GARP FRM® Overview

We truly thank you for considering our help as you go towards

your goal of passing the GARP exams and attaining FRM certification.

From our family to yours, please accept our best wishes for success

Yours Sincerely,

The Question Bank Family

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview

For Additional Free Downloadable FRM Content:

https://www.frmquestionbank.com/shop/

For Weekly Insightful FRM Articles:

https://www.frmquestionbank.com/category/frm-articles/

Our Homepage:
https://www.frmquestionbank.com/

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview

Dear Candidates,

Please note that ALL our content, free and paid, feature:

 Unlimited Printing

 Unlimited Downloads

 Password-free Direct-Download Links

 Universal PDF Formatting

Additionally:

 There are no time-restrictions on your downloaded files

 We do not use third-party software to control the usage of our e-books

 There is no software to download or install in order to use our materials

 We allow and support file-copying of our e-books across multiple devices owned
by the user

 We fundamentally believe that all students have the right to use the content that
they have paid for, as long as they desire and without any restrictions

 We do not use or support subscription-based service models. With us, you only
pay once

Yours Sincerely,

The Question Bank Family

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview

In preparing for the FRM Examinations, we encourage students to plan ahead so that no time will be
wasted in trying to cover all necessary areas before exam day and that adequate time will be available
for practicing questions

The following information sets are excerpts taken from GARP texts and should only been seen as high-
level overviews. We encourage all students to purchase the official GARP books in order to adequately
prepare themselves for the FRM examinations

Make a special note of the sectional percentage weightings and plan accordingly

In addition to this, spend a bit more time on your weaker subject areas to better understand the
essential concepts and practice more questions surrounding these problematic topics

Please use the following information only as a general guide

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Table of Contents

Table of Contents – Level 1

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Table of Contents

1: Foundations of Risk Management Pages A2 – A20

Risk Management………….A2

Managing Financial Risk……………………A6

Governance of Risk………….A7

Credit Risk Transfer Mechanisms……………..A9

Modern Portfolio Theory and Capital Asset Pricing Model…………...A10

Arbitrage Pricing Theory and Multifactor Models……..…A11

Effective Data Aggregation and Risk Reporting……………………………….A12

Enterprise Risk Management and Future Trends………..A14

Learning from Financial Disasters………..A16

The Financial Crisis of 2007–2009………………………A18

GARP Code of Conduct……………A20

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Table of Contents

2: Quantitative Analysis Pages A21 – A54

Fundamentals of Probability…………………….A21

Random Variables…………..A23

Common Univariate Random Variables…………………A25

Multivariate Random Variables…………A28

Sample Moments……………..A31

Hypothesis Testing………………………A34

Linear Regression………………A37

Regression with Multiple Explanatory Variables……………A39

Regression Diagnostics………………A41

Stationary Time Series…………………………………..A44

Non-Stationary Time Series…………A47

Measuring Returns, Volatility, and Correlation…………….A49

Simulation and Bootstrapping……………….A52

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Table of Contents

3: Financial Markets and Products Pages A55 – A95

Banks…………………A55

Insurance Companies and Pension Plans…………………A58

Fund Management…………………A60

Introduction to Derivatives…………………A63

Exchanges and OTC Markets…………………A65

Central Clearing…………………A67

Using Futures for Hedging…………………A69

Foreign Exchange Markets…………………A71

Pricing Financial Forwards and Futures…………………A73

Commodity Forwards and Futures…………………A74

Options Markets…………………A76

Properties of Options…………………A77

Trading Strategies…………………A78

Exotic Options…………………A81

Properties of Interest Rates…………………A85

Corporate Bonds…………………A87

Mortgages and Mortgage-Backed Securities…………………A90

Interest Rate Futures…………………A93

Swaps…………………A94

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Table of Contents

4: Valuation and Risk Models Pages A96 – A128

Measures of Financial Risk…………………A96

Calculating and Applying VaR…………………A99

Measuring and Monitoring Volatility…………………A101

External and Internal Credit Ratings…………………A104

Country Risk…………………A106

Measuring Credit Risk…………………A109

Operational Risk…………………A112

Stress Testing…………………A114

Pricing Conventions, Discounting, and Arbitrage…………………A116

Interest Rates…………………A118

Bond Yields and Return Calculations…………………A120

Applying Duration, Convexity and DV01…………………A121

Modeling Non-Parallel Term Structure Shifts and Hedging…………………A123

Binomial Trees…………………A124

The Black-Scholes-Merton Model…………………A126

Option Sensitivity Measures…………………A128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

GARP FRM® Summary

Level I

Page A1 of 128
FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

1: Foundations of Risk Management

FRM Level I Summary: Book 1 Segment 1

/// Risk Management

How we think about risk is the biggest determinant of whether we recognize or assess them properly

We isolate ten risk management building blocks

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)

Each key risk type demands a specific set of skills and its own philosophical approach

Market prices and rates continually change, creating the potential for loss

Market risk is driven by:

• General market risk:

This is the risk that an asset class will fall in value, leading to a fall in portfolio value

• Specific market risk:

This is the risk that an individual asset will fall in value more than the general asset class

Page A2 of 128
FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Credit risk arises from the failure of one party to fulfill its financial obligations to another party

Examples of credit risk include:

 A debtor fails to pay interest or principal on a loan (bankruptcy risk)

 An obligor or counterparty is downgraded (downgrade risk)

 A counterparty to a market trade fails to perform (counter-party risk)

Credit risk is driven by:

 The probability of default of the obligor or counterparty

 The exposure amount at the time of default

 The amount that can be recovered in the event of a default

Liquidity risk is used to describe two separate kinds of risk:

 Funding liquidity risk and

 Market liquidity risk

Funding liquidity risk is the risk that covers the risk that a firm cannot access enough liquid cash and
assets to meet its obligations

Market liquidity risk, sometimes known as trading liquidity risk, is the risk of a loss in asset value when
markets temporarily seize up

Page A3 of 128
FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Operational risk can be defined as the “risk of loss resulting from inadequate or failed internal
processes, people, and systems or from external events.”

 It includes legal risk, but excludes business, strategic, and reputational risk

Business risks includes all the usual worries of firms, such as customer demand, pricing decisions,
supplier negotiations, and managing product innovation

Strategic risk is distinct from business risk

Strategic risk involves making large, long-term decisions about the firm’s direction

Strategic risk is often accompanied by major investments of capital, human resources, and management
reputation

Reputation risk is the danger that a firm will suffer a sudden fall in its market standing or brand with
economic consequences

The Risk Management Process

 Identify the risk

 Analyze and Measure the risk

 Assess the impact

 Manage the risk

VaR was a popular risk aggregation measure in the years leading up to the global financial crisis

Page A4 of 128
FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Financial risk managers have long recognized that they must overcome silo-based risk management
process to build a broad picture of risk across risk types and business lines

 We know this as Enterprise Risk Management (ERM)

Page A5 of 128
FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 1 Segment 2

/// Managing Financial Risk

The risk management process as a road-map can be seen:

1. Identify risk appetite

2. Map risks, make choices

3. Operationalize risk appetite

4. Implement

5. Re-evaluate regularly to capture changes

Just because a risk can be hedged does not mean that it should be hedged

Hedging is simply a tool and, like any tool, it has limitations

Risk appetite describes the amount and types of risk a firm is willing to accept

 This is in contrast to risk capacity, which describes the maximum amount of risk a firm can
absorb

Page A6 of 128
FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 1 Segment 3

/// Governance of Risk

Corporate governance is the way in which companies are run

Corporate governance describes the roles and responsibilities of a firm’s shareholders, board of
directors, and senior management

Basel III designed a macro-prudential overlay intended to reduce systemic risk and lessen pro-cyclicality

Ultimately, only four basic choices need to be made in the management of corporate risk:

1. The choice to undertake or not to undertake certain activities

2. The choice to transfer or not transfer either all or part of a given risk to a third party

3. The choice to preemptively mitigate risk through early detection and prevention

4. The choice to assume or not assume risk

Publishing a risk appetite statement (RAS) is an important component of corporate governance

The Financial Stability Board (FSB) describes an RAS as “a written articulation of the aggregate level and
types of risk that a firm will accept or avoid in order to achieve its business objectives.”

The RAS includes both qualitative and quantitative statements

Page A7 of 128
FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Internal auditors are responsible for:

 Reviewing monitoring procedures

 Tracking the progress of risk management system upgrades

 Assessing the adequacy of application controls

 Affirming the efficacy of vetting processes

Page A8 of 128
FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 1 Segment 4

/// Credit Risk Transfer Mechanisms

The core risk exposure for banks is credit risk

Banks have long had several ways to reduce their exposure to credit risk:

 Purchasing insurance from a third-party guarantor/underwriter

 Netting of exposures to counterparties

 Marking-to-market/margining

 Requiring collateral be posted

 Termination/Put options

 Reassignment of a credit exposure

Securitization involves the repackaging of loans and other assets into new securities that can then be
sold in the securities markets

Securitization eliminates a substantial amount of risk (i.e., liquidity, interest rate, and credit risk) from
the originating bank’s balance sheet when compared to the traditional buy-and-hold strategy

Page A9 of 128
FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 1 Segment 5

/// Modern Portfolio Theory and Capital Asset Pricing Model

A “rational investor” is an investor who is risk averse and seeks to maximize utility

Markowitz demonstrated that a rational investor should evaluate potential portfolio allocations based
upon the associated means and variances of the expected rate of return distributions

The theory also assumes:

 Capital markets are perfect

 There are no taxes or transaction costs

 All traders have costless access to all available information

 Perfect competition exists among all market participants

 Returns are normally distributed

According to Markowitz, the level of investment in a particular financial asset should be based upon that
asset’s contribution to the distribution of the portfolio’s overall return (as measured by the mean and
variance)

 In other words, what matters is the covariability of the asset’s return with respect to the return
of the overall portfolio

Along the efficient frontier, the only way to achieve a higher expected rate of return is by increasing the
riskiness of the portfolio

The CAPM model shows that market equilibrium is achieved when all investors hold portfolios consisting
of the riskless asset and the market portfolio

Page A10 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 1 Segment 6

/// Arbitrage Pricing Theory and Multifactor Models

The capital asset pricing model (CAPM) is a single-factor model that describes an asset’s expected rate
of return as a linear function of the market’s risk premium above a risk-free rate

 Beta is the coefficient (i.e., the slope) of this relationship

Arbitrage Pricing Theory (APT) is based on the reasoning behind CAPM. However, it explains an asset’s
expected rate of return as a linear function of several market factors

Arbitrage Pricing Theory assumes that there are no arbitrage opportunities

APT suggests that multiple factors can help explain the expected rate of return on a risky asset

 These factors may include indices on stocks, bonds, and commodities, as well as macroeconomic
factors

Page A11 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 1 Segment 7

/// Effective Data Aggregation and Risk Reporting

Effective risk analysis requires sufficient and high-quality data

 This makes data a major asset in today's world

A bank with a limited ability to integrate data will have difficulties in satisfying the Basel principles

A key challenge is collecting data from the various internal and external sources and feeding it into risk
analytics systems

Firms need to monitor their data on an ongoing basis to ensure accuracy and integrity

Risk data should be complete, reconciled with sources, and include all material risk disclosures at a
granular level

Page A12 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Key Governance Principles

Principle 1: Governance

Principle 2: Data architecture and IT infrastructure

Principle 3: Accuracy and Integrity

Principle 4: Completeness

Principle 5: Timeliness

Principle 6: Adaptability

Principle 7: Accuracy

Principle 8: Comprehensiveness

Principle 9: Clarity and usefulness

Principle 10: Frequency

Principle 11: Distribution

A study from PwC showed higher performance for compliance with Principles 7–11 (risk reporting)
compared to Principles 3–6 (data aggregation)

Principles 1 (governance) and 2 (data architecture and infrastructure) have poor compliance rates

Page A13 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 1 Segment 8

/// Enterprise Risk Management and Future Trends

At the enterprise level, risks may:

 Negate each other (e.g., through netting and diversification) or

 Exacerbate each other (e.g., through risk concentrations, contagion, and cross-over risks)

Enterprise risk management (ERM) applies the perspective and resources at the top of the enterprise to
manage the entire portfolio of risks and account for them in strategic decisions

Another important feature of ERM is that it supports a consistent approach

Top ten benefits of ERM

1. Helps firms define and adhere to risk appetites

2. Focuses oversight on most threatening risks

3. Identifies enterprise-scale risks generated at business line level

4. Manages risk concentrations across the enterprise

5. Manages emerging enterprise risks (e.g., cyber risk, AML (anti-money laundering) risk)

6. Supports regulatory compliance and stakeholder reassurance

7. Helps firms to understand risk-type correlations and cross-over risks

8. Optimizes risk transfer expenses in line with risk scale and total cost

9. Incorporates stress scenario capital costs into pricing and business decisions

10. Incorporates risk into business model selection and strategic decisions

Page A14 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Risk culture can be thought of as the set of goals, values, beliefs, procedures, customs, and conventions
that influence how staff create, identify, manage, and think about risk within an enterprise

The Financial Stability Board (FSB) has specified four key risk culture indicators:

1. Accountability

2. Effective communication and challenge

3. Incentives

4. Tone from the top

Page A15 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 1 Segment 9

/// Learning from Financial Disasters

Over the last century, interest rate risk has caused the failure of individual firms as well as entire
industries within the financial services sector

To mitigate interest rate risk, firms must manage their balance sheet structure such that the effect of
any interest rate movement on assets remains highly correlated with the effect on liabilities

Funding liquidity risk can stem from external market conditions (e.g., during a financial crisis) or from
structural problems within a bank’s balance sheet

Rogue trading can cause major financial institutions to collapse (as seen in the case of Barings Bank/Nick
Leeson)

 A main lesson from the Barings collapse is that reporting and monitoring of positions and risks
(i.e., back-office operations) must be separated from trading

The case of Continental Illinois Bank is an example of how internal credit portfolio problems can
precipitate a funding liquidity crisis

The 2007 failure of mortgage bank Northern Rock is a recent illustration of liquidity risk arising from
structural weaknesses in a bank’s business model

 In this case, a combination of an excessive use of short-term financing for long-term assets and a
sudden loss of market confidence triggered a funding liquidity crisis that rapidly led to disaster

Page A16 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

MGRM (Metallgesellschaft AG) was exposed to curve risk (i.e., the risk of shifts in the price curve
between backwardation and contango)

 Additionally, the firm was exposed to basis risk resulting from deviations between short-term
prices and long-term prices

Long Term Capital Management (LTCM) failure reflected its inability to anticipate the dramatic increase
in correlations and volatilities and the sharp drop in liquidity that can occur during an extreme crisis

 LTCM also succumbed to an internal liquidity crunch brought on by large margin calls on its
futures holdings

 LTCM made heavy use of a Value-at-Risk (VaR) model as part of its risk control

Enron used “creative” (i.e., fraudulent) accounting practices to hide flaws in its actual financial
performance

 An example of Enron’s duplicity is a scheme by which the firm would build a physical asset and
then immediately declare a projected mark-to-market profit on its books

Model risk can stem from using an incorrect model, incorrectly specifying a model, and/or using
insufficient data and incorrect estimators

Banks may mitigate funding liquidity risk by reducing the maturity of their assets

VaR is a measure of the worst-case loss for an given normal market conditions

Cyber risk has become a critically important consideration in recent years

Page A17 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 1 Segment 10

/// The Financial Crisis of 2007–2009

The cascade of events that came be known as the Great Financial Crisis of 2007–2009 (GFC) began with
a downturn in the U.S. subprime mortgage market in the summer of 2007

The years preceding the crisis saw an exceptional boom in credit growth in the United States, a massive
housing price bubble, and an excess of leverage in the financial system

February 2008 saw the nationalization of troubled U.K. mortgage lender Northern Rock, a victim of the
first bank run that nation had experienced in 140 years

The following month, U.S. investment bank Bear Stearns was absorbed by J.P. Morgan Chase in a deal
brokered by the U.S. Treasury Department and the Federal Reserve

The peak of the subprime crisis came in September 2008, which saw a cascade of events

 Lehman Brothers declared bankruptcy

 Morgan Stanley and Goldman Sachs, were converted to bank holding companies and became
regulated by the Federal Reserve

 Fannie Mae and Freddie Mac were nationalized

 AIG was brought back from the brink of collapse via a USD 150 billion capital infusion by the U.S.
Treasury and the Federal Reserve

 In Europe, many countries had to step in to provide massive support to their banks

 Dutch financial conglomerate Fortis was broken up and sold

Page A18 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Systemic risk is the risk that events at one firm, or in one market, can extend to other firms or markets

 Systemic risk played a large role in exacerbating the impact of the crisis

Page A19 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 1 Segment 11

/// GARP Code of Conduct

The GARP Code of Conduct sets forth principles of professional conduct for Global Association of Risk
Professionals, Financial Risk Management and Energy Risk Professional certifications and other GARP
certification and diploma holders and candidates, GARP’s Board of Trustees, its Regional Directors, GARP
Committee Members and GARP’s staff in support of the advancement of the financial risk management
profession

 These principles promote the highest levels of ethical conduct and disclosure and provide
direction and support for both the individual practitioner and the risk management profession

Rules of Conduct

1. Professional Integrity and Ethical Conduct

2. Conflict of Interest

3. Confidentiality

4. Fundamental Responsibilities

5. General Accepted Practices

Page A20 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

2: Quantitative Analysis

FRM Level I Summary: Book 2 Segment 1

/// Fundamentals of Probability

A probability measures the likelihood that some event occurs

Probability is introduced through three fundamental principles

1. The probability of any event is non-negative

2. The sum of the probabilities across all outcomes is one

3. The joint probability of two independent events is the product of the probability of each

Probabilities are always between 0 and 1 (inclusive)

An event with probability 0 never occurs

An event with a probability 1 always occurs

Conditional probability deals with computing a probability on that condition that another event occurs

Two events are independent if the probability that one event occurs does not depend on whether the
other event occurs

Page A21 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Note that two types of independence—unconditional and conditional—do not imply each other

Events can be both unconditionally dependent (i.e., not independent) and conditionally independent

Similarly, events can be independent, yet conditional on another event they may be dependent

Page A22 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 2 Segment 2

/// Random Variables

Probability can be used to describe any situation with an element of uncertainty

However, random variables restrict attention to uncertain phenomena that can be described with
numeric values

 This restriction allows standard mathematical tools to be applied to the analysis of random
phenomena

Two functions are commonly used to describe the chance of observing various values from a random
variable:

1. The probability mass function (PMF) and

2. The cumulative distribution function (CDF)

The PMF is particularly useful when defining the expected value of a random variable

Moments are used to summarize the key features of random variables

A moment is the expected value of a carefully chosen function designed to measure a characteristic of a
random variable

Page A23 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Four moments are commonly used in finance and risk management:

1. The mean (which measures the average value of the random variable)

2. The variance (which measures the spread/dispersion)

3. The skewness (which measures asymmetry)

4. The kurtosis (which measures the chance of observing a large deviation from the mean)

The quantile function, which can be used to map a random variable’s probability to its realization,
defines two moment-like measures:

1. The median (which measures the central tendency of a random variable) and

2. The interquartile range (which is an alternative measure of spread)

A discrete random variable assigns a probability to a set of distinct values

 This set can be either finite or contain a countably infinite set of values

Random variables can be described precisely using mathematical functions

The set of values that the random variable may take is called the support of the function

In most applications in finance and risk management, the assumed distributions are continuous and
without regions of zero probability

Page A24 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 2 Segment 3

/// Common Univariate Random Variables

There are over two hundred named random variable distributions

 Each of these distributions has been developed to explain key features of real-world
phenomena

Risk managers model uncertainty in many forms, so this set includes both discrete and continuous
random variables

There are three common discrete distributions:

1. The Bernoulli

2. The binomial

3. The Poisson

The Bernoulli is a general purpose distribution that is typically used to model binary events

The binomial distribution describes the sum of n independent Bernoulli random variables

The Poisson distribution is commonly used to model hazard rates, which count the number of events
that occur in a fixed unit of time

Mixture distributions are built using two or more distinct component distributions

Page A25 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

A mixture is produced by randomly sampling from each component so that the mixture distribution
inherits characteristics of each component

Mixtures can be used to build distributions that match important features of financial data

The normal distribution is the most commonly used distribution in risk management

The normal distribution is commonly referred to as a Gaussian distribution or a bell curve

A normal distribution has no skewness (because it is symmetrical) and a kurtosis of 3

The lognormal distribution is a simple transformation of a normal distribution and is the distribution
underlying the famous Black-Scholes Merton model

A variable Y is said to be log-normally distributed if the natural logarithm of Y is normally distributed

 In other words, if X = ln Y, then Y is log-normally distributed if and only if X is normally

distributed

Page A26 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

The chi-squared distribution is frequently encountered when testing hypotheses about model
parameters. It is also used when modeling variables that are always positive

The Student’s t distribution is closely related to the normal, but it has heavier tails. The Student’s t
distribution was originally developed for testing hypotheses using small samples

 A Student’s t is a one-parameter distribution

 This parameter, denoted by n, is also called the degrees of freedom parameter

The F is another distribution that is commonly encountered when testing hypotheses about model
parameters

 The F has two parameters known as the numerator and denominator degrees of freedom

The exponential distribution uses a single parameter that determines both the mean and variance

 The exponential distribution is closely related to the Poisson distribution

Exponential variables are “memoryless”, meaning that their distributions are independent of their
histories

The Beta distribution applies to continuous random variables with outcomes between 0 and 1

 It is commonly used to model probabilities that naturally fall into this range

Page A27 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 2 Segment 4

/// Multivariate Random Variables

Multivariate random variables are vectors of random variables

Multivariate random variables extend the concept of a single random variable to include measures of
dependence between two or more random variables

Multivariate random variables are natural extensions of univariate random variables

 They are defined using PMFs (for discrete variables) or PDFs (for continuous variables), which
describe the joint probability of outcome combinations

The probability mass function (PMF)/probability density function (PDF) for a bivariate random variable
returns the probability that two random variables each take a certain value

The trinomial PMF has three parameters:

1. n (i.e., the total number of experiments),

2. p1, (i.e., the probability of observing outcome 1), and

3. p2 (i.e., the probability of observing outcome 2)

The expectation of a function of a bivariate random variable is defined analogously to that of a

univariate random variable

Expectations are used to define moments of bivariate random variables in the same way that they are
used to define moments for univariate random variables

Page A28 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

The covariance is a measure of dispersion that captures how the variables move together

In a bivariate random variable, there are two variances and one covariance

Bivariate distributions can be transformed into either marginal or conditional distributions

A marginal distribution summarizes the information about a single variable and is simply a univariate
distribution

A conditional distribution describes the probability of one random variable conditional on an outcome
or a range of outcomes of another

Correlation measures the strength of the linear relationship between two variables and is always
between -1 and 1

Correlation plays an important role in determining the benefits of portfolio diversification

The return on a portfolio depends on:

 The distribution of the returns on the assets in the portfolio, and

 The portfolio’s weights on these assets

When two random variables are independent, they must have zero correlation

However, if two random variables have zero correlation, they are not necessarily independent

Page A29 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Correlation is a measure of linear dependence

 If two variables have a strong linear relationship (i.e., they produce values that lie close to a
straight line), then they have a large correlation

If two random variables have no linear relationship, then their correlation is zero

Page A30 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 2 Segment 5

/// Sample Moments

This segment describes how sample moments are used to estimate unknown population moments

When data are generated from independent identically distributed (iid) random variables, the mean
estimator has several desirable properties:

 It is (on average) equal to the population mean

 As the number of observations grows, the sample mean becomes arbitrarily close to the
population mean

 The distribution of the sample mean can be approximated using a standard normal distribution

Data can also be used to estimate higher-order moments such as variance, skewness, and kurtosis

The first four (standardized) moments (mean, variance, skewness, and kurtosis) are widely used in
finance and risk management to describe the key features of data sets

Quantiles provide an alternative method to describe the distribution of a data set

Quantile measures are particularly useful in applications to financial data because they are robust to
extreme outliers

The mean estimator is a function that transforms data into an estimate of the population mean

Page A31 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

An estimator is a mathematical procedure that calculates an estimate based on an observed data set

 In contrast, an estimate is the value produced by an application of the estimator to data

The mean estimator is a function of random variables, and so it is also a random variable

The expected value of the mean estimator is the same as the population mean

The variance of the mean estimator depends on two values:

1. The variance of the data

2. The number of observations

The variance in the data is noise that obscures the mean

The more variable the data, the harder it is to estimate the mean of that data

The variance of the mean estimator decreases as the number of observations increases

 So larger samples produce estimates of the mean that tend to be closer to the population mean

Means and standard deviations are the most widely reported statistics. Their popularity is due to several
factors:

 The mean and standard deviation are often sufficient to describe the data

 These two statistics provide guidance about the likely range of values that can be observed

 The mean and standard deviation are in the same units as the data, and so can be easily
compared

Page A32 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

One challenge when using asset price data is the choice of sampling frequency

The important properties of the mean estimator include the following:

 The mean is unbiased

 When the observed data are iid, the mean has a simple expression for its standard error

 The mean estimator is BLUE

 The mean estimator is consistent, and in large samples the estimated mean is close to the
population mean

 When the variance is finite, the distribution of the mean estimator can be approximated using
the CLT

Page A33 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 2 Segment 6

/// Hypothesis Testing

Hypothesis testing can be reduced to one universal question:

 How likely is the observed data if the hypothesis is true?

Testing a hypothesis about a population parameter starts by specifying null hypothesis and an
alternative hypothesis

The null hypothesis is an assumption about the population parameter

The alternative hypothesis specifies the population parameter values (i.e., the critical values) where the
null hypothesis should be rejected

The critical values are determined by:

 The distribution of the test statistic when the null hypothesis is true, and

 The size of the test, which reflects our aversion to rejecting a null hypothesis that is in fact true

Observed data are used to construct a test statistic, and the value of the test statistic is compared to the
critical values to determine whether the null hypothesis should be rejected

Page A34 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

A hypothesis test has six distinct components:

1. The null hypothesis, which specifies a parameter value that is assumed to be true;

2. The alternative hypothesis, which defines the range of values where the null should be
rejected;

3. The test statistic, which has a known distribution when the null is true;

4. The size of the test, which captures the willingness to make a mistake and falsely reject a null
hypothesis that is true;

5. The critical value, which is a value that is compared to the test statistic to determine whether
to reject the null hypothesis; and

6. The decision rule, which combines the test statistic and critical value to determine whether to
reject the null hypothesis

In some testing problems, the alternative hypothesis might not fully complement the null

 The most common example of this is called a one-sided alternative, which is used when the
outcome of interest is only above or only below the value assumed by the null

The test statistic is a summary of the observed data that has a known distribution when the null
hypothesis is true

In an ideal world, a false (true) null would always (never) be rejected. However, in practice there is a
tradeoff between avoiding a rejection of a true null and avoiding a failure to reject a false null

Rejecting a true null hypothesis is called a Type I error

The probability of committing a Type I error is known as the test size

Page A35 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

The test size is chosen to reflect the willingness to mistakenly reject a true null hypothesis

 The most common test size is 5%

The critical value depends on the distribution of the test statistic and defines a range of values where
the null hypothesis should be rejected in favor of the alternative

 This range is known as the rejection region

When the test statistic has a standard normal distribution, the critical value depends on both the size
and the type of the alternative hypothesis (i.e., whether it is one-or two-sided)

A Type II error occurs when the alternative is true, but the null is not rejected

A confidence interval is a range of parameters that complements the rejection region

 A 95% confidence interval contains the set of parameter values where the null hypothesis
cannot be rejected when using a 5% test

A hypothesis test can also be summarized by its p-value

A p-value combines the test statistic, distribution of the test statistic, and the critical values into a single
number that is always between 0 and 1

 This value can always be used to determine whether a null hypothesis should be rejected

 If the p-value is less than the size of the test, then the null is rejected

The p-value of a test statistic is equivalently defined as the smallest test size where the null is rejected

 Any test size larger than the p-value leads to rejection, whereas using a test size smaller than
the p-value fails to reject the null

Page A36 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 2 Segment 7

/// Linear Regression

Linear regression is a widely applied statistical tool for modeling the relationship between random
variables

Linear regression has many appealing features:

 Closed-form estimators,

 Interpretable parameters,

 A flexible specification and

 Can be adapted to a wide variety of problems

Regression analysis is the most widely used method to measure, model, and test relationships between
random variables

 It is widely used in finance to measure the sensitivity of a portfolio to common risk factors,
estimate optimal hedge ratios for managing specific risks, and to measure fund manager
performance

The bivariate linear regression model relates a dependent variable to a single explanatory variable

Regression is surprisingly flexible and can describe a wide variety of relationships

The Ordinary Least Squares (OLS) estimators, which have a simple moment-like structure and depend on
the mean, variance, and covariance of the data

Page A37 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

An important class of explanatory variable is known as a dummy

 A dummy random variable is binary and only takes the value 0 or 1

Dummies are used to encode qualitative information (e.g., a bond’s country of origin)

A Dummy takes the value 1 when the observation has the quality and 0 if it does not

Dummies are also commonly constructed as binary transformations of other random variables

 e.g., a market direction dummy that encodes the return on the market as 1 if negative and 0 if
positive

Page A38 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 2 Segment 8

/// Regression with Multiple Explanatory Variables

Linear regression with a single explanatory variable provides key insights into OLS estimators and their
properties

In practice, however, models typically use multiple variables where it is possible to isolate the unique
contribution of each explanatory variable

A model built with multiple variables can also distinguish the effect of a novel predictor from the set of
explanatory variables known to be related to the dependent variable

The k-variate regression model enables the coefficients to measure the distinct contribution of each
explanatory variable to the variation in the dependent variable

The Fama-French three-factor model is a leading example of a multi-factor approach

The Fama-French three-factor model expands upon CAPM by including two additional factors:

 The size factor (which captures the propensity of small-cap firms to generate higher returns than
large-cap firms) and

 The value factor (which measures the additional return that value firms earn above growth firms)

Controls are explanatory variables that are known to have a clear relationship with the dependent
variable

Page A39 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Model fit is assessed using R2, which measures the ratio of the variation explained by the model to the
total variation in the data

While intuitive, this measure suffers from some important limitations:

 It never decreases when an additional variable is added to a model and

 It is not interpretable when the dependent variable changes.

The adjusted R2 partially addresses the first of these concerns

Page A40 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 2 Segment 9

/// Regression Diagnostics

Ideally, a model should include all variables that explain the dependent variable and exclude all that do
not

 In practice, achieving this goal is challenging

Once a model has been selected, the specification should be checked for any obvious deficiencies

 Omitting explanatory variables that affect the dependent variable creates biased coefficients

 Including irrelevant variables does not bias coefficients

Determining whether a variable should be included in a model reflects a bias-variance tradeoff

Large models that include all conceivable explanatory variables are likely to have coefficients that are
unbiased

An omitted variable is one that has a non-zero coefficient but is not included in a model

Omitting a variable has two effects:

1. First, the remaining variables absorb the effects of the omitted variable attributable to
common variation

2. Second, the estimated residuals are larger in magnitude than the true shocks

Page A41 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

An extraneous variable is one that is included in the model but is not needed

 This type of variable has a true coefficient of 0 and is consistently estimated to be 0 in large
samples

The choice between omitting a relevant variable and including an irrelevant variable is ultimately a
tradeoff between bias and variance

 Larger models tend to have a lower bias but they also have less precise estimated parameters

 Models with few explanatory variables have less estimation error but are more likely to produce
biased parameter estimates

The bias-variance tradeoff is the fundamental challenge in variable selection

Homoscedasticity is one of the five assumptions used to determine the asymptotic distribution of an
OLS estimator

 It requires that the variance is constant and so does not systematically vary with any of the
explanatory variables

 When this is not the case, then the residuals are heteroskedastic

When residuals are heteroskedastic, the standard errors can be estimated using White’s estimator (also
called Eiker-White in some software packages)

Parameters can be tested using t-tests by using White’s standard error in the place of standard error
used for homoscedastic data

On the other hand, F-tests, are not as easy to adjust for heteroskedasticity and so caution is required
when testing multiple hypotheses if the shocks are heteroskedastic

Page A42 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Multicollinearity occurs when one or more explanatory variables can be substantially explained by the
other(s)

Multicollinearity differs from perfect collinearity, where one of the variables is perfectly explained by
the others

Multicollinearity is a common problem in finance and risk management because many regressors are
simultaneously determined by and sensitive to the same news

Residual plots are standard methods used to detect deficiencies in a model specification

 An ideal model would have residuals that are not systematically related to any of the included
explanatory variables

Page A43 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 2 Segment 10

/// Stationary Time Series

Time-series analysis is a fundamental tool in finance and risk management

Many key time series (e.g., interest rates and spreads) have predictable components

Building accurate models allows past values to be used to forecast future changes in these series

A time series can be decomposed into three distinct components:

 The trend, which captures the changes in the level of the time series over time

 The seasonal component, which captures predictable changes in the time series according to
the time of year

 The cyclical component, which captures the cycles in the data

Whereas the first two components are deterministic, the third component is determined by both the
shocks to the process and the memory (i.e., persistence) of the process

A time series is covariance-stationary if its first two moments do not change across time

Any time series that is covariance-stationary can be described by a linear processes

Page A44 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

While linear processes are very general, they are also not directly applicable to modeling

Two classes of models are used to approximate general linear processes:

 Autoregressions (AR)

 Moving averages (MAs)

The ability of a model to forecast a time series depends crucially on whether the past resembles the
future

Stationarity is a key concept that formalizes the structure of a time series and justifies the use of
historical data to build models

Covariance stationarity depends on the first two moments of a time series:

1. The mean

2. The autocovariances

White noise is the fundamental building block of any time-series model

White noise processes have three properties:

1. Mean zero

2. Constant and finite variance

3. No autocorrelation or autocovariance

Page A45 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

The lack of correlation is the essential characteristic of a white noise process and plays a key role in the
estimation of time-series model parameters

Dependent white noise relaxes the iid assumption while maintaining the three properties of white noise

Autoregressive models are the most widely applied time-series models in finance and economics

Page A46 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 2 Segment 11

/// Non-Stationary Time Series

Covariance-stationary time series have means, variances, and autocovariances that do not depend on
time

Any time series that is not covariance-stationary is non-stationary

This segment covers the three most pervasive sources of non-stationarity in financial and economic time
series:

 Time trends

 Seasonalities

 Unit roots (more commonly known as random walks)

Time trends are the simplest deviation from stationarity

Time trend models capture the propensity of many time series to grow over time

Seasonalities induce non-stationary behavior in time series by relating the mean of the process to the
month or quarter of the year

Page A47 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Seasonalities can be modeled in one of two ways:

1. Shifts in the mean that depend on the period of the year, or

2. An annual cycle where the value in the current period depends on the shock in the same period
in the previous year

Random walks (also called unit roots) are the most pervasive form of non-stationarity in financial and
economic time series

All non-stationary time series contain trends that may be deterministic or stochastic

For deterministic trends (e.g., time trends and deterministic seasonalities), knowledge of the period is
enough to measure, model, and forecast the trend

On the other hand, random walks are the most important example of a stochastic trend

 A time series that follows a random walk depends equally on all past shocks

The correct approach to modeling time series with trends depends on the source of the non-stationarity

 If a time series only contains deterministic trends, then directly capturing the deterministic
effects is the best method to model the data

Unit roots generalize random walks by adding short-run stationary dynamics to the long-run random
walk

Page A48 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 2 Segment 12

/// Measuring Returns, Volatility, and Correlation

Financial asset return volatilities are not constant, and how they change can have important implications
for risk management

Capturing the dependence among assets in a portfolio is also a crucial step in portfolio construction

In portfolios with many assets, the distribution of the portfolio return is predominantly determined by
the dependence between the assets held

 If the assets are weakly related, then the gains to diversification are large, and the chance of
experiencing an exceptionally large loss should be small

 If the assets are highly dependent, especially in their tails, then the probability of a large loss
may be surprisingly high

The volatility of a financial asset is usually measured by the standard deviation of its returns

Implied volatility is an alternative measure that is constructed using option prices

 Both put and call options have payouts that are nonlinear functions of the underlying price of an
asset

The most well-known expression for determining the price of an option is the Black-Scholes-Merton
model

Page A49 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

The Black-Scholes-Merton model relates the price of a call option to:

 the interest rate of a riskless asset

 the current asset price
 the strike price
 the time until maturity and
 the annual variance of the return

All values in the Black-Scholes-Merton model, including the call price, are observable except the
volatility

The Black-Scholes-Merton option pricing model uses several simplifying assumptions that are not
consistent with how markets actually operate

A normal distribution is symmetric and thin-tailed, and so has no skewness or excess kurtosis

 However, many return series are both skewed and fat-tailed

The Jarque-Bera (JB) test statistic is used to formally test whether sample skewness and kurtosis are
compatible with an assumption that the returns are normally distributed

An alternative method to understand the non-normality of financial returns is to study the tails

 Normal random variables have thin tails

The Student’s t is an example of a widely used distribution with a power law tail

Linear correlation is insufficient to capture dependence when assets have nonlinear dependence

Page A50 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Researchers often use two alternative dependence measures:

1. Rank correlation (also known as Spearman’s correlation) and

2. Kendal’s (tau)

 These statistics are correlation-like: both are scale invariant, have values that always lie between
-1 and 1,
 are zero when the returns are independent, and
 are positive (negative) when there is in increasing (decreasing) relationship between the
random variables

Rank correlation is the linear correlation estimator applied to the ranks of the observations

Rank correlation has two distinct advantages over linear correlation:

1. It is robust to outliers because only the ranks, not the values of X and Y, are used

2. It is invariant with respect to any monotonic increasing transformation of Xi and Yi

Linear correlation is only invariant with respect to increasing linear transformations

Page A51 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 2 Segment 13

/// Simulation and Bootstrapping

Simulation is an important practical tool in modern risk management with a wide variety of applications

Examples of these applications include:

 Computing the expected payoff of an option

 Measuring the downside risk in a portfolio

 Assessing estimator accuracy

Monte Carlo simulation is a simple approach to approximate the expected value of a random variable
using numerical methods

Another important application of simulated methods is boot-strapping

Bootstrapping uses observed data to simulate from the unknown distribution generating the observed
data

 This is done by combining observed data with simulated values to create a new sample that is
closely related to, but different from, the observed data

The key to understanding bootstrapping lies in one simple fact:

 The unknown distribution being sampled from is the same one that produced the observed data

The bootstrap method avoids the specification of a model and instead makes the key assumption that
the present resembles the past

Page A52 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Monte Carlo simulation and bootstrapping are closely related

 Both methods use computer-generated values to numerically approximate an expected value

The fundamental difference between simulation and bootstrapping is the source of the simulated data:

 When using simulation, the user specifies a complete data generating process (DGP) that is used
to produce the simulated data

 In bootstrapping, the observed data are used directly to generate the simulated data set
without specifying a complete DGP

Monte Carlo experiments allow the finite sample distribution of an estimator to be tabulated and
compared to its asymptotic distribution derived from the Central Limit Theorem (CLT)

Antithetic variates add a second set of random variables that are constructed to have a negative
correlation with the iid variables used in the simulation

 They are generated in pairs using a single uniform value

The biggest challenge when using simulation to approximate moments is the specification of the DGP

 If the DGP does not adequately describe the observed data, then the approximation of the
moment may be unreliable

While bootstrapping is a useful statistical technique, it has its limitations. There are two specific issues
that arise when using a bootstrap:

 First, bootstrapping uses the entire data set to generate a simulated sample

 The second limitation arises due to structural changes in markets so that the present is
significantly different from the past

Page A53 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Both Monte Carlo simulation and bootstrapping suffer from the “Black Swan” problem—simulations
generated using either method resemble the historical data

 Bootstrapping is especially sensitive to this issue, and a bootstrap sample cannot generate data
that did not occur in the sample

A good statistical model, on the other hand, should allow the possibility of future losses that are larger
than those that have been realized in the past

Page A54 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

3: Financial Markets and Products

FRM Level I Summary: Book 3 Segment 1

/// Banks

Commercial banking involves the traditional activities of receiving deposits and making loans

 These activities can be categorized as either retail or wholesale

Retail banking involves transacting with private individuals and small businesses

Wholesale banking involves transacting with large corporations

 Loans and deposits are much larger in wholesale banking than in retail banking

Investment banking involves a variety of activities such as:

 Raising debt or equity capital for companies

 Providing advice to companies on mergers, acquisitions, and financing decisions

 Acting as a broker–dealer for trading debt, equity, and other securities

A major activity of a bank’s investment banking arm is raising capital for companies in the form of debt,
equity, or more complicated securities (e.g., convertible debt)

 This process is referred to as underwriting

Page A55 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

The three major risks that banks face:

1. Market Risks

2. Credit Risks

3. Operational Risks

Market risks are the risks arising from a bank’s exposure to movements in market variables (e.g.,
exchange rates, interest rates, commodity prices, and equity prices)

Credit risk arises from the possibility that borrowers will fail to repay their debts

Operational risk is defined by bank regulators as: The risk of loss resulting from inadequate or failed
internal processes, people, and systems or from external events

It is important for banks to keep sufficient capital for the risks they are taking

 The most important capital is equity capital

When calculating regulatory capital, it is important to distinguish between the trading book and the
banking book

 The trading book consists of assets and liabilities that are held to trade

 The banking book consists of assets and liabilities that are expected to be held until maturity

Many of the problems experienced during the financial crisis were a result of a lack of liquidity, rather
than a shortage of capital

Page A56 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

The Basel Committee for Banking Supervision was established in 1974 to provide a forum where the
bank regulators from different countries could exchange ideas

As a result of the liquidity problems encountered during the crisis, the Basel Committee has (as part of
Basel III) developed two liquidity ratios to which banks are required to adhere:

 The Liquidity Coverage Ratio is a requirement designed to ensure that banks have sufficient
sources of funding to survive a 30-day period of acute stress

 The Net Stable Funding Ratio is a requirement that limits the size of mismatches between the
maturity of assets and the maturity of liabilities

Traditionally, banks have originated loans and kept them on their balance sheet

 An alternative to this is what has become known as the originate-to-distribute model

 Under this model, banks use their expertise to originate loans and then sell them (directly or
indirectly) to investors

Page A57 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 2

/// Insurance Companies and Pension Plans

Insurance provides protection against specific adverse events

 The company or individual obtaining protection is known as the policyholder

 Typically, the policyholder must make regular payments known as premiums

Most insurance contracts can be categorized as either life insurance or property and casualty insurance

There are similarities between pension plans and the contracts offered by life insurance companies

 In an employer-sponsored pension plan, it is typically the case that both the employee and the
employer make regular contributions to the plan

 The contributions are used to fund a lifetime pension for the employee following the
employee’s retirement

Pension plans are like annuity contracts in that they are designed to produce income for an individual
for the remainder of his or her life following retirement

There are two types of pension plans: defined contribution and defined benefit

 In a defined contribution plan, the funds are invested by the employer

 In a defined benefit plan, funds are also usually contributed by the employer and employee. In
this case, however, the contributions are pooled, and a formula is used to determine the
pension received by the employee on retirement

A defined benefit plan is much riskier for an employer than a defined contribution plan

Page A58 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

In a defined contribution plan, the company is merely acting as an agent investing the pension plan
contributions on behalf of its employees

When a company does not want to keep catastrophe risks, it can pay a reinsurance company to take
them on

 It can also use derivatives known as CAT (catastrophe) bonds

A CAT bond is a bond issued by an insurance company that pays a higher than normal rate of interest

Moral hazard is the risk that the behavior of the policyholder will change as a result of the insurance

Adverse selection is the risk that insurance will be purchased only by high-risk policy holders

Solvency II specifies a minimum capital requirement (MCR) and a solvency capital requirement (SCR)

 If capital falls below the SCR, an insurance company is required to formulate a plan to bring it
back up above the SCR level

 If it falls below the MCR level, the insurance company may be prevented from taking new
business

Page A59 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 3

/// Fund Management

Fund managers invest money on behalf of individuals and companies

Funds from different clients are pooled, and the fund managers choose investments in accordance with
stated investment goals and risk appetites

There are several advantages to this approach:

1. Fund managers may have more investment expertise

2. Transaction costs are usually lower for large trades

3. Smaller investors can achieve better diversification

Mutual funds (called unit trusts in some countries) have been a popular investment vehicle for small
investors

 There are two types of mutual funds: open-end and closed-end

 Open-end funds are by far the most popular and account for over 98% of mutual fund assets in
the U.S.

The key feature of open-end funds is that the number of shares (and the size of the fund) expand and
contract as investors choose to buy and sell shares

Open-end funds can be categorized as follows:

 Money market funds

 Bond funds, and
 Equity funds

Page A60 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Funds that invest in more than one type of security are referred to as hybrid funds (or multi-asset funds)

Closed-end funds are funds where the number of shares remains constant through time

 A closed-end fund is basically a regular company whose business is to invest in other companies

Whereas open-end funds are bought and sold at their NAV, share prices for closed-end funds are
typically lower than their NAV

Advantages of closed-end funds:

 Unlike open-end fund shares, shares of closed-end funds can be bought and sold at any time of
day; they can even be shorted

 Unlike open-end funds, closed-end funds do not need to keep enough liquid assets to handle
possible redemptions

 This is because closed-end fund investors trade with each other, whereas open-end fund
investors trade with the fund itself

Exchange-traded funds (ETFs) combine features of open-end mutual funds with features of closed-end
mutual funds

Hedge funds (a form of alternative investments) are subject to less regulation than mutual funds and
ETFs

 While mutual funds and ETFs cater to the needs of small investors, hedge funds usually accept
only large investments from wealthy private individuals or institutions

Page A61 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Differences between hedge funds and mutual funds/ETFs:

 A mutual fund or ETF allows investors to redeem their shares on any day. A hedge fund may
have a lock-up period during which time funds cannot be withdrawn

 The NAV of a mutual fund or ETF must be calculated and reported at least once a day. Hedge
funds have no such requirements, and their NAVs are reported much less frequently

 Mutual funds and ETFs must disclose their investment strategies. Hedge funds generally follow
proprietary strategies but do not disclose everything

 Mutual funds and ETFs may be restricted in their use of leverage. A hedge fund is only restricted
by the amount banks are willing to lend to it

 Hedge funds charge both an incentive fee as well as a management fee

Page A62 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 4

/// Introduction to Derivatives

Derivatives are contracts whose values depend on (or derive from) the values of one or more financial
variables (e.g., equity prices and interest rates)

 These variables are referred to as underlyings

Derivatives can be categorized into linear and non-linear products

 Linear derivatives provide a payoff that is linearly related to the value of the underlying asset

 Forward contracts are an example of linear derivatives

The value and payoff of a forward contract prior to maturity is linearly dependent on the value of the
underlying asset

Options, on the other hand, are non-linear derivatives

 Their payoff is a non-linear function of the value of their underlying asset

 They are contracts where the holder has the right (but not the obligation) to buy or sell an asset
for a specified price at a future time

Derivatives trade on exchanges as well as in over-the-counter markets

Advantages of over-the-counter (OTC) markets:

 The contracts traded do not have to be the standard contracts defined by exchanges

 Market participants can trade any contracts they like

Page A63 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

A forward contract is an over-the-counter contract where two parties agree to buy and sell an asset for
a predetermined price at a future time

Spot contracts are agreements to buy or sell an asset almost immediately

A futures contract provides a similar payoff to a forward contract, but it trades on an exchange

Options are derivatives that give the holder the right (but not the obligation) to buy or sell an asset at a
predetermined price in the future

 They trade on exchanges as well as in the over-the-counter market

There are three main categories of traders in derivatives markets:

1. Hedgers

2. Speculators

3. Arbitrageurs

 Hedgers use derivatives to reduce risk exposure

 Speculators use derivatives to take risks with a relatively small upfront payment

 Arbitrage involves taking advantage of inconsistent pricing across two or more markets

Page A64 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 5

/// Exchanges and OTC Markets

An exchange is an organization with members who trade with each other

Netting is a procedure where short positions and long positions in a particular contract offset each other

Exchanges operate what are known as central counterparties (CCPs) to clear all transactions between
members

An advantage of CCPs is that it is much easier for exchange members to close out positions

Once an exchange has decided to establish a CCP, it must find a way of managing the associated credit
risk. It can do this with a combination of the following:

 Netting

 Variation margin and daily settlement

 Initial margin

 Default fund contributions

“Shorting” a stock involves borrowing shares and selling them in the usual manner

 At some later date, the shares are repurchased and returned to the account from which they
were borrowed

Buying on margin refers to the practice of borrowing funds from a broker to buy shares or other assets

Page A65 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Special Purpose Vehicles (SPV) or Special Purpose Entities (SPE), are companies created by another
company in such a way that the credit risks are kept legally separate

 SPVs and SPEs are sometimes created to manage a large project without the organization
setting it up being put at risk

Page A66 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segments 6 – 7

/// Central Clearing

Central counterparties (CCPs) have been used for trading derivatives in exchange-traded markets for
many years

The rules developed by CCPs for members posting margin allow the exchanges to handle credit risks
efficiently

 As a result, failures of CCPs handling exchange-traded products have been rare

While exchange-traded futures contracts trade continuously, OTC contracts trade only intermittently

 As a result, OTC contracts are less liquid than exchange-traded contracts

CCPs clearing trades in the OTC markets operate in much the same way as CCPs clearing trades on
exchanges

 Members are required to post initial margin and variation margin as well as make contributions
to the default fund

Advantages of the central clearing model:

 It is much easier for market participants to exit a CCP transaction

 They manage the margining, netting, settlement, and default resolution that would typically be
handled by each market participant in the case of bilateral clearing

 They can also improve liquidity in the OTC market by making it much easier for market
participants to net and exit from transactions

 They are much simpler organizations than banks and are therefore much easier to regulate

Page A67 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

A disadvantage of CCPs is that they tend to increase the severity of adverse economic events

 That is, they are pro-cyclical

Very few futures contracts lead to the delivery of an underlying asset

 This is because traders prefer to close out contracts before the delivery period

Forward vs. Futures

Forward and futures contracts are similar in that both are agreements to buy or sell an asset in the
future. However, there are key differences:

 Most forward contracts are on foreign exchange or interest rates

 In contrast, futures contracts are on a wide range of financial and non-financial assets

 A futures contract is traded on an exchange but a forward contract is an over-the-counter

product

 A forward contract is subject to more credit risk

 A futures contract is settled daily but a forward contract is settled at the end of its life

 Closing out a forward is not as easy as it is for a futures contract

 A company with a forward contract must approach its counterparty and negotiate a close out

 Forward contracts usually specify a single delivery date. In contrast, futures contracts specify a
period (sometimes a month)

 Because futures contracts are traded on an exchange, they are standardized financial products

 Forward contracts have the advantage in that the delivery date can be chosen to meet the
precise needs of the client

Page A68 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 8

/// Using Futures for Hedging

Like other derivatives, futures can be used for either speculation or hedging

A position in a futures contract can reduce exposure to exchange rates, interest rates, equity indices, or
commodity prices

Eliminating all risk exposures using futures is usually impossible

 It is therefore important to develop a way of calculating an optimal hedge

 An optimal hedge is a hedge that reduces risk as much as possible

A short futures position is appropriate in the following situations:

 A company owns a certain quantity of an asset and knows that it will sell it at a certain time in
the future

 A company knows that it will receive a certain quantity of an asset in the future and plans to sell
it

A long hedge is the opposite of a short hedge

 It can be used when a company knows it will have to buy a certain asset quantity in the future

Basis risk is the risk associated with the basis at the time a hedge is closed

Basis risk arises from the difference between the spot price of the hedged asset and the futures price for
the contract used for hedging at the time the hedge is closed out

Page A69 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

The beta of a portfolio is the sensitivity of its return to the return of the market portfolio

 If a portfolio has a beta of 1.0, it mirrors what the market does

 If the portfolio has a beta of 0.5, it is half as volatile as the market

 When the beta is 2.0, it is twice as volatile as the market

Hedging using stock index futures is quite popular

 Stock index futures are a way of reducing or increasing an investor’s exposure to the market for
a period of time

Page A70 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 9

/// Foreign Exchange Markets

The foreign exchange market (Forex, FX, or currency market) is the market where participants exchange
one currency for another

Note the following:

 Spot trades - where there is an agreement for the immediate or almost immediate exchange of
currencies

 Forward trades - where there is an agreement to exchange currencies at a future time

The Forex market attracts both hedgers and speculators

In terms of notional trading volume, the foreign exchange market is by far the largest market in the
world

The most common exchange rate quotes are between USD and another currency

Spot exchange rates are typically quoted with four decimal places

The bid-ask spread in large trade amounts of a currency is typically quite small

Page A71 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

A forward foreign exchange transaction, where two parties agree on an exchange at some future date, is
termed an out-right transaction or a forward outright transaction

 It can be contrasted with an FX swap transaction, where currency is exchanged on two different
dates

Typically, an FX swap involves a foreign currency being bought (sold) in the spot market and then sold
(bought) in the forward market

An FX swap is a way of funding an asset denominated in a foreign currency by paying interest in the
domestic currency

Transaction risk is the risk related to receivables and payables

Translation risk arises from assets and liabilities denominated in a foreign currency

Economic risk is the risk that a company’s future cash flows will be affected by exchange rate
movements

Distinguishing between nominal interest rates and real interest rates:

 Nominal interest rates are usually quoted in the market and indicate the return that will be
earned on a currency

 Real interest rates are adjusted for inflation

There is a no-arbitrage relationship between forward exchange rates and spot exchange rates that
involves interest rates

Page A72 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 10

/// Pricing Financial Forwards and Futures

A financial asset is an asset whose value derives from a claim of some sort

An investment asset is an asset held by market participants for investment purposes

All financial assets (and a small number of non-financial assets) are investment assets

Non-investment assets are sometimes referred to as consumption assets

In theory futures prices and forward prices for contracts with the same maturity on the same asset
should be approximately equal

Both of the following trading strategies can be categorized as index arbitrage

 If an index futures price is greater than its theoretical value, an arbitrageur can buy the portfolio
of stocks underlying the index and sell the futures

 If the futures price is less than the theoretical price, the arbitrageur can short the stocks
underlying the index and take a long futures position

The no-arbitrage forward/futures price of a financial asset can be computed from risk-free interest rates
and the income generated by the asset

Page A73 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 11

/// Commodity Forwards and Futures

Most commodities are consumption assets

 This means that they are rarely held for purely investment reasons
 Metals such as gold and silver are exceptions

Commodity owners usually intend to use the commodity in some way, after which it ceases to be
available for sale

There are several important differences between commodities and financial assets. Some differences in
particular are as follows:

 The storage costs associated with financial assets (e.g., stocks and bonds) are negligible

 The storage costs for commodities can be quite substantial (e.g. insurance cost)

 Commodities can be costly to transport and thus their prices can depend on their location

 By contrast, financial assets are usually transported electronically at virtually no cost

 A commodity held for investment purposes (e.g., gold or silver) can be borrowed for shorting

 A financial asset provides investors with an expected financial return that reflects its risk. Most
commodities do not have this property

 The prices of most commodities are mean reverting. This means it tends to get pulled back
toward some central value, even in the face of volatility

Agricultural commodities with futures contracts include products that are grown (e.g., corn, wheat and
sugar) as well as livestock (e.g., cattle and hogs)

 It is expensive to store agricultural commodities

Page A74 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Commodity metals include gold, silver, platinum, palladium, copper, tin, lead, zinc, nickel, and aluminum

 Their storage costs are typically lower than those of agricultural products

Energy products are another important category of commodities. There are futures contracts on crude
oil and crude oil extracts (e.g., petroleum and heating oil)

 Futures also trade on natural gas and electricity

Derivative contracts on weather are available in both the exchange-traded and over-the-counter
markets

 The most popular contracts are those with payoffs contingent on temperature (which are used
by energy companies as hedges)

Some precious metals are held for investment purposes

 Gold and silver are in this category

The lease rate for an investment commodity is the interest rate charged to borrow the underlying asset

The cost of carry for an asset reflects the impact of:

 Storage costs

 Financing costs

 Income earned on the asset

Page A75 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 12

/// Options Markets

A European call (or put) option gives the buyer the right to buy (or sell) an asset at a certain price on a
specific date

An American call (or put) option gives the buyer the right to buy (or sell) an asset at a certain price at
any time before and during the specified date

The date specified in the option is known as the expiration date (or maturity date)

Most (not all) exchange-traded options are American

 By contrast, many of the options traded in the over-the-counter market are European

The price at which an asset can be bought or sold using an option is referred to as the strike price (or
exercise price)

American options are more difficult to analyze than European options because they can be exercised at
any time before maturity

European options can be valued using the Black-Scholes Merton model

American options can only be valued by using numerical procedures such as binomial trees

Cash dividends usually do not affect the terms of a stock option

Page A76 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 13

/// Properties of Options

The price of stock option can depend on:

 The price of the underlying stock

 The strike price

 The risk-free rate

 The volatility of the stock price

 The time to maturity

 The dividends to be paid during the life of the option

Many exchanged-traded options (including options on individual stocks) are American

Put-call parity describes the relationship between the price of a European call option and that of a
European put option with the same strike price and time to maturity

Page A77 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 14

/// Trading Strategies

Options can be arranged to form a wide spectrum of payoff patterns

 In theory, an investor with access to European options with all strike prices for a given maturity
could achieve any continuous payoff function of the underlying asset price at expiry

The option trading strategies considered in this segment can be divided into four groups:

1. Strategies involving an option and the underlying asset

2. Strategies involving two or more call options

3. Strategies involving two or more put options

4. Strategies involving both call and put options

Strategies involving only call options or only put options are termed spreads

Strategies involving both call and put options are termed combinations

The put-call parity describes the relationship between the price of a European put option and that of a
European call option with the same strike price and time to maturity

A principal protected note (PPN) is a security created from a single option such that the investor benefits
from any gain in the value of a specified portfolio without the risk of losses

Page A78 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

A package is a portfolio consisting of plain vanilla options on an asset

 Examples of packages include: bull spreads, bear spreads, butterfly spreads, calendar spreads,
straddles, and strangles

Packages are sometimes regarded as exotic options

 This, as they are positions built to reflect a specific market view and risk tolerance

A bull spread is a position appropriate for an investor expecting an increase in the price of an asset

A bear spread is a position where the trader buys a European put option with strike price K2 and sells a
European put option with strike price K1

Like a bull spread, a bear spread has a small probability of attaining a large return if both options begin
out-of-the-money and a high probability of attaining a modest return if both options begin in-the-money

A box spread is a portfolio created from a bull spread (using call options) and a bear spread (using put
options)

 The strike prices and times to maturity used for the bull spread are the same as those used for
the bear spread

A butterfly spread involves positions in three options

 It can be created from either call or put options

A straddle is a position created from a long call and a long put with the same strike price and time to
maturity

 The strike price is usually close to the current asset price

Page A79 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

The cost of a straddle can be reduced by making the strike price of the call greater than the strike price
of the put

 The position is then called a strangle

A diagonal spread is created from a long call (or put) and a short call (or put) where both the strike
prices and the times to maturity are different

 It can be considered as a cross between a bull/bear spread and a calendar spread

A strip is like a straddle except that two puts are purchased for every call

 It is appropriate when a trader anticipates a big move in the asset price and a downward
movement is considered more likely than an upward movement

A strap is like a straddle except that two calls are purchased for every put

 It is appropriate when a trader anticipates a big move in the asset price and an upward
movement is considered more likely than a downward movement

Page A80 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 15

/// Exotic Options

Standard European and American options which usually trade on exchanges are termed plain vanilla
options

Options with non-standard properties are termed exotic options

Exotic options are designed by derivatives dealers to meet the specific needs of their clients and are
usually traded in the over-the-counter markets

Exotic options can be very profitable for derivatives dealers because they have relatively large bid-offer
spreads

Recall: A package is a portfolio consisting of plain vanilla options on an asset

 Examples of packages include: bull spreads, bear spreads, butterfly spreads, calendar spreads,
straddles, and strangles

Packages are sometimes regarded as exotic options because they are positions built to reflect a specific
market view and risk tolerance

Any derivative product can be converted into a zero-cost product by arranging for it to be paid for in
arrears

Exchange-traded American options can be exercised at any time at the pre-determined fixed strike price

Page A81 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

A forward start option is an option that will begin at a future time

 It is usually stated that the option will be at-the-money at the time it starts

A gap option is a European call or put option where the price triggering a payoff is different from the
price used in calculating the payoff

A cliquet option is a series of forward start options with certain rules for determining the strike prices

With a chooser option, the holder has a period of time (after purchasing the option) where he or she can
choose whether it is a put option or a call option

There are four types of binary options:

1. Cash-or-nothing call

2. Cash-or-nothing put

3. Asset-or-nothing call

4. Asset-or-nothing put:

Traditional European options can be thought of as combinations of binary options

Page A82 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

A long position in a European call option is a combination of:

 A long position in an asset-or-nothing call, and

 A short position in a cash-or-nothing call with a payoff equal to the strike price

Similarly, a long position in a European put option is:

 A short position in an asset-or-nothing put, and

 A long position in a cash-or-nothing put with a payoff equal to the strike price

Cash-or-nothing options are sometimes referred to as digital options

Asian options provide a payoff dependent on an arithmetic average of the underlying asset price during
the life of the option

The payoff from a lookback option depends on the maximum or minimum asset price reached during
the life of the option.

Barrier options have payoffs that depend on whether the asset price reaches a particular barrier

A compound option is an option on another option

 Thus, there are two strike prices and two maturity dates

In an asset-exchange option, the holder has the right to exchange one asset for another

Page A83 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

A basket option is an option on a portfolio of assets

 These portfolios can contain assets such as stocks, stock indices, and currencies

A volatility swap is a forward contract on the realized volatility of an asset during a certain period

The payoff from a variance swap is calculated analogously to the payoff from a volatility swap

 The variance rate for an asset is the square of its volatility

Page A84 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 16

/// Properties of Interest Rates

The interest rate term structure describes how interest rates vary depending on their maturity

In an upward-sloping term structure, long-term interest rates are higher than short-term interest rates

A major factor in determining an interest rate is the risk that the borrower will default and not repay the
lender in full

 This risk is called credit risk

As credit risk increases, the interest rate required by the lender from the borrower also increases

Another factor in determining interest rates is liquidity

 In this context, liquidity refers to the ease with which an interest-bearing instrument can be sold
from one investor to another at a competitive price

The London Interbank Offered Rate (Libor) has historically been an important reference rate in financial
markets

 Libor interest rates are compiled from the estimated unsecured borrowing costs of 18 highly
rated global banks

Page A85 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

In a repo agreement, securities are sold by Party A to Party B for a certain price with the intention of
being repurchased at a later time at higher price

The risk-free rates used to value derivatives are determined from overnight interbank rates using
overnight indexed swaps

 Treasury rates are not used because they are considered to be artificially low

The valuation of a bond involves identifying its cash flows and discounting them at the interest rates
corresponding to their maturities

The return earned by an investor on a bond is often described by what is termed the bond yield

 This is the discount rate that equates the present value of all the cash flows to the market price

The par yield of a bond is the coupon rate that would cause the value of the bond to equal its par value

Yield duration measures the sensitivity of a bond’s price to a change in its yield

Forward rates are the future interest rates implied by today’s zero-coupon interest rates

A forward rate agreement (FRA) can be thought of as an agreement to apply a certain interest rate to a
certain principal for a certain period in the future

Page A86 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 17

/// Corporate Bonds

A bond is a debt instrument sold by the bond issuer (the borrower) to bondholders (the lenders)

 The bond issuer agrees to make payments of interest and principal to bondholders

 The principal of a bond (also called its face value or par value) is the amount the issuer has
promised to repay at maturity

 Bonds perceived to be riskier than others available require higher interest rates to attract
investors

 The interest rate on a bond is termed the coupon rate. In the U.S., coupons are usually paid
every six months

The face value of a bond in the U.S. is usually USD 1,000 and bond prices are typically quoted per USD
100 of principal

Corporate bond issuances are typically arrangement by investment banks

The issuing corporation can choose between a private placement and a public issue

 In a private placement, bonds are placed with a small number of large institutions (e.g., pension
funds)

Page A87 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

A private placement has several advantages to the issuer:

 There are fewer registration requirements

 Rating agencies are not involved because they don’t usually rate non-public issuances

 The issuance cost is lower

 The issuance can be completed quickly

 The issuance can be relatively small

Interest rates for private placement bonds are generally higher than those for equivalent publicly issued
bonds

 The issuer must therefore weigh the benefits of private placement against the payment of a
higher interest rate

Bonds issued via private placements are often not traded

 Instead, they are typically held by the original purchasers until maturity

A bond indenture is a legal contract between a bond issuer and the bondholder(s) defining the
important features of a bond issue. These features include:

 The maturity date

 The amount and timing of interest payments
 Callable and convertible features (if any)
 The rights of bondholders in the event of contract violations

Page A88 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Ratings agencies such as Moody’s, S&P, and Fitch provide opinions on the creditworthiness of bond
issuers

Bonds rated above a certain threshold are referred to as investment grade

 Bonds below this threshold are given various names: high-yield, non-investment grade,
speculative grade, or simply junk

Two important statistics published by rating agencies are:

1. The default rate

2. The recovery rate

Page A89 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 18

/// Mortgages and Mortgage-Backed Securities

Mortgages are used to finance residential and commercial property

Mortgage-backed securities (MBSs) are investments created from the cash flows provided by portfolios
of mortgages

Variable-rate mortgages are termed adjustable-rate mortgages (ARMs)

In an ARM, the interest rate is typically fixed for several years and is then tied to an interest rate index

ARMs are less risky than fixed-rate mortgages for lenders and riskier than fixed-rate mortgages for
borrowers

 For this reason, ARMs typically have lower initial interest rates than comparable fixed-rate
mortgages

An interesting aspect of fixed-rate mortgages in the U.S. is that borrowers have an American-style
option to pay off their outstanding mortgage balances

 This is referred to as the borrower’s prepayment option.

An amortization table shows the monthly principal and interest payments on a mortgage

Page A90 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Mortgage portfolios (or mortgage pools) can be created for investment purposes

The mortgages in a pool are usually similar in terms of loan type, interest rate, and origination date

The weighted-average coupon (WAC) is the weighted-average interest rate on the mortgages in the pool

 With the weight assigned to each mortgage being proportional to its outstanding principal

Pass-throughs are characterized by:

1. Their issuers

2. Their coupons

3. Their maturities

A trade known as a dollar roll involves selling a TBA for one settlement month and buying a similar TBA
for the following settlement month

Refinancing arises when a borrower prepays a mortgage in order to refinance the underlying property

 The most likely reason for this is a decline in interest rates

Curtailments are partial prepayments

 These tend to occur when loans are relatively old and balances are relatively low

Turnover prepayments arise when a borrower sells the property in question

Page A91 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

The option-adjusted spread (OAS) is the excess of the expected return provided by a fixed-income
instrument over the risk-free return adjusted to account for embedded options

Page A92 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 19

/// Interest Rate Futures

The bonds issued by the U.S. government with original maturities of ten years or less are referred to as
Treasury notes

 Bonds with longer maturities are referred to as Treasury bonds

 However, Treasury notes and bonds are collectively referred to as bonds

Eurodollar futures contracts provide payoffs dependent on movements in short-term interest rates

Treasury note and bond futures contracts provide payoffs dependent on movements in longer-term
rates

Final settlement for Eurodollar futures contracts is in cash and happens on the Monday before the third
Wednesday of the delivery month

 The payout equals USD 100 minus the Libor fixing on that day

In contrast, Treasury note/bond futures are settled by delivering a particular bond/note

 The party with the short position can choose which bond/note to deliver and decide when the
delivery will take place

Page A93 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 3 Segment 20

/// Swaps

Swaps are over-the-counter (OTC) derivatives contracts where the parties agree to exchange certain
cash flows in the future

 These exchanges of cash flows depend in part on the future values of variables such as interest
rates, exchange rates, equity prices, and commodity prices

 As a result, there is always some uncertainty associated with swaps

Forward contracts can be treated as swaps where there will be a cash-flow exchange on just one future
date

 However, swaps often feature exchanges on many future dates

While the value of a swap is normally zero (or very close to zero) when it is initiated, the value of each
exchange made in the swap is typically not zero

 It is usually the case that some exchanges have positive values while others have negative values
at the time the swap is initiated

The most common interest rate swap involves Libor being exchanged for a pre-determined fixed rate for
several years

Interest rate swaps are popular products because they can be used to transform assets and liabilities

 That is, a company with a floating-rate loan can use a swap to convert it to a fixed-rate liability

Page A94 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Swaps where Libor is exchanged for a fixed interest rate can be used to estimate Libor forward rates

 The procedure used is a bootstrap method where progressively longer maturity swaps are
considered

Swaps exchanges can be defined in many ways

An equity swap is a swap where a fixed return is exchanged for the return generated when the notional
principal is invested in pre-specified equity

Swaps have the potential to give rise to credit risk

Page A95 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

4: Valuation and Risk Models

FRM Level I Summary: Book 4 Segment 1

/// Measures of Financial Risk

Consider the two risk measures: value-at-risk (VaR) and expected shortfall (ES)

The mean and standard deviation of a portfolio’s return can be calculated using the means and standard
deviations of its components’ returns

 This leads to an important concept known as the efficient frontier

 The efficient frontier shows the trade-offs between mean and standard deviation that are
available to the holder of a well-diversified portfolio

