s information ratio is equal to: