FRM Part I Exam

By AnalystPrep

Questions with Answers - Foundations of Risk Management

Last Updated: Mar 29, 2024

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 Table of Contents

1 - The Building Blocks of Risk Management 3

2 - How Do Firms Manage Financial Risk? 31
3 - The Governance of Risk Management 48
4 - Credit Risk Transfer Mechanisms 71
Modern Portfolio Theory (MPT) and the Capital Asset Pricing
5 - 84
Model (CAPM)
The Arbitrage Pricing Theory and Multifactor Models of Risk
6 - 139
and Return
7 - Risk Data Aggregation and Reporting Principles 161
8 - Enterprise Risk Management and Future Trends 180
9 - Learning From Financial Disasters 187
10 - Anatomy of the Great Financial Crisis of 2007-2009 213
11 - GARP Code of Conduct 252

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 Reading 1: The Building Blocks of Risk Management

Q.1 In the context of financial markets, liquidity can be categorized into different types, each
with its unique characteristics and implications. Market liquidity, in particular, is a critical aspect
that investors and financial institutions often consider. Given the following definitions, which one
is most likely to be associated with the concept of market liquidity?

A. The risk that a bank will not be able to roll over a repo to finance their short-term cash
flow needs.

B. The risk that depositors will flock into banks and withdraw their funds or that
shareholders will redeem their shares en masse.

C. The risk that the collateral value of an asset will decline after a derivative position is
established, resulting in an increase in the margin requirement.

D. The risk that an investor who lends out an asset will be forced to sell at a lower price
once the asset is returned.

The correct answer is D.

Market liquidity risk, also known as trading liquidity risk, refers to the potential loss in the value
of an asset when markets temporarily seize up. In such situations, a market participant may not
be able to execute a trade or liquidate a position immediately at the best price. This could force
the seller to accept an abnormally low price, or in some cases, completely lose the ability to
convert the asset into cash. This scenario is accurately depicted in choice D, where an investor
who lends out an asset may be forced to sell it at a much lower price once the asset is returned,
especially if the trading volume declines due to changes in one or more market factors such as
interest rates and inflation.

Choice A is incorrect because it describes a scenario related to funding liquidity risk, not

market liquidity risk. Funding liquidity risk is concerned with the ability of a firm or a bank to

meet its short-term cash flow needs. In the given scenario, the risk that a bank will not be able to

roll over a repo to finance their short-term cash flow needs is a clear example of funding liquidity

risk. This is because it involves the bank's ability to secure short-term debt, which is a liability, to

fund its operations.

Choice B is incorrect because it also describes a situation related to funding liquidity risk. The

risk that depositors will flock into banks and withdraw their funds or that shareholders will

redeem their shares en masse is a scenario that pertains to the ability of a firm to meet its

liabilities. This is a characteristic of funding liquidity risk, which is concerned with the ability of

a solvent institution to make agreed-upon payments in a timely fashion. This is different from

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market liquidity risk, which is concerned with the ability to sell an asset at its fair price.

Choice C is incorrect because it describes a scenario that is more related to collateral and

margin requirements, which is not directly related to market liquidity risk. The risk that the

collateral value of an asset will decline after a derivative position is established, resulting in an

increase in the margin requirement, is a risk associated with derivative trading and collateral

management. While it may have implications on liquidity, it does not directly describe market

liquidity risk, which is concerned with the ability to sell an asset at its fair price in the market.

Things to Remember

Funding liquidity risk and market liquidity risk are two distinct types of liquidity risks in the

financial markets. Funding liquidity risk is concerned with the ability of a firm to meet its

liabilities. It involves scenarios such as the inability of a bank to roll over a repo to finance their

short-term cash flow needs or the risk of mass withdrawals by depositors or redemptions by

shareholders. The International Monetary Fund (IMF) defines funding liquidity as 'the ability of a

solvent institution to make agreed-upon payments in a timely fashion.'

On the other hand, market liquidity risk, also known as asset liquidity risk, is concerned with the

ability to sell an asset at its fair price. It involves scenarios such as the inability to execute a

trade or liquidate a position immediately at the best price due to market conditions. An example

is when an investor who lends out an asset is forced to sell it at a much lower price once the

asset is returned due to changes in market factors.

Q.3 In 2016, the United Kingdom made a historic decision to exit the European Union, a move
commonly referred to as 'Brexit'. Following this decision, the value of the British pound
depreciated against other major global currencies such as the U.S. dollar and the Chinese Yuan.
Which one of the following risks best explains this observation?

A. Interest rate risk

B. Foreign exchange risk

C. Reputation risk

D. Equity risk

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The correct answer is B.

Foreign exchange risk, also known as currency risk, is a financial risk that arises from potential

changes in the exchange rate between two currencies. Investors who have investments in foreign

countries are exposed to this risk because the value of the foreign investments will decrease if

the currency of the investment's country weakens against their own domestic currency. In the

context of the question, the Brexit vote led to a decrease in the value of the British pound against

other currencies. This is a classic example of foreign exchange risk. Investors who held assets

denominated in British pounds would have seen the value of those assets decrease when

converted back to their own domestic currency. The uncertainty surrounding the economic

impact of Brexit, including potential disruptions to trade agreements and economic ties with the

European Union, contributed to the depreciation of the pound. Therefore, the risk that best

explains the observation in the question is foreign exchange risk.

Choice A is incorrect because interest rate risk is the risk that the value of an investment will

decrease due to changes in the absolute level of interest rates, in the spread between two rates,

in the shape of the yield curve, or in any other interest rate relationship.

Choice C is incorrect because reputation risk is the risk of loss resulting from damages to a

firm's reputation, in lost revenue; increased operating, capital or regulatory costs; or destruction

of shareholder value, consequent to an adverse or potentially criminal event even if the company

is not found guilty. Adverse events typically associated with reputation risk include ethics, safety,

security, sustainability, quality, and innovation. Reputation risk is more relevant to individual

companies or organizations and is often associated with the company's operational practices,

ethical stance, or response to a specific event or crisis.

Choice D is incorrect because equity risk is the risk of loss because of a drop in the market

price of shares. Equity risk often refers to equity investment risk, which is the risk associated

with the investment in shares/stocks of a company. This risk arises from fluctuations in the share

price and the risk of the issuer defaulting.

Things to Remember

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Financial risk management is a practice that involves identifying potential risks, measuring

them, and creating strategies to manage and mitigate those risks. It's important for businesses

and investors to understand the different types of financial risks and how they can affect their

investments. The four types of risks mentioned in the question are all different types of financial

risks, each with its own characteristics and implications. Understanding these risks can help

investors make informed decisions and protect their investments. For example, an investor with

a high exposure to foreign exchange risk might consider using financial instruments like futures

or options to hedge against potential losses caused by currency fluctuations. Similarly, an

investor with a high exposure to interest rate risk might consider diversifying their portfolio to

include a mix of fixed-income securities with different maturities and credit qualities. Ultimately,

effective financial risk management involves a combination of knowledge, strategy, and careful

monitoring of the financial markets.

Q.4 Market risk, also known as systematic risk, is a type of risk that is inherent to the entire
market or market segment. Which of the following scenarios would be considered an example of
market risk?

A. Inadequate/malfunctioning computer systems

B. Circumvention of issued regulations and guidelines

C. Occurrence of a natural disaster, such as a tornado

D. An increase in the price of gas

The correct answer is D.

An increase in the price of gas is an example of market risk, also known as systematic risk. This
is the potential for an investor to experience losses due to factors that affect the overall
performance of financial markets. These factors are typically broad-based, beyond the control of
individual companies or investors, and impact a large number of assets simultaneously. It
includes risks associated with changes in interest rates, foreign exchange rates, commodity
prices, and equity prices. Market risk can affect the value of a portfolio or individual security,
resulting in losses for investors or traders.

Operational risk refers to the possibility of incurring losses resulting from operational

breakdowns caused by either internal or external factors. Operational risks include legal risk,

anti-money laundering risk, cyber risk, and rogue trading. Moreover, operational include

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corporate disasters such as operational mishaps and corporate governance scandals.

A is incorrect. Inadequate/malfunctioning computer systems is an example of operational risk

because it refers to a failure within the organization's internal processes or systems that can

result in losses.

B is incorrect. Circumvention of issued regulations and guidelines is an example of compliance

risk, which is a type of operational risk. Compliance risk refers to the possibility of incurring

losses due to non-compliance with laws, regulations, and internal policies and procedures.

C is incorrect. Occurrence of a natural disaster, such as a tornado, is an example of operational

risk because it refers to the possibility of losses due to external events beyond the control of the

organization.

Things to Remember

Market risk, also known as systematic risk, is the risk that an investor's portfolio might suffer

losses due to broad market factors that affect the overall performance of financial markets.

These factors are typically beyond the control of individual companies or investors and impact a

large number of assets simultaneously. It includes risks associated with changes in interest rates,

foreign exchange rates, commodity prices, and equity prices. Market risk can be mitigated

through diversification, as the impact of market risk is reduced when investments are spread

across different asset classes and sectors.

Operational risk refers to the risk of loss resulting from inadequate or failed internal processes,

people, and systems, or from external events. This includes legal risk but excludes strategic and

reputational risk. Operational risk can be managed through effective internal controls, risk

management systems, and business continuity planning.

Compliance risk is the potential for losses arising from non-compliance with laws or regulations.

This can result from the company failing to follow laws, regulations, and guidelines, or from

changes in the regulatory environment. Compliance risk can be managed through effective

compliance programs, which include policies and procedures, training, monitoring, and

reporting.

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Q.5 In the context of business operations, risk management plays a crucial role in ensuring the
stability and sustainability of an organization. One approach to risk management is the
enterprise-wide risk management. This approach is characterized by certain features that
distinguish it from other risk management strategies. Based on your understanding of
enterprise-wide risk management, which of the following best describes enterprise-wide risk
management?

A. Applying risk management within individual departments on a piecemeal basis.

B. Risk management that includes all major departments in a company.

C. A structured and consistent set of principles or risk management that are applied
across the whole of a company.

D. Risk management that encompasses all business units.

The correct answer is C.

Enterprise-wide risk management involves the development of structured and consistent

business principles that govern the way different business units of a company do business, in

regard to risk by applying consistent risk management principles across the whole of a company,

all risks, including inter-departmental risks, are taken into account.

A is incorrect: Applying risk management within individual departments on a piecemeal basis is

a silo approach in which different departments/business units are left to manage risks on their

own without considering the impact on other departments or the company as a whole.

B is incorrect: Enterprise risk management includes not only major departments in a company

but also minor departments and all other areas of the company that may be exposed to risks.

D is incorrect: Enterprise risk management involves applying risk management to all business

units, but it also includes a structured and consistent set of principles that guide the way risks

are identified, assessed, monitored, and managed across the entire organization.

Things to Remember

Enterprise-wide risk management is a holistic approach to managing risks that involves the

entire organization. It is not limited to certain departments or business units, but encompasses

the entire organization. This approach ensures that all risks are identified, assessed, and

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managed in a consistent and coordinated manner. It involves the development and application of

a consistent set of risk management principles that are used throughout the company. The goal

of enterprise-wide risk management is to create a risk-aware culture within the organization

where every decision made takes into consideration the potential risks and how they can be

mitigated. This approach allows for better coordination and communication of risk management

strategies and practices across all levels of the organization, leading to more effective risk

management.

Q.6 In financial markets, risk management plays a pivotal role in safeguarding investments and
financial activities from potential losses. It involves a series of activities that aim to create
economic value. Among the following options, which one best encapsulates the definition of risk
management in the context of financial markets?

A. The practice of creating economic value by identifying and investing in risky projects
that could earn a profit.

B. The practice of avoiding an extremely risky financial undertaking to prevent a loss.

C. The practice of creating economic value by identifying and measuring risks, and
formulating robust plans to address and manage these risks.

D. Setting risk limits beyond which an entity should not operate.

The correct answer is C.

Risk management in the context of financial markets involves identifying and measuring risks

associated with a business, both qualitatively and quantitatively, and formulating robust plans to

address and manage these risks. The goal of risk management is to create economic value by

minimizing the negative impact of risks on the business while maximizing the positive outcomes

of risk-taking. This involves a range of activities, including risk identification, risk assessment,

risk mitigation, risk monitoring, and risk reporting.

A is incorrect: Risk management is not about investing in risky projects to earn a profit.

Instead, it is about identifying and managing risks associated with a business to minimize

negative outcomes and maximize positive outcomes.

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B is incorrect: Risk management is not about avoiding all risky financial undertakings to

prevent a loss. Instead, it is about identifying and managing risks associated with a business to

minimize negative outcomes and maximize positive outcomes.

D is incorrect: Setting risk limits is an important part of risk management, but it is not the only

aspect. Risk management also involves risk identification, risk assessment, risk mitigation, risk

monitoring, and risk reporting.

Things to Remember

Risk management is a comprehensive process that involves identifying, assessing, mitigating,

monitoring, and reporting risks. It is not about avoiding risk entirely or merely setting risk limits.

Instead, it is about managing risks in a way that minimizes negative outcomes and maximizes

positive outcomes. This involves a range of activities, including risk identification (identifying

potential risks that could negatively impact the business), risk assessment (evaluating the

likelihood and potential impact of these risks), risk mitigation (developing strategies to manage

these risks), risk monitoring (keeping track of the identified risks and the effectiveness of the

mitigation strategies), and risk reporting (communicating information about the risks and the

risk management activities to relevant stakeholders). By understanding and effectively managing

risks, businesses can create economic value and ensure their long-term sustainability.

Q.7 Tohonday, a motor vehicle production company, has historically channeled most of its
earnings and spare cash into short-term government bonds maturing in less than a year. The
board wishes to change its investment policy substantially and intends to tap the riskier but
more profitable long-term bond market. Assuming you're the risk manager for the company,
which of the following risks would be of utmost (immediate) concern from an operational point of
view?

A. Trading liquidity risk

B. Funding liquidity risk

C. Interest rate risk

D. Market risk

The correct answer is B.

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Financial institutions do not always fail because of the inability to generate a profit. Rather, it's

the inability to meet short-term financial obligations that often leads to bankruptcy. This is

known as funding liquidity risk. Suppose Tohonday decides to invest in long-term assets, in

that case, it must take into account its day-to-day funding requirements, especially because

funds invested in long-term assets cannot be realized quickly enough to meet short-term debts

and other unforeseen obligations, such as lawsuits. Northern Rock, a significant UK mortgage

lender, encountered a severe funding liquidity crisis in 2007, a situation that signaled the onset

of the global financial crisis. The bank heavily relied on wholesale markets instead of depositor

funds to finance its mortgage lending, a strategy that backfired amidst the global credit crunch

triggered by the US subprime mortgage crisis. With most of its assets tied up in long-term

mortgages, Northern Rock found itself unable to liquidate these assets swiftly enough to meet its

short-term obligations, particularly the short-term debts it had incurred to finance long-term

loans. This liquidity crisis led to the first bank run in the UK in over a century, resulting in a loss

of customer confidence, a government bailout, and eventually nationalization in February 2008.

A is incorrect.Trading liquidity risk (also called market liquidity risk) is the risk associated with

the inability of a firm to execute transactions at the prevailing market price. It may reduce the

institution's ability to hedge market risk, and also it is the capacity to liquidate assets when

necessary.

C is incorrect: Interest rate risk is the risk that arises from fluctuations in the market interest

rates, which may cause a decline in the value of interest-rate-sensitive portfolios.

D is incorrect: Market risk is the risk that results due to movements in market prices and rates.

Things to Remember

When a company decides to change its investment strategy, it must consider a variety of risks. In

the case of Tohonday, the company's decision to invest in long-term bonds introduces several

new risks, including trading liquidity risk, interest rate risk, and market risk. However, the most

immediate concern for the company should be its funding liquidity risk. This is because the

company's ability to meet its short-term financial obligations is crucial for its survival. If the

company invests its funds in long-term assets, it may not be able to quickly convert these assets

into cash to meet its short-term debts and other unexpected liabilities. Therefore, when changing

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its investment strategy, the company must carefully consider its funding needs and ensure that it

has sufficient liquidity to meet its short-term obligations.

Q.8 In financial risk management, particularly in relation to credit risk, two key concepts are
'expected loss' and 'unexpected loss'. These terms are used to estimate potential credit losses
and are integral to the risk management strategies of financial institutions. Which of the
following accurately differentiates between expected loss and unexpected loss?

A. Expected loss is the average credit loss we expect from an exposure while unexpected
loss is the loss that occurs over and above the expected loss.

B. Unexpected loss is the average credit loss we expect from an exposure while expected
loss is the loss that occurs over and above the unexpected loss.

C. Expected loss is the average credit loss that we would expect from an exposure while
unexpected loss is the loss that would occur without a quantitative expression.

D. Expected loss is the average credit loss that we would expect from an exposure while
unexpected loss is the sum of expected losses from several time periods.

The correct answer is A.

Expected loss is the average credit loss that we would expect from an exposure over a given

period of time. It is calculated as the product of the probability of default (PD), the loss given

default (LGD), and the exposure at default (EAD). Expected loss is a key component of credit risk

management and is used to estimate the amount of capital that a bank needs to hold to cover

potential credit losses.

Unexpected loss is the amount of loss that actually exceeds the expected amount. It is the

difference between the expected loss and the actual loss incurred. Unexpected loss is also known

as the tail risk or the potential loss in extreme scenarios. It represents the risk that the actual

losses may be much higher than the expected losses, which can have a significant impact on a

bank's capital and profitability.

Choice B is incorrect. It reverses the definitions of expected loss and unexpected loss.

Choice C is incorrect. Unexpected loss is quantitatively expressed as the difference between

the expected loss and the actual loss incurred. It is not a nebulous or unquantifiable concept, but

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a specific measure used in financial risk management.

Choice D is incorrect. Unexpected loss is not a cumulative measure of expected losses over

time. Instead, it is the difference between the expected loss and the actual loss incurred in a

given period.

Things to Remember

Expected loss and unexpected loss are fundamental concepts in financial risk management,

particularly in relation to credit risk. Understanding the difference between these two measures

is crucial for effective risk management. Expected loss is a measure of the average credit loss

that a financial institution expects from an exposure over a given period of time. It is a key

component of credit risk management and is used to estimate the amount of capital that a bank

needs to hold to cover potential credit losses.

Unexpected loss, on the other hand, is the amount of loss that exceeds the expected loss. It

represents the risk that the actual losses may be much higher than the expected losses, which

can have a significant impact on a bank's capital and profitability. Unexpected loss is also known

as tail risk or the potential loss in extreme scenarios.

Both expected loss and unexpected loss are calculated using statistical models and historical

data. They are used to estimate potential credit losses and to develop risk management

strategies. Misunderstanding or misrepresenting these concepts can lead to inaccurate risk

assessments and ineffective risk management strategies.

Q.9 The concept of risk and reward is a fundamental principle that governs investment decisions.
This principle suggests a certain relationship between the level of risk an investor is willing to
take and the potential reward they might receive. Which of the following statements accurately
describes this relationship between investment risk and potential reward?

A. As the investment risk increases, the reward decreases.

B. As the investment risk decreases, the reward increases.

C. As the investment risk increases, the potential for reward increases.

D. The relation between investment risk and reward depends on the financial product.

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The correct answer is C.

The principle of risk-reward tradeoff in finance suggests that the potential for higher returns

comes with a higher level of risk. This means that as the investment risk increases, the potential

for reward also increases. However, it's important to note that higher risk doesn't guarantee

higher returns; it merely provides the potential for higher returns. The actual outcome may still

result in a loss. This is because the risk in investments is the uncertainty that an investment's

actual future returns will deviate from its expected returns. The greater the degree of risk, the

greater the possible deviation from the expected return, and thus the greater the range of

possible outcomes, including both losses and gains. Therefore, investors who are willing to

accept higher levels of risk do so with the expectation of achieving higher potential returns.

A is incorrect because, typically, risk and potential reward are directly related, not inversely. If

you're taking on more risk, it's usually because you expect the possibility of a higher return to

compensate for that risk. This doesn't guarantee a higher return, but the potential is greater.

B is incorrect because it contradicts the basic principle of the risk-reward tradeoff. Lower-risk

investments generally yield lower potential returns. For example, a government bond (low risk)

typically offers lower returns than investing in a new tech startup (high risk).

D is incorrect because it suggests there is no general correlation between risk and reward in

investments, and it boils down to individual assets. While the specific level of risk and potential

reward can vary between different financial products, the general principle that higher risk is

associated with a higher potential for reward holds true across virtually all types of investments.

Things to Remember

The risk-reward tradeoff is a fundamental concept in finance that suggests a direct relationship

between the level of risk an investor is willing to take and the potential reward they might

receive. This principle is based on the premise that in order to achieve higher potential returns,

an investor must be willing to accept a higher level of risk. However, it's important to note that

higher risk doesn't guarantee higher returns; it merely provides the potential for higher returns.

The actual outcome may still result in a loss. This is because the risk in investments is the

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uncertainty that an investment's actual future returns will deviate from its expected returns. The

greater the degree of risk, the greater the possible deviation from the expected return, and thus

the greater the range of possible outcomes, including both losses and gains. Therefore, investors

who are willing to accept higher levels of risk do so with the expectation of achieving higher

potential returns.

Q.10 Credit risk is a primary category that encompasses several sub-types of risk. Among the
following options, which one would most likely be classified as credit risk?

A. Commodity price risk

B. Currency exchange risk

C. Interest rate risk

D. Default risk

The correct answer is D.

Default risk is a form of credit risk. It refers to the risk that a borrower will not be able to meet

scheduled repayments of interest or principal on a debt obligation. This is the most direct form of

credit risk. In such a case, the lender or investor may lose the principal and interest, disrupt

cash flows, and increase the cost of collection. Default risk is a significant factor in determining

the interest rate on a loan or on a bond.

A is incorrect. Commodity price risk is a form of market risk, not credit risk. It refers to the

uncertainty stemming from changes in the price of a commodity.

B is incorrect. Currency exchange risk, also known as foreign exchange risk, it is a market risk

posed by an exposure to unanticipated changes in the exchange rate between two currencies.

Businesses that operate internationally often face currency exchange risk.

C is incorrect. Interest rate risk is the risk that an investment's value will change due to a

change in the absolute level of interest rates, the spread between two rates, or the shape of the

yield curve. While this risk can impact the value of fixed-income investments (like bonds) and

therefore indirectly impact a borrower's ability to repay debt, it is considered a type of market

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risk rather than a form of credit risk.

Things to Remember

Credit risk is a significant category of risk in financial risk management. It primarily deals with

the potential that a borrower may not fulfill their contractual debt obligations. There are several

sub-types of credit risk, including default risk, which is the risk that a borrower will not be able

to meet scheduled repayments of interest or principal on a debt obligation. Understanding these

different types of risks is crucial for any financial institution or individual involved in lending or

investing activities.

It's also important to note that not all financial risks fall under the category of credit risk. Other

categories of financial risk include market risk (which includes commodity price risk, currency

exchange risk, and interest rate risk) and operational risk. Each of these categories of risk

requires different risk management strategies and techniques. Therefore, a comprehensive

understanding of the different types of financial risks and how to manage them is crucial for

anyone involved in financial decision-making.

Q.11 In risk management, risks are often categorized as either quantifiable or non-quantifiable.
Quantifiable risks can be measured in numerical terms and are often associated with financial or
market risks. Non-quantifiable risks, on the other hand, are difficult to measure numerically and
are often associated with event or operational risks. Given this context, which of the following
pairs correctly associates a quantifiable risk with a non-quantifiable risk?

A. Quantifiable: Interest rate risk; Non-quantifiable: Default risk

B. Quantifiable: Civil war; Non-quantifiable: Liquidity risk

C. Quantifiable: Equity price risk; Non-quantifiable: Risk of terrorist attack

D. Quantifiable: Civil war; Non-quantifiable: Settlement risk

The correct answer is C.

Equity price risk is a quantifiable risk because it can be measured in numerical terms. For

instance, if a stock's price drops from $100 to $90, the equity price risk is quantifiable as a 10%

loss. On the other hand, the risk of a terrorist attack is a non-quantifiable risk. It's a type of event

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risk that is inherently unpredictable and difficult to measure numerically. Its impact on

investments is uncertain and cannot be precisely quantified.

Option A is incorrect because both interest rate risk and default risk are quantifiable risks.

Interest rate risk, the risk that an investment's value will change due to a change in the absolute

level of interest rates, can be measured in numerical terms. Default risk, the risk that a borrower

will be unable to make the required payments on their debt obligations, can also be quantified,

often using credit ratings or credit spreads.

Option B is incorrect because civil war is a non-quantifiable risk, while liquidity risk is a

quantifiable risk. A civil war is a type of political risk that is inherently uncertain and hard to

quantify. On the other hand, liquidity risk, the risk of not being able to quickly realize an

investment without a substantial loss in value, can be quantified in terms of bid-ask spread,

market depth, or impact cost.

Option D is incorrect because civil war is a non-quantifiable risk due to its unpredictable

nature and broad impacts. Settlement risk, the risk that one party will fail to deliver the terms of

a contract with another party at the time of settlement, can be quantified, often in terms of

potential losses if a counterparty defaults at various points during the settlement process.

Things to Remember

1. Quantifiable risks are those that can be measured in numerical terms. They are often

associated with financial or market risks, such as interest rate risk, equity price risk, and

liquidity risk. These risks can be managed using financial hedging strategies, such as derivatives

and portfolio diversification.

2. Non-quantifiable risks are those that are difficult to measure numerically. They are often

associated with event or operational risks, such as the risk of a terrorist attack or civil war.

These risks are unpredictable and their impacts on investments are uncertain. They are often

managed through insurance, contingency planning, and other risk mitigation strategies.

3. Risk management involves identifying, assessing, and managing both quantifiable and non-

quantifiable risks. It is a critical practice in finance and investment to safeguard against

potential losses.

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Q.13 A public company is evaluating several projects for potential implementation. The risk
manager, during his appraisal, identifies that some of these projects may lead to conflicts with
the Food and Drug Administration due to potential ethical issues and violations of human safety
standards. Which type of risk is the company primarily exposed to in this situation?

A. Operational risk

B. Credit risk

C. Market risk

D. Liquidity risk

The correct answer is A.

Operational risk refers to the risk of loss resulting from inadequate or failed internal processes,

people, and systems, or from external events. In this scenario, if the company's projects could

potentially violate ethical standards and safety regulations, leading to conflicts with the Food and

Drug Administration (FDA), this would be classified as an operational risk. This is because these

issues stem from the company's internal operations and processes. It's also worth noting that

regulatory compliance is a key aspect of operational risk.

Option B is incorrect: Credit risk is the possibility of a loss resulting from a borrower's failure

to repay a loan or meet contractual obligations. In this scenario, the company's potential

conflicts with the FDA do not involve the risk of not receiving payment from a borrower or

counterparty, so credit risk does not apply.

Option C is incorrect: Market risk, also called systematic risk, refers to the risk that the value

of an investment will decrease due to changes in market factors such as interest rates, stock

prices, or exchange rates. The scenario presented doesn't involve these factors.

Option D is incorrect: Liquidity risk is the risk that a company or individual will not be able to

meet short-term financial demands. This could occur because the individual or company cannot

convert an asset to cash without a substantial loss in value. In the context of the question, the

company's potential regulatory issues with the FDA have nothing to do with its ability to quickly

convert assets to cash to meet immediate financial obligations.

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Things to Remember

Risk management is a critical aspect of any business operation. It involves identifying, assessing,

and prioritizing risks, and implementing strategies to manage or mitigate them. The four major

types of risk mentioned in the question - operational, credit, market, and liquidity risk - are all

integral parts of risk management. Understanding these risks and how they can impact a

business is crucial for effective risk management. It's also important to note that these risks are

not mutually exclusive and can often be interconnected. For example, a company facing

operational risk due to regulatory issues may also face liquidity risk if it has to pay hefty fines.

Therefore, a comprehensive approach to risk management that considers all types of risks and

their potential interactions is essential for the long-term success of a business.

Q.14 In finance and investment, risks are often categorized into different types based on their
nature and impact. Two such categories are systemic risks and specific risks. These two types of
risks differ in terms of their scope and the entities they affect. The difference between systemic
and specific risks is that:

A. Systemic risk refers to the risks that affect the entire economy, while specific risks are
risks that affect only a particular company or line of business.

B. Systemic risks are risks borne by a single entity while specific risks are borne by the
economy as a whole.

C. Systemic risks are quantifiable while specific risks are non-quantifiable.

D. Systemic risk is diversifiable while specific risk is non-diversifiable.

The correct answer is A.

Systemic risk and specific risk are two fundamental concepts in finance and investment.
Systemic risk refers to the risk that can affect the entire economy. It is often associated with
significant events or disruptions that have far-reaching impacts, such as the failure of a major
financial institution, a significant disruption in a critical market or infrastructure, global
pandemics, natural disasters, and geopolitical events that can disrupt global trade and financial
flows. These risks are non-diversifiable, meaning they cannot be eliminated through
diversification. On the other hand, specific risks are risks that affect only a particular company
or line of business. These risks are often related to the company's operations, management, or
industry-specific factors. Examples of specific risks include product recalls, labor strikes, and
changes in consumer preferences. Unlike systemic risks, specific risks are typically diversifiable,
meaning that investors can reduce their exposure to these risks by investing in a diversified
portfolio of assets.

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Choice B is incorrect because it reverses the definitions of systemic and specific risks.

Systemic risks are not borne by a single entity; instead, they affect the entire economy.

Conversely, specific risks are not borne by the economy as a whole; they are risks that affect only

a particular company or line of business.

Choice C is incorrect because it inaccurately suggests that systemic risks are quantifiable

while specific risks are non-quantifiable. Both systemic and specific risks can be quantified,

albeit with varying degrees of precision. Systemic risks can be quantified using macroeconomic

indicators and financial market data, while specific risks can be quantified using company-

specific data and industry analysis.

Choice D is incorrect because it inaccurately suggests that systemic risk is diversifiable while

specific risk is non-diversifiable. In fact, the opposite is true. Systemic risks, which affect the

entire economy, are non-diversifiable, meaning they cannot be eliminated through diversification.

On the other hand, specific risks, which affect only a particular company or line of business, are

diversifiable.

Things to Remember

Understanding the difference between systemic and specific risks is crucial for investors and

financial professionals. Systemic risks, which affect the entire economy, are non-diversifiable and

can have far-reaching consequences. They are often associated with significant events or

disruptions, such as the failure of a major financial institution or a significant disruption in a

critical market or infrastructure. On the other hand, specific risks, which affect only a particular

company or line of business, are diversifiable and can be managed through diversification

strategies. These risks are often related to the company's operations, management, or industry-

specific factors. By understanding these differences, investors can better manage their risk

exposure and make more informed investment decisions.

Q.15 Financial institutions are constantly striving to maintain and enhance the trust and
confidence of their stakeholders, which include customers, lenders, shareholders, among others.
This trust is crucial as it ensures that each party feels secure about their interests. What type of
risk is most relevant that companies need to manage to ensure the confidence of all stakeholders
is not compromised?

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 A. Legal and regulatory risk

B. Reputation risk

C. Specific risk

D. Operational risk

The correct answer is B.

Reputation risk refers to potential losses and negative impacts to a firm's financial condition and

overall operations due to damage to its reputation. This damage can be the result of a failure to

meet stakeholders' expectations, which can be caused by a wide range of events, such as legal

issues, poor customer service, unethical conduct, poor governance, or operational failures. If

stakeholders lose confidence in a company, it can lead to lost business, legal issues, a drop in

share price, and other negative outcomes.

Option A is incorrect: Legal and regulatory risk refers to the potential for losses due to non-

compliance with laws or regulations. While such non-compliance could harm a company's

reputation, it's a more specific type of risk that doesn't necessarily address the broader issue of

stakeholder confidence in the company.

Option C is incorrect: Specific risk, also known as unsystematic risk or idiosyncratic risk,

refers to the risk associated with individual assets within a portfolio, as opposed to the market as

a whole. These risks can be mitigated through diversification. Specific risk is not directly related

to the general confidence of stakeholders in a company's ability to safeguard their interests.

Option D is incorrect: Operational risk is the risk of loss resulting from inadequate or failed

internal processes, people, and systems, or from external events. While failures in these areas

could impact stakeholder confidence, it doesn't fully capture the broader idea of maintaining

stakeholder confidence across all aspects of a company's operations.

Things to Remember

Reputation risk is a crucial aspect of risk management for any company, especially financial

institutions. It is directly linked to the confidence and trust of stakeholders in the company. A

company's reputation can be damaged by various factors, including legal issues, poor customer

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service, unethical conduct, poor governance, or operational failures. Therefore, companies need

to have robust risk management strategies in place to manage and mitigate reputation risk. This

includes having strong corporate governance structures, ethical business practices, effective

customer service, and compliance with all relevant laws and regulations. Additionally, companies

should also have crisis management plans in place to manage any potential damage to their

reputation.

Q.31 In the context of credit risk, which of the following statements best distinguishes between
expected loss (EL) and unexpected loss (UL)?

A. Expected loss is the average loss that occurs due to defaults, while unexpected loss is
the maximum possible loss due to defaults.

B. Expected loss is the potential loss during normal market conditions, while unexpected
loss is the potential loss during extreme market events.

C. Expected loss is the average loss that a bank anticipates to occur due to credit events,
while unexpected loss represents the variability around that average.

D. Expected loss is the loss incurred from credit events that have already occurred, while
unexpected loss is the loss from potential future credit events.

The correct answer is C.

Expected loss (EL) and unexpected loss (UL) are two fundamental concepts in credit risk

management. Expected loss is the average loss that a financial institution anticipates to occur

due to credit events such as defaults or delinquencies. It is calculated as the product of the

probability of default (PD), exposure at default (EAD), and loss given default (LGD). This means

that it is a measure of the average loss that the bank expects to incur over a certain period due

to credit events. On the other hand, unexpected loss represents the variability or uncertainty

around the expected loss. It is the potential deviation from the average loss and is usually

associated with extreme or rare credit events. While banks typically set aside provisions to cover

expected losses, they maintain capital buffers to absorb unexpected losses.

Choice A is incorrect. While expected loss does refer to the average loss due to defaults,

unexpected loss is not the maximum possible loss. Instead, it represents the variability or

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uncertainty around that average.

Choice B is incorrect. Expected and unexpected losses are not differentiated by normal versus

extreme market conditions. Rather, expected loss refers to anticipated losses from credit events,

while unexpected loss measures the potential deviation from this expectation.

Choice D is incorrect. Expected loss does not pertain only to losses from already occurred

credit events; it also includes anticipated future credit events based on historical data and

models. Unexpected loss refers to potential deviations from these expectations due to unforeseen

circumstances or errors in prediction.

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Q.33 The purpose of economic capital is to absorb:

A. economic losses

B. expected loss

C. unexpected loss

D. tail loss

The correct answer is C.

Economic capital is designed to absorb unexpected losses. These are losses that are not

anticipated and can occur due to various unforeseen circumstances. The concept of economic

capital is based on the premise that a bank or financial institution should have enough capital to

absorb such losses and continue its operations without any significant disruption. This is why

economic capital is often calculated based on a certain level of confidence, which represents the

probability that the capital will be sufficient to cover the unexpected losses.

It's important to note that economic capital is not a fixed amount. It varies depending on the risk

profile of the bank or financial institution. The higher the risk, the more economic capital is

needed.

Choice A is incorrect. Economic capital does not serve the purpose of economic losses.

Economic losses are a result of poor financial decisions or market downturns, which are not

directly related to the concept of economic capital.

Choice B is incorrect. Economic capital does not cover expected loss. Expected loss is typically

covered by provisions and reserves set aside as part of normal business operations, and it's not

the primary purpose of economic capital.

Choice D is incorrect. While tail loss refers to extreme events with low probability but high

impact, it's too specific to be the main purpose of economic capital. Economic capital serves a

broader role in covering unexpected losses that may arise from various sources, not just extreme

events.

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Q.34 Which of the following is NOT the definition of risk measurement tools and procedures used
by a firm to measure and manage risk?

A. VAR is the maximum loss over a target horizon such that there is a low, prespecified
probability that the actual loss will be larger.

B. Scenario Testing is a quantitative risk measurement that takes into consideration

potential risk factors such as interest rate, payroll data, etc. that are often quantifiable
and focussed on frequency.

C. Stress Testing is both a qualitative and quantitative risk measurement tool that
analyses the financial outcome of a firm based on a given stress

D. Enterprise Risk Management (ERM) is an integrative risk measure approach that

considers entity-wide risk factors and integrates all the risk factors in entity-wide
decisions

The correct answer is B.

The definition provided for Scenario Testing is not accurate. Scenario Testing, in the context of

risk management, is a tool that considers potential risk factors that are often quantifiable.

However, the focus of Scenario Testing is not on frequency, as stated in the option, but rather on

severity. It is used to assess the potential severity of a risk by considering various hypothetical

scenarios. The scenarios are designed to mimic possible situations that the firm might face, and

the impact of these situations on the firm's financial health is then assessed. This allows the firm

to prepare for a variety of potential risks and to develop strategies to mitigate these risks.

Choice A is incorrect. Value at Risk (VaR) is indeed defined as the maximum loss over a target

horizon such that there is a low, pre-specified probability that the actual loss will be larger. This

definition accurately represents VaR's purpose and function in risk management.

Choice C is incorrect. Stress Testing does involve both qualitative and quantitative risk

measurement tools to analyze the financial outcome of a firm based on given stress scenarios. It

helps firms understand their vulnerability to adverse events or market conditions.

Choice D is incorrect. Enterprise Risk Management (ERM) accurately describes an integrative

approach to risk management that considers entity-wide risk factors and integrates all these

risks into entity-wide decisions. ERM aims to manage risks and seize opportunities related to the

achievement of an organization's objectives.

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Q.35 The relationship between risk and return is simple for some assets and complex for others.
The public perception of risk and return trade-off is that higher risk will lead to higher returns.
However, in some asset classes like fixed-income securities, a large number of factors such as
market risk, inflation, interest rate risk, and risk tolerance are considered. Which of the
following options is most appropriate for a market with investors having a high risk tolerance?

A. As the risk tolerance of investors is high, more investors will choose corporate bonds
over government bonds

B. As the risk tolerance of investors is high, more investors will choose government
bonds over corporate bonds

C. As the risk tolerance of investors is high, all investors will choose a good mix of
corporate and government bonds

D. As the risk tolerance of investors is high, all investors will choose not to buy corporate
bonds

The correct answer is A.

When investors have a high tolerance for risk, they are more likely to invest in assets that offer

higher potential returns despite the increased risk. Corporate bonds typically offer higher yields

than government bonds to compensate for the additional risk. This risk comes from the

possibility that the issuing corporation may default on its obligations. Therefore, in a market

where investors have a high risk tolerance, it is reasonable to expect that more investors will

choose corporate bonds over government bonds. This is because these investors are willing to

accept the higher risk associated with corporate bonds in exchange for the potential of higher

returns.

Choice B is incorrect. This choice suggests that investors with a high risk tolerance would

prefer government bonds over corporate bonds. However, this contradicts the general

understanding of risk and return in finance. Government bonds are typically considered safer

investments with lower returns, while corporate bonds carry higher risk but also offer higher

potential returns. Therefore, investors with a high tolerance for risk would be more likely to

choose corporate bonds over government ones.

Choice C is incorrect. While it's true that diversification can help manage risk, this choice

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assumes that all investors will choose a mix of corporate and government bonds regardless of

their individual risk tolerances. This is not necessarily the case as some high-risk tolerant

investors might prefer to invest more heavily in higher-risk assets like corporate bonds for

potentially greater returns.

Choice D is incorrect. This option suggests that all high-risk tolerant investors will avoid

buying corporate bonds altogether which contradicts the basic principles of investment theory

where higher risks are associated with potentially higher returns. Investors who have a high

tolerance for risk are generally more willing to invest in risky assets such as corporate bonds

because they offer the potential for greater return.

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Q.36 Equity price risk is the type of market risk that refers to the variability in the prices of
equity or stocks. Equity price risk is further subdivided into specific risk and systematic risk.
Which of the following is most likely a type of specific risk?

A. The risk of changes in the consumer price index (CPI).

B. The risk of change in the aggregate demand of a specific sector.

C. The risk of strategic weaknesses in a business.

D. The risk of changes in tax rates.

The correct answer is C.

The risk of strategic weaknesses in a business is a type of specific risk. Specific risk, also known

as unsystematic risk, idiosyncratic risk, or diversifiable risk, refers to the risk associated with

individual stocks in a portfolio. This risk can be reduced or eliminated from a portfolio through

diversification. Strategic weaknesses in a business, such as poor management decisions, failed

investments, or operational inefficiencies, are examples of specific risks as they directly impact

the individual business and not the entire market.

Choice A is incorrect. The risk of changes in the consumer price index (CPI) is a type of

systematic risk, not specific risk. Systematic risks are market-wide risks that affect all

companies, such as inflation or interest rate changes. Changes in CPI represent inflationary

trends and impact all firms rather than a specific one.

Choice B is incorrect. The risk of change in the aggregate demand of a specific sector also falls

under systematic risk as it affects all companies within that sector and not just one particular

company.

Choice D is incorrect. The risk of changes in tax rates is another example of systematic risk

because tax policies usually apply to an entire economy and thus affect all businesses operating

within that economy, not just one particular firm.

Q.37 BT Motors and New Atlas bank are two parties of a derivative contract to hedge exchange
rate risk. At the end of the contract, BT Motors has a net loss position of $6.9 million but refused
to pay the entire amount. Which of the following sub-types of credit risk best describes this

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situation?

A. Bankruptcy risk.

B. General market Risk.

C. Settlement risk.

D. Default risk.

The correct answer is C.

Settlement risk is a type of credit risk that arises when one party in a transaction fails to honor

their financial obligations on the settlement date. In the context of the scenario described, BT

Motors, despite being in a net loss position of $6.9 million, refuses to pay the entire amount. This

refusal to fulfill their financial commitment is a clear example of settlement risk. Settlement risk

is a significant concern in financial transactions, particularly in derivative contracts like the one

between BT Motors and New Atlas bank. It can lead to substantial financial losses for the party

that is left unpaid, in this case, New Atlas bank. Therefore, it is crucial for financial institutions

to manage and mitigate settlement risk effectively to protect their financial interests.

Choice A is incorrect. Bankruptcy risk refers to the risk that a firm will be unable to meet its

financial obligations due to insolvency. While BT Motors is refusing to pay, there's no information

suggesting it's because they are insolvent or facing bankruptcy.

Choice B is incorrect. General market risk refers to the potential for losses due to changes in

market conditions such as interest rates, exchange rates, commodity prices etc. In this case,

while the derivative contract was indeed meant as a hedge against exchange rate fluctuations,

the issue at hand isn't about general market risk but rather BT Motors' refusal to settle its

obligations.

Choice D is incorrect. Default risk pertains to the possibility that a party will not fulfill their

contractual obligations. Although BT Motors has not fulfilled its obligation by refusing payment,

this situation specifically relates more closely with settlement risk which involves one party

fulfilling their part of deal and other party failing/refusing to do so after conclusion of contract.

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Q.5298 Which of the following definitions of bankruptcy risk is correct?

A. The potential risk of harm to a company's brand or reputation resulting from negative
public perception or publicity.

B. The potential risk of financial, operational, or reputational harm to a company

resulting from cyber threats or attacks.

C. The likelihood that a company will become insolvent and unable to meet its financial
obligations to creditors and investors.

D. The likelihood that a borrower will default on their debt obligations, resulting in
financial losses for the lender.

The correct answer is C.

Bankruptcy risk refers to the probability that a company will become insolvent, meaning it will

be unable to meet its financial obligations to its creditors and investors. This risk arises when a

company's liabilities exceed its assets, and it is unable to generate sufficient cash flow to fulfill

its financial commitments. Bankruptcy risk is a critical consideration for creditors, investors, and

other stakeholders, as it directly impacts their financial interests and decision-making processes.

Understanding and managing bankruptcy risk is a key aspect of financial risk management, and

it involves assessing a company's financial health, monitoring its cash flow and liabilities, and

taking proactive measures to mitigate potential risks.

Choice A is incorrect. While harm to a company's brand or reputation can indeed have

financial implications, this does not directly relate to bankruptcy risk. Bankruptcy risk

specifically pertains to the likelihood of a company becoming insolvent and unable to meet its

financial obligations, rather than potential damage to its reputation.

Choice B is incorrect. This option describes cyber risk, which involves potential harm from

cyber threats or attacks. Although such risks could potentially lead to financial instability and

even bankruptcy if severe enough, they are not synonymous with bankruptcy risk itself.

Choice D is incorrect. This choice refers more closely to credit risk - the likelihood that a

borrower will default on their debt obligations - rather than bankruptcy risk. While these two

types of risks are related (as default can lead towards insolvency), they are distinct concepts

within the field of financial management.

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Q.5299 A financial analyst is analyzing a bank's financial health and is particularly worried about
the potential increase in the bank's cost of debt due to a possible decline in its credit rating. This
concern is associated with which type of risk among the following options?

A. Interest Rate Risk

B. Equity Price Risk

C. Bankruptcy Risk

D. Downgrade Risk

The correct answer is D.

Downgrade risk is an example of credit risk. It refers to the potential for a company's credit

rating to be lowered by credit rating agencies, such as Standard & Poor's, Moody's, and Fitch

Ratings. Credit ratings are an assessment of a company's creditworthiness and its ability to meet

financial obligations, such as debt payments. A downgrade indicates that the credit rating

agency perceives an increased risk of default or financial distress for the company.

A is incorrect. Interest rate risk arises from fluctuations in the market interest rates, and it may

cause a decline in the value of interest-rate-sensitive portfolios.

B is incorrect. Equity price risk is the risk that is associated with volatility in stock prices. It

doesn't result in an increase in the cost of debt.

C is incorrect. Bankruptcy risk is another example of credit risk. It is associated with a

borrower's inability to clear his debt leading to a takeover of his collateralized assets.

Q.5300 Which of the following risks is associated with uncertainties in demands, the cost of
production, and the cost of delivery of products?

A. Operational Risk

B. Business Risk

C. Strategic Risk

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 D. Liquidity Risk

The correct answer is B.

Business risk is the risk associated with the uncertainties of operating a business. These

uncertainties can arise from various factors, including fluctuations in customer demand, changes

in production costs, and variations in delivery expenses. The level of business risk a company

faces can significantly impact its profitability and financial stability. Therefore, effective

management of business risk is crucial for a company's success.

Business risk can be influenced by both internal and external factors. Internal factors include

operational efficiency, cost management, and product quality. External factors include market

conditions, customer preferences, and competitive landscape. Companies can manage business

risk by implementing effective strategic planning, optimizing production and delivery processes,

and maintaining a strong brand image.

It's important to note that while all businesses face some level of business risk, the degree of risk

can vary significantly depending on the industry, market conditions, and the specific business

model of the company.

Choice A is incorrect. Operational risk refers to the risk of loss resulting from inadequate or

failed internal processes, people and systems, or from external events. It does not directly link to

uncertainties in customer demand, production costs, or delivery expenses.

Choice C is incorrect. Strategic risk involves the potential for loss due to a company's strategic

business decisions such as mergers and acquisitions, partnerships, and geographic expansion.

While these decisions can indirectly affect customer demand and production costs, they are not

directly linked to these uncertainties.

Choice D is incorrect. Liquidity Risk pertains to a company's ability to meet its short-term

financial obligations when they fall due without incurring unacceptable losses. This type of risk

does not have a direct connection with uncertainties in customer demand or the cost of

producing goods/services.

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Q.5303 Which statement best describes a benefit of using the Risk-Adjusted Return on Capital
(RAROC)?

A. It considers systemic risk.

B. It helps financial institutions allocate their capital effectively.

C. It considers non-financial risks, such as operational risk.

D. It is simple to calculate.

The correct answer is B.

The primary benefit of using the Risk-Adjusted Return on Capital (RAROC) is that it aids financial

institutions in effectively allocating their capital. The RAROC metric is calculated by dividing the

risk-adjusted profit (net income minus expected losses and allocated capital costs) by the

economic capital, which represents the amount of capital required to cover unexpected losses

given a specific confidence level. By using RAROC, financial institutions can compare the risk-

adjusted returns of different investments or business units, allowing them to allocate capital

more effectively and pursue opportunities with the optimal balance of risk and return. This helps

in achieving a balance between risk and return, and in making informed decisions about where

to invest capital for maximum return on investment.

Choice A is incorrect. The RAROC framework does not specifically consider systemic risk.

Systemic risk refers to the risk that could collapse an entire financial system or market, and it is

not directly incorporated into the RAROC model.

Choice C is incorrect. While RAROC can be used to evaluate various types of risks, it primarily

focuses on financial risks rather than non-financial risks such as operational risk. Therefore, this

statement is not accurate.

Choice D is incorrect. RAROC isn't necessarily simple to calculate as it requires complex

calculations and data inputs related to different types of risks and capital costs associated with a

particular investment or business decision.

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Q.5304 Which of the following methods of risk management involves derivative products where a
company pays a premium to a party to accept a certain level of risk?

A. Avoiding the risk.

B. Retaining the risk.

C. Transferring the risk.

D. Mitigating the risk.

The correct answer is C.

This method of risk management involves shifting the risk from one party to another. In the

context of the question, the company is transferring its risk to another party through the use of

derivative products. By paying a premium, the company is essentially buying insurance against a

certain level of risk. The party receiving the premium is accepting the risk and is obligated to

compensate the company if the risk event occurs. This method is commonly used in financial

markets where risks can be quantified and priced. It allows companies to focus on their core

business activities without worrying about potential financial losses from risks that can be

transferred.

Choice A is incorrect. Avoiding the risk involves not taking any action that could lead to the

risk in the first place. This strategy does not involve paying a premium to transfer risk, but

rather avoiding situations or decisions that could potentially lead to financial instability.

Choice B is incorrect. Retaining the risk means accepting and managing it internally within

the company, without transferring it to another party. In this case, there would be no need for a

derivative product or payment of a premium.

Choice D is incorrect. Mitigating the risk involves taking steps to reduce its potential impact or

likelihood of occurrence, but not necessarily transferring it entirely as described in this scenario

with derivative products.

Q.5305 A risk analyst is analyzing a company’s risks. The analyst is using the following factors:
The probability of occurrence of a risk event, the size (severity) of the loss, and the exposure to
risk. Which of the following metrics is the analyst attempting to calculate?

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 A. Value at risk

B. Expected loss

C. Unexpected loss

D. Tail loss

The correct answer is B.

Expected loss is a key metric in risk analysis that represents the average amount of loss that an

institution can anticipate to incur on a portfolio of assets over a specified time period. The

calculation of expected loss involves three components: the probability of default (PD), the loss-

given default (LGD), and the exposure at default (EAD). The probability of default represents the

likelihood of a risk event occurring. The loss-given default is an estimate of the potential severity

of the loss if the risk event occurs. The exposure at default represents the total value that is at

risk if the default occurs. By multiplying these three components together, the analyst can

estimate the expected loss, which provides a measure of the potential financial impact of the risk

events that the company is exposed to.

Choice A is incorrect. Value at Risk (VaR) is a statistical technique used to measure and

quantify the level of financial risk within a firm or investment portfolio over a specific time

frame. This metric is most commonly used by investment and commercial banks to determine the

extent and occurrence rate of potential losses in their institutional portfolios. However, it does

not take into account the severity of loss, which is one of the factors considered by the analyst.

Choice C is incorrect. Unexpected Loss (UL) represents potential loss due to unexpected

events or risks that are not covered under normal business operations or risk models. While this

metric does consider both likelihood and severity, it doesn't factor in overall exposure to risk as

required by our analyst's comprehensive assessment.

Choice D is incorrect. Tail Loss refers to risks occurring at the tail end of a distribution curve -

these are extreme events with low probability but high impact. While this concept considers

severity, it doesn't necessarily incorporate likelihood or overall exposure in its calculation making

it an unsuitable choice for our analyst's needs.

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Q.5306 An analyst is calculating the expected loss using the following information.

Probability of default 2%
Loss given default 50%
Z-Score 1.645
Standard deviation 2.59
Exposure at default $1, 000, 000

The expected loss is closest to?

A. $20,000

B. $500,000

C. $10,000

D. $51,800

The correct answer is C.

The expected loss is calculated by multiplying the probability of default (PD) by the loss given

default (LGD) and the exposure at default (EAD).

Expected Loss = P D × LGD × EAD

= 2% × 50% × $1, 000, 000
= $10, 000

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 Reading 2: How Do Firms Manage Financial Risk?

Q.17 A Canadian company harbors an ambitious plan to launch a project in the U.S. in twelve
months. The company uses the Canadian dollar as the functional currency, and the project would
most likely be executed in U.S. dollars. However, the company's top management is worried that
the CAD will weaken against the USD in the months leading up to the beginning of the project,
which might, in turn, increase the amount the company will have to pay for the project. As the
company's risk manager, which of the following business strategies would work best regarding
the foreign exchange risk?

A. Launching the project earlier than planned.

B. Take a hedging position in the form of a currency futures contract.

C. Advise the company to purchase stock index futures.

D. Immediately pay for some upfront costs of the project.

The correct answer is B.

A lot can change in 12 months. If the USD appreciates significantly against the CAD, the project

will become more expensive, and its internal rate of return will decrease. To hedge that risk, the

company could take a position in a currency futures contract to lock in the value of the CAD

versus the USD.

Option A is incorrect: Launching the project earlier than planned, may help for some time

but the company will still suffer when the CAD depreciates over the USD.

Option C is incorrect: purchasing stock index futures is used to hedge against the risk of

fluctuation in market prices.

Option D is incorrect: Paying for some upfront costs of the project immediately may reduce

future costs however, the company will still suffer from the effects of the currency depreciation.

Things to Remember

Foreign exchange risk, also known as currency risk, is a financial risk that arises from potential

changes in the exchange rate between two currencies. Companies that do business

internationally are exposed to this risk because the value of their foreign revenues and expenses

can fluctuate due to changes in exchange rates. There are several strategies that companies can

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use to manage foreign exchange risk, including forward contracts, futures contracts, options,

and swaps. These financial instruments allow companies to hedge their currency risk by locking

in the exchange rate for a future date. It's important to note that while these strategies can

provide protection against currency fluctuations, they also involve costs and can limit the

potential upside from favorable currency movements. Therefore, companies need to carefully

consider their risk tolerance and financial objectives when deciding how to manage their foreign

exchange risk.

Q.18 In risk management, the term 'hedging' is often used to describe a specific strategy aimed
at protecting the value of an asset or portfolio against potential losses due to market
fluctuations. Which of the following options most accurately captures the essence of this
concept?

A. Buying an asset to offset a decline in value of another asset.

B. Holding an asset that appreciates in value to offset the decrease in the value of
another asset.

C. Selling a loss-making asset and replacing it with a profitable one.

D. Holding an offsetting position in an asset or portfolio whose value we expect to move

in line with market changes.

The correct answer is D.

Hedging entails any action taken to safeguard the value of an asset in the face of changing

market prices. It's actually an attempt to "lock-in" the value of an asset. The investor protects

their investment by holding assets that have a predetermined future price.

Option A is incorrect: Buying an asset to offset a decline in the value of another asset refers to

diversification.

Option B is incorrect: Holding an asset that appreciates in value to offset the decrease in the

value of another asset is also a diversification method.

Option C is incorrect: Selling a loss-making asset and replacing it with a profitable one is a

form of Profit/Loss strategy.

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Things to Remember

Hedging is a risk management strategy employed to offset losses in investments by taking an

opposite position in a related asset. The reduction in risk provided by hedging also typically

results in a reduction in potential profits. Hedging strategies typically involve derivatives, such

as options and futures contracts. Diversification and profit/loss strategies are different from

hedging. Diversification involves spreading investments around so that the performance of one

investment does not affect the overall performance of the portfolio. Profit/loss strategy involves

selling assets that are not performing well and replacing them with assets that are expected to

perform better.

Q.19 An international construction company places a bid for a major construction project. Top
management is convinced the company will secure the contract but are also wary of currency
fluctuations during the bids evaluation process, which would make the project more costly and
reduce the profit margin. Which of the following actions do you think can reduce this risk?

A. Negotiating the price of construction materials with sellers in advance

B. Purchasing construction materials in advance with the option to sell them if the bid
turns out unsuccessful

C. Getting into a currency futures contract

D. Adding a risk premium to the bid amount

The correct answer is C.

Using a currency futures contract, the company can price the bid quoting current market rates

and then use the futures contract to hedge its exposure to currency fluctuation. This way, the

company would ensure that even if the market rates change, the bid would be sufficient to

undertake the project and earn a profit.

Option A is incorrect: prices may be negotiated in advance; however, without a contract, then

you will still buy the materials at the prevailing market prices in case the prices rise, since stocks

may also rise in price.

Option B is incorrect: A lot may happen with time. The price of the materials may rise, and

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therefore purchasing construction materials in advance with the option to sell them if the bid

turns out unsuccessful will not help reduce the risk.

Option D is incorrect: the owner of the project pays the risk premium in advance and if the

risk does not materialize, then this will only benefit the contractor of the project

Things to Remember

Currency risk, also known as exchange rate risk, is a financial risk that arises from potential

changes in the exchange rate of one currency in relation to another. Companies that conduct

business internationally are exposed to currency risk as the value of their revenues, costs,

assets, and liabilities can be affected by currency fluctuations. There are several strategies that

companies can use to manage currency risk, including the use of financial derivatives like

futures, forwards, options, and swaps. These instruments allow companies to hedge their

exposure to currency risk, effectively locking in the exchange rate at which they can buy or sell a

particular currency in the future. This can help protect the company's profit margins and ensure

the financial viability of their international operations.

Q.20 In a company's risk management strategy, the risk appetite statement plays a crucial role. It
outlines the types of risks the company is willing to take, the risk management tools it prefers to
use, and the maximum loss it is prepared to bear within a certain confidence limit and
timeframe. Given these elements, which of the following is most likely to be excluded from a
company's risk appetite statement?

A. The types of risks the firm is willing to tolerate, specifying the risks to hedge and the
ones to assume

B. The preferred risk management tools e.g, insurance, derivatives, etc.

C. The maximum loss the firm is willing to incur at a given confidence limit and time

D. The timings of cash flows from the firm's projects

The correct answer is D.

The timings of cash flows from the firm's projects are not typically included in a firm's risk

appetite statement. This is because each project that a firm undertakes is likely to have its

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unique capital outlay and duration. Therefore, it would be impractical and potentially misleading

to include specific timings of cash flows in the risk appetite statement. The risk appetite

statement is more concerned with outlining the types of risks the firm is willing to take, the risk

management tools it prefers to use, and the maximum loss it is prepared to bear within a certain

confidence limit and timeframe. It is not intended to provide detailed financial projections for

individual projects.

Choice A is incorrect because the types of risks the firm is willing to tolerate, specifying the

risks to hedge and the ones to assume, are indeed a crucial part of a firm's risk appetite

statement. This information helps stakeholders understand the firm's approach to risk

management and the types of risks it is willing to take on in pursuit of its business objectives.

Therefore, it is unlikely to be omitted from the risk appetite statement.

Choice B is incorrect because the preferred risk management tools, such as insurance and

derivatives, are also typically included in a firm's risk appetite statement. These tools are part of

the firm's overall risk management strategy and provide insight into how the firm plans to

mitigate and manage the risks it faces.

Choice C is incorrect because the maximum loss the firm is willing to incur at a given

confidence limit and time is a key component of a firm's risk appetite statement. This information

provides a clear indication of the firm's tolerance for risk and its capacity to absorb losses.

Things to Remember

A risk appetite statement is a key document in a firm's risk management framework. It outlines

the types of risks the firm is willing to take, the risk management tools it prefers to use, and the

maximum loss it is prepared to bear within a certain confidence limit and timeframe. The

statement is intended to provide a clear and comprehensive overview of the firm's approach to

risk management, and it is typically shared with stakeholders to ensure transparency and

accountability. It is important to note that while the risk appetite statement provides a broad

overview of the firm's approach to risk management, it does not include detailed financial

projections for individual projects, such as the timings of cash flows.

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Q.23 Distinguish between exchange-traded and over-the-counter risk management instruments.

A. Exchange-traded instruments are standardized and exchange-tradable while over-the-

counter instruments are non-standardized, privately negotiated financial contracts that
cannot be traded on an exchange.

B. Over-the-counter instruments are standardized and exchange-tradable while

exchange-traded instruments non-standardized, privately negotiated financial contracts
that cannot be traded on an exchange.

C. Exchange-traded instruments are those instruments that only deal with intangible
financial assets while over-the-counter instruments only deal with commodities such as
coffee.

D. Exchange-traded instruments have time to maturity of less than one year while over-
the-counter instruments have longer maturity periods.

The correct answer is A.

Exchange-traded instruments are indeed standardized and can be traded on an exchange. This

standardization is a key feature of these instruments, as it allows for a more liquid and

transparent market. The standardization refers to the fact that the terms and conditions of the

contracts are set by the exchange, and therefore, all contracts of the same type and expiry date

are identical. This makes them easily tradable on the exchange, as any buyer can be matched

with any seller. Examples of exchange-traded instruments include futures and options.

On the other hand, over-the-counter (OTC) instruments are non-standardized and are privately

negotiated. This means that the terms and conditions of the contracts are agreed upon by the

two parties involved, making each OTC contract unique. Because of this, OTC contracts cannot

be traded on an exchange. Instead, they are traded directly between two parties, either through

a dealer network or in a decentralized manner. Examples of OTC instruments include forwards

and swaps.

Choice B is incorrect. Over-the-counter instruments are not standardized and exchange-

tradable. Instead, they are non-standardized, privately negotiated financial contracts that cannot

be traded on an exchange. This is the opposite of what is stated in this choice.

Choice C is incorrect. The type of assets dealt with by exchange-traded or over-the-counter

instruments does not strictly depend on whether they are tangible or intangible. Both types of

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instruments can deal with a variety of assets including both tangible commodities and intangible

financial assets.

Choice D is incorrect. The time to maturity for both exchange-traded and over-the-counter

instruments can vary widely and does not necessarily follow the pattern suggested in this choice.

It depends more on the specific terms agreed upon by the parties involved in each individual

contract.

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Q.24 A reputable bank is approached by a newly-formed private company wishing to enter into
an option contract on the British pound. The bank's risk managers prefer an exchange-traded
option to an over-the-counter one. Which of the following statements least likely explains the
managers' preference?

A. Price discovery

B. Counterparty risk

C. Flexibility in settlement

D. Liquidity

The correct answer is C.

Exchange-traded derivatives are not as flexible in settlement as over-the-counter (OTC)

derivatives. OTC contracts can be settled in a variety of ways, such as cash settlement, physical

delivery, or a combination of the two. This flexibility in settlement is an advantage of OTC

derivatives over exchange-traded derivatives. Therefore, flexibility in settlement is least likely to

explain the bank's risk managers' preference for an exchange-traded option over an OTC one.

Choice A is incorrect. Price discovery is a significant advantage of exchange-traded options.

The prices of these options are determined by the market, which ensures transparency and

fairness. This process allows both parties to understand the value of the option contract better.

Choice B is incorrect. Counterparty risk is lower in exchange-traded options as compared to

over-the-counter ones because the clearinghouse acts as a counterparty to both sides in each

transaction, reducing credit risk significantly.

Choice D is incorrect. Liquidity tends to be higher for exchange-traded options due to their

standardized nature and large number of participants, making it easier for parties to enter or

exit positions.

Q.25 A firm borrows funds at a variable interest rate. Buying which of the following instruments
would help the firm protect itself against increases in the market rate of interest?

A. Currency forward contracts

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 B. Options on interest rate futures

C. Currency swaps

D. Currency futures contracts

The correct answer is B.

Interest rate futures are a type of derivative contract through which the holder agrees to buy or

sell an interest-bearing asset on a future date. The price of an interest rate future moves

inversely to the change in interest rates. If interest rates go down, the price of the interest rate

future goes up and vice-versa. An option on an interest rate future gives the holder the right, but

not the obligation, to buy (call option) or sell (put option) the underlying interest rate future at a

specified price (the strike price) on or before a specified date (the expiration date).

In this case, a put option on an interest rate future would be an effective hedge for the firm. If

interest rates rise, the firm can exercise its option to sell the interest rate future at the strike

price, which would be higher than the market price. This would offset the increased cost of

borrowing due to the rise in interest rates. If interest rates fall, the firm can choose not to

exercise its option and benefit from the lower borrowing cost.

Choice A is incorrect. Currency forward contracts are used to hedge against the risk of

exchange rate fluctuations, not interest rate changes. They allow parties to buy or sell a specific

amount of foreign currency at a predetermined price on a future date, thus providing no

protection against rising interest rates.

Choice C is incorrect. Currency swaps involve the exchange of one currency for another

between two parties, with an agreement to reverse the swap at a later date. While this can help

manage exposure to foreign exchange risk, it does not directly address the risk of rising interest

rates on a loan.

Choice D is incorrect. Similar to currency forward contracts, currency futures contracts are

used primarily for hedging against foreign exchange risk and do not provide protection against

increasing market interest rates.

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Q.26 Which of the following is not a common characteristic of interest rate swaps?

A. Payments made by both parties are in different currencies

B. The contract is usually based on a ''notional'' principal amount

C. They trade over the counter

D. Interest rate swaps are used to hedge against or speculate on changes in interest
rates.

The correct answer is A.

Payments made by counterparties in an interest rate swap must be in the same currency. This is

one of the main differences between currency swaps and interest rate swaps.

The following are characteristics of interest rate swaps:

i. The contract is usually based on a ''notional'' principal amount which remains the same
over the entire lifetime of the swap.
ii. They are over-the-counter financial instruments.
iii. Interest rate swaps are used to hedge against or speculate on changes in interest rates
iv. Counterparties negotiate and agree on the fixed-rate and day-count conventions at the
initiation of the swap contract
v. The swap duration can go from one week to 30 years.

Q.29 A construction firm wishes to enter into cleared derivative positions to manage risks such
as price variation of raw materials and increase interest rates. However, the firm is aware of a
few problems that could accompany the decision to invest in exchange-traded derivatives. Which
of the following should not be worrisome for the management of the firm?

A. Liquidity risk

B. Counterparty risk

C. Market risk

D. Transaction costs

The correct answer is B.

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Counterparty risk is the risk that the other party in an agreement will default or fail to live up to

their obligations. In the context of exchange-traded derivatives, this risk is significantly

mitigated because the exchange itself acts as the counterparty for each transaction. This means

that the exchange assumes the role of the buyer for every seller and the seller for every buyer.

Therefore, the risk of default is transferred from the individual parties to the exchange. This is a

key feature of exchange-traded derivatives and one of the reasons why they are considered safer

than over-the-counter derivatives, where counterparty risk can be a significant concern.

Choice A is incorrect. Liquidity risk is a valid concern for the company's management. This

risk refers to the possibility that the company may not be able to quickly buy or sell its derivative

positions without causing a significant change in their prices. In other words, if the market for

these derivatives is not sufficiently liquid, it could negatively impact the company's ability to

manage its risks effectively.

Choice C is incorrect. Market risk should also be a concern for the company's management.

This type of risk refers to potential losses that can arise from movements in market prices, such

as those of raw materials and interest rates, which are exactly what this construction company

aims to hedge against by using cleared derivative positions.

Choice D is incorrect. Transaction costs are another potential issue that could arise from

investing in exchange-traded derivatives. These costs include brokerage fees and other charges

associated with buying and selling these financial instruments on an exchange, which can eat

into any profits made from these transactions or add to any losses incurred.

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Q.30 Besides credit risk, counterparties in a derivative position face another major type of risk.
Which one is it?

A. Interest rate risk

B. Foreign exchange risk

C. Commodity price risk

D. Market risk

The correct answer is D.

Market risk, also known as 'systematic risk' or 'undiversifiable risk', is a type of risk that is

inherent to the entire market or market segment. It represents the potential for losses arising

from changes in market risk factors such as interest rates, exchange rates, and commodity

prices. In the context of derivative transactions, market risk is a major concern for

counterparties as it can significantly impact the value of their investments. Market risk

encompasses other risks such as interest rate risk, foreign exchange risk, and commodity price

risk. Therefore, it is not uncommon for market participants to enter into offsetting agreements or

use other hedging strategies to mitigate their exposure to market risk. These strategies typically

involve entering into a second agreement that works in exactly the opposite direction, effectively

canceling out the potential loss that could be incurred in the first agreement.

Choice A is incorrect. Interest rate risk is a type of market risk, but it only pertains to the

potential losses that may arise due to fluctuations in interest rates. It does not encompass all the

market risk factors such as equity prices, commodity prices, and foreign exchange rates.

Choice B is incorrect. Foreign exchange risk is also a type of market risk, but it specifically

refers to the potential losses that may occur due to changes in foreign exchange rates. It does

not cover all other types of market risks.

Choice C is incorrect. Commodity price risk refers to the potential losses that can occur due to

changes in commodity prices. While this is a significant part of market risks for certain

businesses, it does not represent all forms of market risks faced by counterparties in derivative

transactions.

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Q.41 The board of directors of BRT Inc. is determining the risk appetite of the firm. It believes
increasing the firm's risk appetite will introduce BRT to new potential business opportunities and
increase the rewards to stakeholders. However, changing the risk appetite of a firm can be a
cause of conflict between parties. Determining the risk appetite of a firm can cause the greatest
conflict between:

A. Management and debtholders.

B. Management and shareholders.

C. Shareholders and the board of directors.

D. Shareholders and debtholders.

The correct answer is D.

The conflict between shareholders and debtholders is the most intense when determining a

firm's risk appetite. This is because their interests are diametrically opposed when it comes to

risk. Shareholders, as residual claimants, have an unlimited upside potential and therefore

prefer a higher risk appetite. They stand to gain more if the firm takes on more risk and

succeeds. On the other hand, debtholders, as fixed-income claimants, have a limited upside

potential, which is confined to the interest rate agreed upon. Therefore, they prefer a lower risk

appetite to ensure the firm's ability to meet its debt obligations. This fundamental difference in

risk preference creates a significant conflict between shareholders and debtholders when

determining the risk appetite of a firm.

Choice A is incorrect. While management and debtholders may have differing views on the

company's risk appetite, it is not the most likely pair to experience the highest level of conflict.

Management typically has a higher risk tolerance as they are focused on growth and profitability,

while debtholders prefer lower risk to ensure repayment of their debt. However, these

differences can be managed through effective communication and negotiation.

Choice B is incorrect. Although there might be disagreements between management and

shareholders regarding the company's risk appetite due to their different perspectives on risk-

return trade-off, this conflict is usually not as intense as that between shareholders and

debtholders. Shareholders generally favor higher risks for potentially higher returns while

management might prefer a more balanced approach.

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Choice C is incorrect. The board of directors represents the interests of shareholders in setting

the company's strategic direction including its risk appetite. Therefore, conflicts between these

two parties are less likely compared to other pairs since they share common objectives in

maximizing shareholder value.

Q.42 Anadolu Tire Company is the market leader in the tires manufacturing sector in Turkey. It
acquires its raw material from its neighbor, Iran, on fixed trade terms and pays the supplier in
the local Turkish currency. Anadolu also sells its tires to some eastern European countries and
accepts payments in Euro. Based on the business perspective of Anadolu, determine which of the
following risk it should hedge.

A. Pricing risk.

B. Foreign currency risk.

C. Interest rate risk.

D. Market risk.

The correct answer is B.

Anadolu Tire Company should prioritize hedging against foreign currency risk. This is because

the company conducts business transactions in multiple currencies - it pays its suppliers in the

local Turkish currency and receives payments from its customers in Euros. If the value of the

Euro depreciates against the Turkish currency, the company's revenue from its sales in Eastern

Europe would decrease when converted back to the local currency. This could potentially lead to

financial losses. Therefore, to protect itself from the potential adverse effects of currency

fluctuations, Anadolu Tire Company should hedge against foreign currency risk.

Choice A is incorrect. Pricing risk refers to the potential for a change in the price of a product

or service due to market factors such as competition, supply and demand, among others. While

Anadolu Tire Company may face pricing risk, it is not directly related to their business model of

sourcing raw materials from Iran and exporting products to Eastern European countries.

Choice C is incorrect. Interest rate risk pertains to the potential for changes in interest rates

that could affect a company's operations or its financial condition. Although this type of risk can

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impact any business, there's no specific information given in the question that suggests Anadolu

Tire Company should prioritize hedging against interest rate risk.

Choice D is incorrect. Market risk involves exposure to changes in market prices, such as

equity prices or commodity prices. While Anadolu Tire Company might be exposed to some level

of market risk due its operations, it doesn't appear as significant as foreign currency risk given

their business model which involves transactions in multiple currencies.

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Q.43 Which of the following statements are incorrect regarding static hedging and dynamic
hedging strategies?

A. In static hedging, the risk is recognized at the beginning, and the appropriate hedging
position is opened

B. A dynamic hedging strategy is more complex as the underlying risky position may
change with time

C. Static hedging requires more time and monitoring effort

D. Dynamic hedging requires additional transaction costs to maintain the risky position
hedged

The correct answer is C.

The statement that static hedging requires more time and monitoring effort is incorrect. In fact,

it is dynamic hedging that requires more time and monitoring effort. This is because dynamic

hedging involves adjusting the hedging position as the underlying risky position changes over

time. This necessitates continuous monitoring of the market conditions and the risky position,

and making appropriate adjustments to the hedging position. This can be a time-consuming and

effort-intensive process. On the other hand, static hedging involves recognizing the risk at the

outset and opening the appropriate hedging position. Once the hedging position is opened, it

remains in place until the exposure ends.

Choice A is incorrect. This statement is correct as static hedging involves identifying the risk

at the beginning and then opening a hedging position to mitigate that risk. The hedge is set up

once and does not change over time, hence it's called 'static'.

Choice B is incorrect. This statement accurately describes dynamic hedging strategies. They

are indeed more complex because they require continuous adjustment of the hedge position as

market conditions change, which can be quite frequent.

Choice D is incorrect. Dynamic hedging does indeed involve additional transaction costs due to

its nature of constant adjustments to maintain an effective hedge against changing market

conditions.

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Q.44 Which of the following is not an attribute of exchange-traded and over-the-counter (OTC)
financial instruments?

A. Exchange-traded instruments are more simple and standardized.

B. Over-the-counter financial instruments are more liquid than exchange-traded

instruments.

C. Exchange-traded instruments are easier to price than OTC instruments.

D. Over-the-counter financial instruments contain default risk.

The correct answer is B.

The statement that over-the-counter financial instruments are more liquid than exchange-traded

instruments is incorrect. Liquidity refers to the ease with which an asset or security can be

bought or sold in the market without affecting its price. Exchange-traded instruments are

generally more liquid than OTC instruments. This is because exchange-traded instruments are

standardized, traded in a centralized market, and are subject to stringent regulatory oversight,

which enhances their liquidity. On the other hand, OTC instruments are customized contracts

that are traded privately between two parties. This customization and lack of centralization often

result in lower liquidity for OTC instruments as compared to exchange-traded instruments.

Choice A is incorrect. Exchange-traded instruments are indeed more simple and standardized.

This is because they are traded on an exchange where the terms and conditions of the contracts

are standardized by the exchange itself.

Choice C is incorrect. Exchange-traded instruments are generally easier to price than OTC

instruments due to their standardization and transparency of information available in exchanges.

Choice D is incorrect. Over-the-counter financial instruments do contain default risk, as there's

no central clearing house to guarantee trades like in an exchange environment, increasing

counterparty risk.

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Q.5036 A firm has a total risk capacity of $600 million. Senior managers have set a risk appetite
at $300 million. Which of the following would most likely be within the acceptable risk profile for
the firm?

A. $400 million

B. $250 million

C. $900 million

D. $450 million

The correct answer is B.

The risk profile of a company is the amount of risk it is currently exposed to. It should be less

than the company's risk appetite, which is the amount of risk the company is willing to take on.

In this case, the company's risk appetite is $300 million. Therefore, the risk profile should be less

than this amount. Option B, which is $250 million, is the only option that is less than the

company's risk appetite. This is in line with the principle that a company's risk profile should

always be less than its risk appetite, which in turn should be less than its total risk capacity. This

ensures that the company does not take on more risk than it can handle, thereby safeguarding its

financial stability and long-term viability.

Choice A is incorrect. The risk amount of $400 million exceeds the firm's risk appetite of $300

million, which means it falls outside the acceptable risk profile.

Choice C is incorrect. The risk amount of $900 million not only exceeds the firm's risk appetite

but also its total risk capacity of $600 million, making it an unacceptable level of risk for the

company.

Choice D is incorrect. Similar to choice A, a risk amount of $450 million surpasses the

company's established risk appetite and therefore does not align with its acceptable risk profile.