When portfolios are described by the mean and standard deviation of their returns, it is natural to
assume we are dealing with normal distributions

Most financial variables have fatter tails than the normal distribution

 In other words, extreme events are more likely to occur than the normal distribution would
predict

Value-at-risk (VaR) and expected shortfall are two risk measures focusing on adverse events

Expected shortfall is less intuitive than VaR

 However, Expected shortfall has more desirable theoretical properties

 Expected shortfall is also an example of a coherent risk measure

Page A96 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Investors are typically faced with a trade-off between risk and return

 The greater the risks that are taken, the higher the expected return that can be achieved

Expected return does not describe the return that we expect to happen

 The term is actually used by statisticians to describe the average (or mean) return

The normal (or Gaussian) distribution is one of the most well-known and widely used probability
distributions

The normal (or Gaussian) distribution has two parameters

1. The mean and

2. The standard deviation

Value at Risk, VaR, is an important risk measure that focuses on adverse events and their probability

The VaR for an investment opportunity is a function of two parameters:

1. The time horizon, and

2. The confidence level

One problem with VaR is that it does not say how bad losses might be when they exceed the VaR level

 Expected shortfall is one way of overcoming this disadvantage

 Expected shortfall is defined as the expected (or average) loss conditional on the loss being
greater than the VaR level

Page A97 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

A risk measure that satisfies all four conditions below is termed coherent:

1. Monotonicity: If a portfolio always produces a worse result than another portfolio, it should
have a higher risk measure

2. Translation Invariance: If an amount of cash K is added to a portfolio, its risk measure should
decrease by K

3. Homogeneity: Changing the size of a portfolio by multiplying the amounts of all the components
by λ results in the risk measure being multiplied by λ

4. Subadditivity: For any two portfolios, A and B, the risk measure for the portfolio formed by
merging A and B should be no greater than the sum of the risk measures for portfolios A and B

As a risk measure, Standard Deviation is a good way of describing the overall uncertainty associated with
a set of outcomes

Page A98 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 2

/// Calculating and Applying VaR

Previously we looked at two risk measures: value-at-risk (VaR) and expected shortfall (ES). This segment
discusses how they can be calculated:

 One popular approach is a non-parametric method, where the future behavior of the underlying
market variables is determined in a very direct way from their past behavior

 This method is known as historical simulation

If we assume the returns on the underlying variables are multivariate normal, then:

1. Changes in portfolio value are also normally distributed

2. Calculating VaR will then be relatively straightforward

 This approach is sometimes referred to as the delta-normal model

For a portfolio that is not linearly dependent on the underlying market variables (e.g., because it
contains options), the delta-normal model can also be used

 However, it is less accurate in this context

The delta-normal model works well for linear portfolios when the risk factor probability distributions are
at least approximately normal

An alternative to historical simulation and the delta-normal model is provided by Monte Carlo
simulations

 These are like historical simulation, but their scenarios are randomly generated (rather than
being determined directly from the behavior of market variables in the past)

Page A99 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Monte Carlo simulations generate scenarios by taking random samples from the distributions assumed
for the risk factors

Historical simulation is a popular method of calculating VaR and ES

 Typically, the time horizon is chosen as one day

Historical simulation involves identifying the market variables on which the value of the portfolio under
consideration depends

In practice, risk factors are divided into two categories:

1. Those where the percentage change in the past is used to define a percentage change in the
future, and

2. Those where the actual change in the past is used to define an actual change in the future

Standard deviations increase during stressed market conditions

 It is also true that correlations generally increase during this period

Page A100 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 3

/// Measuring and Monitoring Volatility

The volatility of a variable measures the extent to which its value changes through time

A constant volatility would be fairly easy to estimate using historical data

 In practice, however, volatility changes through time

 This leads to situations where asset returns are not normally distributed; instead, they tend
to have fatter tails than a normal distribution would predict

 This is important for the estimation of risk measures (such as VaR and expected shortfall)
because these measures depend critically on the tails of asset return distributions

An alternative to assuming asset returns are constantly normal is to assume they are normal
conditioned on the volatility being known

 When volatility is high, the daily return is normal with a high standard deviation

 When the volatility is low, the daily return is normal with a low standard deviation

The conditionally normal model may not be perfect, but it is an improvement over the constant volatility
model

To implement the conditionally normal model, it is necessary to monitor volatility so that a current
volatility estimate is produced. We consider two ways of doing that:

1. The exponentially weighted moving average (EWMA) model and

2. The GARCH (1,1) model

Page A101 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

There are three ways in which an asset’s return can deviate from normality:

1. The return distribution can have fatter tails than a normal distribution

2. The return distribution can be non-symmetrical

3. The return distribution can be unstable with parameters that vary through time

The standard error of an estimate is the standard deviation of the difference between the estimate and
the true value

The standard error of a volatility estimate calculated from m observations is approximately equal to the
estimate divided by the square root of 2(m - 1)

One way of overcoming problems with estimating volatility is to use exponential smoothing

 This is also referred to as the exponentially weighted moving average (EWMA)

In EWMA, the weights applied to historical data decline exponentially as we move back in time

 An alternative method is the multivariate density estimation (MDE)

The GARCH model, developed by Robert Engel and Tim Bollerslev, can be regarded as an extension of
EWMA

Page A102 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Implied volatility is the volatility implied from options prices

 It is a forward-looking estimate of volatility

 It is often found to be more accurate than an estimate produced from historical data

 As volatilities increase, the value of the option increases

The correlation between two variables is their covariance divided by the product of their standard
deviations

Page A103 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 4

/// External and Internal Credit Ratings

Rating agencies are an important external source of credit risk data

The most well-known credit rating agencies are:

1. Moody’s

2. Standard and Poor’s (S&P)

3. Fitch

The Dodd-Frank Act now requires rating agencies to make the assumptions and methodologies
underlying their ratings more transparent

 It has also increased the potential legal liability of rating agencies

An external credit rating is usually an attribute of an instrument issued by an entity (rather than of the
entity itself)

However, bond ratings are often assumed to be attributes of the entity rather than of the bond itself

The highest bond rating assigned by Moody’s is Aaa

 Bonds with this rating are considered to have almost no chance of defaulting
 The next highest rating is Aa

Rating agencies rate publicly traded bonds and money market instruments

Page A104 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

In addition to the ratings themselves, rating agencies provide what are termed outlooks

Outlooks are indications of the most likely direction of the rating over the medium term

 A positive outlook means that a rating may be raised

 A negative outlook means that it may be lowered

 A stable outlook means it is not likely to change

Banks and other financial institutions develop their own internal rating systems based on their
assessment of potential borrowers

Banks and other financial institutions typically base their ratings on several factors:

 Financial ratios

 Cash flow projections

 An assessment of the firm’s management

 etc

Page A105 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 5

/// Country Risk

Many large firms have business interests all over the world

For such global entities, it is important to assess the risks associated with the foreign countries they
operate in:

 These risks are collectively referred to as country risk

There are numerous components of country risk

 One such component is political risk

Individuals and corporations can obtain diversification benefits by investing outside their domestic
markets

When lending to foreign governments, it is important for lenders to consider country risk as part of their
credit default risk framework

Many developing markets have economies that are growing faster than those of developed markets

 However, this fast growth may be accompanied by higher economic risks and less stable political
climates

There are often links between political and economic risks

Page A106 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

The growth of a country’s economy is measured its Gross Domestic Product (GDP)

GDP is the total value of goods and services produced by all the people and firms in a country

An important consideration in assessing country risk is how a country will react to economic cycles

 During economic down-turns, developing countries often see larger declines in GDP than their
developed counterparts

 This is because developing economies tend to rely more heavily on commodities

Some countries are highly dependent on a single commodity

 If the price of that commodity declines, the country and the value of its currency will suffer

 Many African and Latin American countries fall into this category

Legal risk is the risk of losses due to inadequacies or biases in a country’s legal system

 A legal system that is trusted and perceived to be fair helps a country to attract foreign
investment

One measure of a country’s risk is the risk it will default on its debt

There are two types of sovereign debt:

1. The type issued in a foreign currency (such as the USD)

2. The type issued in the country’s own currency

Page A107 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Debt issued in a foreign currency is attractive to global banks and other international lenders

 The risk for the issuing country is that it cannot repay the debt by simply printing more money

There are several other factors that are considered when determining a rating

 Social Security Commitments

 The Tax Base

 Political Risk

 Implicit Guarantees

The credit spread for sovereign debt in a specific currency is the excess interest paid over the risk-free
rate in that currency

 There is a strong correlation between credit spreads and ratings

 Credit spreads can provide extra information on the ability of a country to repay its debt

Page A108 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 6

/// Measuring Credit Risk

Economic capital is a bank’s own estimate of the capital it requires

Regulatory capital is the capital bank regulators (also known as bank supervisors) require a bank to keep

Global bank regulatory requirements are determined by the Basel Committee on Banking Supervision in
Switzerland

The three different models for quantifying credit risk in this segment:

 The first is a model where the mean and standard deviation of the loss from a loan portfolio is
determined from the properties of the individual loans

 The second model, known as the Vasicek model, is used by bank regulators to estimate an
extreme percentile of the loss distribution

 The third model is known as CreditMetrics and is often used by banks themselves when
estimating economic capital

Typically, CreditMetrics involves time-consuming Monte Carlo simulations

A bank must keep capital for the risks it takes

 When losses are incurred, they come out of the equity capital

Page A109 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Equity capital is sometimes referred to as “going concern capital” since as it is positive, the bank is
solvent and can therefore be characterized as a going concern

Debt capital is referred to as “gone concern capital” since it only becomes an important cushion for
depositors when the bank is no longer a going concern (i.e., insolvent)

Banks are subject to many risks

 Credit risk has traditionally been the most important risk taken by banks

 Each loan issued by a bank has some risk of default and therefore a risk of a credit loss

 It is the possibility of this loss that constitutes credit risk

In 1974, the central banks of the G10 countries formed the Basel Committee to harmonize global bank
regulation

 By 1988, the committee had agreed on a common approach for determining the required credit
risk capital for the banks under their supervision

o This regulation is now known as Basel I

Both regulatory capital and economic capital feature separate capital calculations for credit risk, market
risk, and operational risk

 For regulatory capital, the results are added to give the total capital requirements

 For economic capital, however, correlations between the risks are often considered

The Vasicek model is used by regulators to determine capital for loan portfolios

 It uses the Gaussian copula model to define the correlation between defaults

 The Vasicek model has an advantage in that the unexpected loss can be determined analytically

Page A110 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

CreditMetrics is the model banks often use to determine economic capital

 Under this model, each borrower is assigned an external or internal credit rating

 A one-year transition table is used to define how ratings change

Page A111 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 7

/// Operational Risk

Operational risk is sometimes defined very broadly as any risk that is not a market risk or a credit risk

A much narrower definition would be that it consists of risks arising from operational mistakes;

 This would include the risk that a bank transaction is processed incorrectly

 But it would not include the risk of fraud, cyberattacks, or damage to physical assets

Operational risk has been defined by the Basel Committee as:

 The risk of loss resulting from inadequate or failed internal processes, people, and systems or
from external events

Seven categories of operational risk have been identified by the Basel Committee

1. Internal fraud

2. External fraud

3. Employment practices and work place safety

4. Clients, products, and business practices

5. Damage to physical assets

6. Business disruption and system failures

7. Execution, delivery, and process management

Page A112 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Compliance risk is another operational risk facing financial institutions

 This is the risk that an organization will incur fines or other penalties because it knowingly or
unknowingly fails to act in accordance with industry laws and regulations, internal policies, or
prescribed best practices

o This includes activities such as money laundering, terrorism financing, and assisting
clients with tax evasion

Rogue trader risk is the risk that an employee will take unauthorized actions resulting in large losses

 One of the most notorious incidents involved Barings Bank trader Nick Leeson

The final Basel II rules for banks had three approaches:

1. The basic indicator approach

2. The standardized approach

3. The advanced measurement approach (AMA)

The key determinants of an operational risk loss distribution are:

 Average Loss frequency: the average number of times in a year that large losses occur, and

 Loss severity: the probability distribution of the size of each loss

Page A113 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 8

/// Stress Testing

Stress testing is a risk management activity that has become increasingly important since the 2007–2008
financial crisis:

 It involves evaluating the implications of extreme scenarios that are unlikely and yet plausible

 It asks if a financial institution has enough capital / liquid assets to survive various scenarios

 Some stress tests are carried out because they are required by regulators

 Others are carried out as part of their internal risk management activities

Measures such as value-at-risk (VaR) and expected shortfall (ES) are often calculated and used in stress
testing analysis

 One disadvantage of VaR and ES is that they are usually backward-looking

o They assume the future will (in some sense) be like the past

 Stress testing, however, is designed to be forward-looking

Using stress tests to derive the full range of all possible outcomes is not usually possible

Risk managers have two types of analyses available to them:

 One is a backward-looking analysis where a loss distribution can be estimated

 The other is a forward-looking analysis where different scenarios are assessed

Page A114 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

In the case of market risk, the VaR/ES approach often has a short time horizon (perhaps only one day),
whereas stress testing usually looks at a much longer period

The first step in choosing a stress-test scenario is to select a time horizon

 The time horizon should be long enough for the full impact of the scenarios to be evaluated

 Scenarios lasting three months to two years are more common

 Very long scenarios can be necessary in some situations

Stress testing involves constructing scenarios and then evaluating their consequences

 Reverse stress testing takes the opposite approach: It asks the question, “What combination of
circumstances could lead to the failure of the financial institution?”

A financial institution should have written policies and procedures for stress testing and ensure that
they are adhered to

Page A115 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 9

/// Pricing Conventions, Discounting, and Arbitrage

Discount factors are numbers that allow us to relate a cash flow received in the future to its value today

Treasury bills are instruments issued by a government to finance its short-term funding needs. They last
one year or less and are defined by:

 Their face value (or principal amount or par value), and

 Their maturity date

While a Treasury bill lasts less than one year from the time it is issued, a Treasury bond lasts more than
one year

 Bonds with a maturity between one and ten years are sometimes referred to as Treasury notes

 To keep the terminology simple many refer to all coupon-bearing Treasury instruments as
Treasury bonds

U.S. Treasury bonds are defined by:

 The face value (or principal amount or par value)

 The coupon rate

 The maturity date

The law of one price states that if two portfolios provide the same future cash flows, they should sell for
the same price.

 If the law of one price did not hold, there would be theoretical arbitrage opportunities

Page A116 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

STRIPS is an acronym for Separate Trading of Registered Interest and Principal of Securities

 STRIPS are created by investment dealers when a coupon-bearing bond is delivered to the
Treasury and exchanged for its principal and coupon components

Day-count conventions describe the way in which interest is earned through time

Page A117 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 10

/// Interest Rates

Investors and traders prefer to express the time value of money in terms of interest rates rather than
discount factors

To understand an interest rate:

 We need to understand the compounding frequency used to measure it

 We also need to understand the different types of interest rates

To fully describe an interest rate, we need to specify the compounding frequency with which it is
measured

The compounding frequency used for an interest rate is often the same as the frequency of payments,
but this is not always the case

The spot rate is the interest rate earned when cash is received at just one future time

 It is also referred to as the zero-coupon interest rate, or just the “zero”

Forward rates are the future spot rates implied by today’s spot rates.

Page A118 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

Key properties of rates so far are as follows:

 If the term structure is flat (with all spot rates the same), all par rates and all forward rates equal
the spot rate

 If the term structure is upward-sloping, the par rate for a certain maturity is below the spot rate
for that maturity

 If the term structure is downward-sloping, the par rate for a certain maturity is above the spot
rate for that maturity

 If the term structure is upward-sloping, forward rates for a period starting at time T are greater
than the spot rate for maturity T

 If the term structure is downward-sloping, forward rates for a period starting at time T are less
than the spot rate for maturity T

The most common swap is an agreement to exchange a fixed rate for Libor

Page A119 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 11

/// Bond Yields and Return Calculations

A bond’s realized return is calculated by comparing the initial investment’s value with its final value

A bond’s yield to maturity is the single discount rate, which if applied to all the bond’s cash flows, would
make the cash flows’ present value equal to the bond’s market price

Properties of the yield-to-maturity are as follows:

 When the yield to maturity is equal to the coupon rate, the bond sells for its face value

 When the yield to maturity is less than the coupon rate, the bond sells for more than its face
value. If time passes with no change to the yield, the price of the bond declines

 When the yield to maturity is greater than the coupon rate, the bond sells for less than its face
value. If time passes with no change to the yield to maturity, the price of the bond increases

 If the term structure is flat with all rates equal to R, the yield to maturity is equal to R for all
maturities

The profit or loss from a trading strategy can be decomposed into the carry roll-down, the amount
resulting from interest rate changes, and the amount resulting from spread changes

The carry roll-down is usually defined as the impact of forward rates being realized (i.e., future forward
rates being equal to today’s forward rates)

 However, it can also be defined as the impact of the term structure remaining unchanged, or
the impact of bond yields remaining unchanged

Spread changes arise from a bond’s market price moving closer to (or further away from) its theoretical
price

Page A120 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 12

/// Applying Duration, Convexity and DV01

One-factor risk metrics are based on the assumption that interest rate term structure movements are
driven by a single factor

 Examples include: DV01, duration, and convexity

Yield-based measures consider what happens to a bond price when there is a small change to its yield

Effective duration and effective convexity consider what happens when all spot rates change by the
same amount

 The latter is referred to as a parallel shift in the term structure

One-factor term structure shifts do not need to be parallel

The term structure shape can also change completely in a one-factor model

DV01 describes the impact of a one-basis-point change in interest rates on the value of a portfolio

DV01 can be calculated for any position whose value depends on interest rates

DV01 is the decrease (increase) in the price of a bond (or other instrument) arising from a one-basis-
point increase (decrease) in rates

Page A121 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

In the case of bonds, we can define DV01, duration, and convexity in terms of small changes in yields
rather than small changes in all rates

 This leads to some analytic results and explains the name “duration”

The DV01 of a portfolio is the sum of the DV01s of the instruments in the portfolio

The duration (convexity) of a portfolio is the average of the durations (convexities) of the instruments in
the portfolio weighted by the value of each instrument

A callable bond is a bond where the issuing company has the right to buy back the bond at a pre-
determined price at certain times in the future

A puttable bond is a bond where the holder has the right to demand early repayment

 A puttable bond should be treated like a callable bond when calculating effective duration

o In this case, the probability of the put option being exercised increases as interest rates
increase

Page A122 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 13

/// Modeling Non-Parallel Term Structure Shifts and Hedging

A statistical technique known as principal components analysis can be used to understand term
structure movements in historical data

 This technique looks at the daily movements in rates of various maturities and identifies certain
factors

DV01 can be defined as the impact of a one-basis-point shift in all spot rates on the value of a portfolio

In practice, perfectly parallel shifts are rare

Principal components analysis shows the term structure changes observed in practice consist of the
following:

 A component where all rates move in the same direction, but not by exactly the same amount

 A component where the term structure steepens or flattens

 A component where there is a bowing of the term structure

The sensitivity of a portfolio to shifts in the term structure can be used to calculate the standard
deviation of the daily change in the portfolio value

 …And can therefore provide estimates of risk measures such as VaR and expected shortfall

Page A123 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 14

/// Binomial Trees

Binomial trees is a valuation method widely used for pricing American-style options and other
derivatives

Derivatives are valued using what is called a no-arbitrage argument

 This means prices are calculated on the assumption that there are no arbitrage opportunities for
market participants

The law of one price states that if portfolios X and Y provide the same cash flows at the same times in
the future, they should sell for the same price

Binomial trees are a convenient way of illustrating how no-arbitrage arguments apply to derivatives

We also use binomial trees to introduce risk-neutral valuation

Risk-neutral valuation is the most important principle in derivatives pricing

A risk-neutral world is one where investors do not adjust their required expected returns for risk, so that
the expected return on all assets is the risk-free rate

A risk-neutral world is one where all tradable assets have an expected return equal to the risk-free
interest rate

Page A124 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

The risk-neutral valuation principle states that if we assume we are in a risk-neutral world, we get the
fair price for a derivative

Delta is the sensitivity of a derivative’s value to the price of its underlying stock

Trees can be constructed for valuing derivatives dependent on a non-dividend paying stock

Trees can also be constructed for valuing derivatives dependent on stock indices, currencies, and futures

When stock price movements are governed by a multi-step tree, we can treat each binomial step
separately and roll back through the tree to value a derivative

 For American options, it is necessary to test for early exercise at each node of the tree

Page A125 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 15

/// The Black-Scholes-Merton Model

Black and Scholes used the capital asset pricing model (CAPM) to derive the relationship between the
return from a stock and the return from an option on the stock

Merton used no-arbitrage arguments like those used in connection with binomial trees:

 The two papers derived the same option pricing formula

 The pricing formula applies to European options on non-dividend paying stocks

 It can be extended to European options on stocks paying discrete dividends and to European
options on other assets (such as stock indices, currencies, and futures)

 It does not apply to American options, which must be valued using the binomial tree
methodology

The Black-Scholes-Merton model assumes that the return from a non-dividend paying stock over a short
period of time is normally distributed

The assumptions necessary to derive the Black-Scholes-Merton options pricing model are as follows

 There are no transaction costs or taxes

 All securities are perfectly divisible

 There are no dividends on the stock during the life of the option

 There are no riskless arbitrage opportunities

 Security trading is continuous

 Investors can borrow or lend at the same risk-free rate

 The options being considered cannot be exercised early

Page A126 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

When the return on a stock over a short period is normally distributed, the stock price at the end of a
relatively long period has a lognormal distribution

 This means the logarithm of the stock price (and not the stock price itself) is normally distributed

Note:

 A normal distribution is symmetrical and the variable can take any value from negative infinity
to infinity

 A lognormal distribution is skewed and the variable can take any positive value

Volatility is a measure of our uncertainty about the returns provided by an investment

The implied volatility of an option is the volatility that gives the market price of the option when it is
substituted into the Black-Scholes-Merton formula

 There is no analytic formula for implied volatility

 It must be found using an iterative trial and error procedure

Warrants are options issued by a company on its own stock

 If warrants are exercised, the company issues more shares, and the warrant holder buys the
shares from the company at the strike price

Page A127 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
GARP FRM® Overview Level 1 Summary

FRM Level I Summary: Book 4 Segment 16

/// Option Sensitivity Measures

The Greek letters measure different aspects of risk in derivatives portfolios:

 Delta measures the sensitivity of a portfolio’s value to changes in the price of the underlying
asset

 Vega is the Greek letter that measures the trader’s exposure to volatility

 The gamma of a stock price–dependent derivative measures the sensitivity of its delta to the
stock price

 The theta of an option is the rate of change in its value over time

 The rho of an option measures its sensitivity to interest rates

Page A128 of 128

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
 We truly thank you for considering our help as you go towards
your goal of passing the GARP exams and attaining FRM certification.

From our family to yours, please accept our best wishes for success

Yours Sincerely,

The Question Bank Family

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group
For Additional Free Downloadable FRM Content:
https://www.frmquestionbank.com/shop/

For Weekly Insightful FRM Articles:

https://www.frmquestionbank.com/category/frm-articles/

Our Homepage:
https://www.frmquestionbank.com/

FRMQuestionBank.com
Professional Learning Network AWP Limited LLC
A Member of the Education Industries Group