Q.5307 ABC Bank’s chief risk officer is trying to reduce the bank’s exposure to foreign exchange
fluctuations. He has suggested using an agreement where the bank gets the right without any
obligation to exchange a given amount of currency at a predetermined price in the future. Which
of the following derivatives is the chief risk officer suggesting?

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 A. Forwards

B. Futures

C. Options

D. Swap

The correct answer is C.

Options are financial derivatives that provide the holder with the right, but not the obligation, to

buy or sell an underlying asset at a predetermined price within a specified period. In the context

of foreign exchange, an option would allow ABC Bank to hedge against potential adverse

currency movements. If the foreign exchange rate moves in a direction that is unfavorable to the

bank, it can exercise the option and exchange the currency at the predetermined rate. However,

if the exchange rate moves in a direction that is favorable to the bank, it can let the option expire

and exchange the currency at the prevailing market rate. This flexibility is a key characteristic of

options and distinguishes them from other derivative instruments such as forwards, futures, and

swaps, which obligate the contracting parties to honor the contract.

Choice A is incorrect. Forwards are a type of derivative instrument, but they do not provide

the right without an obligation. Instead, they involve an agreement to buy or sell an asset at a

specified future date for a price agreed upon today. Therefore, both parties are obligated to fulfill

the contract.

Choice B is incorrect. Futures are similar to forwards in that they involve an agreement to buy

or sell an asset at a specified future date for a price agreed upon today. However, futures

contracts are standardized and traded on exchanges, unlike forwards which are private

agreements between two parties. Like forwards though, futures also impose obligations on both

parties involved.

Choice D is incorrect. Swaps involve the exchange of cash flows between two parties based on

predetermined terms and conditions but do not grant any rights without obligations like options

do.

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 Reading 3: The Governance of Risk Management

Q.21 In risk management within an organization, the board plays a crucial role. This role involves
various responsibilities and tasks that contribute to the overall risk management strategy of the
organization. Which of the following options best describes the primary role of the board in the
risk management process?

A. Issuing guidelines on how to manage risks

B. Developing the risk appetite statement and objectives the managers should strive to
meet within the risk management framework

C. Regularly reviewing decisions made by managers regarding risk exposures

D. Choosing the risk exposures to hedge, the risks to mitigate, and those to avoid
altogether

The correct answer is B.

The board sits above the managers in the hierarchy of management in most for-profit

organizations. The board assembles and develops a comprehensive risk appetite statement,

specifying the risks the company should assume and those to avoid, including the preferred

methods of risk mitigation. The managers consult the risk appetite statement when choosing the

projects to undertake.

The board also delegates the responsibility for approving and reviewing the risk levels to the

board risk management committee.

Option A is incorrect: Issuing guidelines on managing risks is the role of risk advisory

managers.

Option C is incorrect: Regularly reviewing decisions made by managers regarding risk

exposures is the role of the board risk management committee.

Option D is incorrect: Choosing the risk exposures to hedge, the risks to mitigate, and those to

avoid altogether is the role of the risk advisory directors.

Things to Remember

Risk management is a critical aspect of any organization's operations. It involves identifying,

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assessing, and managing potential risks that could negatively impact the organization's

objectives. The board plays a crucial role in this process by setting the organization's risk

appetite and guiding the overall risk management strategy. However, the board's role is strategic

in nature, and it typically delegates the operational aspects of risk management to other bodies

within the organization, such as risk advisory managers, risk management committees, and risk

advisory directors. Understanding the roles and responsibilities of these different bodies can

help ensure effective risk management within an organization.

Q.45 Which of the following statements best describes corporate governance in today's business
world?

A. The process by which the board of directors delegates duties to hired professionals
who oversee the day-to-day running of the company.

B. The system of rules, practices, processes, and regulations guiding risk managers when
determining a company's risk appetite.

C. The system of rules, regulations, and processes by which a company's board of

directors looks after the needs of various stakeholders within the broader agenda of
meeting business objectives.

D. The tools used by the board of directors to drive business strategy, corporate
responsibility, and streamline the interests of the company's shareholders.

The correct answer is C.

Corporate governance is indeed a system of rules, regulations, and processes that guide a

company's board of directors in managing the affairs of the company. It is designed to balance

the interests of the company's many stakeholders, such as shareholders, management,

customers, suppliers, financiers, government, and the community. The board of directors is

responsible for looking after the needs of these various stakeholders within the broader agenda

of meeting business objectives. This involves making decisions that affect the direction of the

company, setting strategic goals, and ensuring they are met. The board also oversees the

company's operations to ensure they are in line with the company's strategic goals. This includes

monitoring the performance of the management and taking corrective actions when necessary.

The board also ensures that the company complies with all relevant laws and regulations and

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maintains high standards of ethics and corporate behavior.

Choice A is incorrect. While the board of directors does delegate duties to professionals for the

day-to-day running of the company, this is only a small part of corporate governance. Corporate

governance encompasses much more than just delegation, including setting company objectives,

establishing policies and procedures, and ensuring accountability and transparency.

Choice B is incorrect. This choice incorrectly narrows down corporate governance to only risk

management aspects. Although risk management is an important part of corporate governance,

it also includes other elements such as strategic direction, performance monitoring and

stakeholder communication.

Choice D is incorrect. Tools used by the board to drive business strategy or streamline

shareholder interests are components of corporate governance but they do not define it entirely.

Corporate Governance involves a broader set of rules and processes that ensure effective

management control over corporations in order to protect all stakeholders' interests.

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Q.46 In the aftermath of the 2007/2009 financial crisis, most companies created the position of
Chief Risk Officer (CRO). Which of the following statements about the CRO is INCORRECT?

A. The CRO reports directly to the shareholders.

B. The CRO acts as the chief advisor to the board on all matters of risk.

C. The CRO gives guidance to lower level (line) managers about risk identification and
management, making suggestions for risk mitigation.

D. The CRO plays a starring role when determining the company's risk appetite.

The correct answer is A.

In most corporate structures, the CRO does not report directly to the shareholders. Instead, the

CRO typically reports to the board of directors or a risk sub-committee delegated by the board.

The board, in turn, is responsible for communicating with the shareholders. The CRO's primary

responsibility is to oversee the risk management function in its entirety, which includes

designing the risk management program, setting risk policies, and monitoring the firm's risk

limits. The CRO also acts as an intermediary between the board and the management, keeping

both parties informed about the firm's risk tolerance and the condition of the risk management

infrastructure.

Choice B is incorrect. The CRO does indeed act as the chief advisor to the board on all matters

of risk. This includes providing insights and recommendations on risk management strategies,

policies, and procedures.

Choice C is incorrect. It is part of the CRO's responsibilities to provide guidance to lower level

managers about risk identification and management. They are expected to make suggestions for

risk mitigation, helping line managers understand potential risks and how they can be managed

or mitigated effectively.

Choice D is incorrect. The CRO plays a significant role in determining the company's risk

appetite. They work closely with senior management and board members to establish a clear

understanding of the level of risk that the organization is willing to accept in pursuit of its

business objectives.

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Q.48 Which of the following is most likely a role of finance and operations?

A. Taking on and managing exposure to approved risk

B. Setting business level risk tolerances

C. Managing risk policy development and implementation

D. Overseeing official valuations including independent verification

The correct answer is D.

Overseeing official valuations including independent verification is indeed a role of the finance

and operations department. This department is responsible for ensuring that the company's

financial records are accurate and up-to-date. This includes overseeing official valuations, which

involves assessing the worth of the company's assets, liabilities, and overall equity. Independent

verification is a part of this process, as it involves a third-party entity reviewing the company's

financial records to ensure their accuracy. This is crucial for maintaining transparency and trust

with stakeholders, including investors, creditors, and regulatory bodies. Other roles of the

finance and operations department may include setting and managing valuations & finance

policies, managing and supporting analysis required for business planning, and ensuring proper

settlement/deal capture and documentations.

Choice A is incorrect. While the finance and operations department may be involved in

managing exposure to approved risk, this responsibility typically falls under the purview of the

risk management department. The finance and operations department's role is more focused on

financial planning, budgeting, cash flow management, etc.

Choice B is incorrect. Setting business level risk tolerances is usually a strategic decision

made by senior management or board of directors rather than a function of the finance and

operations department. This involves determining the amount of risk that an organization can

tolerate or absorb before it impacts its objectives.

Choice C is incorrect. Managing risk policy development and implementation generally falls

under the domain of a company's risk management team or committee rather than being a

responsibility of the finance and operations department. They are responsible for developing

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policies to manage risks that could potentially impact an organization's ability to achieve its

objectives.

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Q.49 The following are some of the roles of a bank's audit committee of the board. Which one is
not?

A. Developing the bank's risk appetite statement.

B. Scrutinizing financial statements to ensure the accuracy of the reported figures.

C. Ensuring that the bank complies with the minimum/best-practice standards in all key
activities.

D. Continuously reviewing the independence of the statutory auditor/audit firm.

The correct answer is A.

The audit committee of a bank's board is not typically involved in developing the bank's risk

appetite statement. The risk appetite statement is a strategic document that outlines the level

and type of risk a bank is willing to accept in pursuit of its business objectives. This statement is

usually developed by the bank's senior management and approved by the board of directors. The

role of the audit committee in relation to the risk appetite statement is more of an oversight

nature. It monitors the bank's risk management processes to ensure they are in line with the risk

appetite statement and comply with relevant regulations. The committee does not directly

participate in the development of the risk appetite statement.

Choice B is incorrect. The audit committee indeed scrutinizes financial statements to ensure

the accuracy of the reported figures. This is one of their primary responsibilities, as they need to

ensure that all financial information presented by the bank is accurate and reliable.

Choice C is incorrect. Ensuring compliance with minimum/best-practice standards in all key

activities also falls under the purview of an audit committee. They are responsible for ensuring

that all operations within the bank adhere to established standards and regulations.

Choice D is incorrect. Continuously reviewing the independence of the statutory auditor/audit

firm is another important task performed by an audit committee. They need to ensure that

auditors are independent and unbiased in their assessments, which helps maintain trust in their

findings.

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Q.50 Most organizations have both executive and non-executive directors. Which one of the
following is not a valid difference between the two categories?

A. While executive directors work full-time, non-executive directors work on a part-time

basis.

B. While executive directors get involved in the day-to-day management of the company,
non-executive directors do not participate in management responsibilities.

C. Executive directors are usually not independent, whereas non-executives should be

independent.

D. While executive directors are appointed to the board by shareholders, non-executive

directors are appointed by the nomination committee.

The correct answer is D.

Both executive and non-executive directors are appointed by the shareholders. The nomination

committee, which is usually composed of non-executive directors, is responsible for identifying

suitable candidates for the board, but the final decision rests with the shareholders. The

nomination committee can recommend candidates for both executive and non-executive

positions. Therefore, the appointment process does not differentiate between executive and non-

executive directors.

Choice A is incorrect. The statement accurately represents a difference between executive and

non-executive directors. Executive directors are typically full-time employees of the company,

while non-executive directors often hold part-time positions, providing strategic guidance and

oversight without being involved in the day-to-day operations.

Choice B is incorrect. This statement correctly differentiates between executive and non-

executive directors. Executive directors are involved in the daily management of the company,

making operational decisions and implementing strategies. On the other hand, non-executive

directors do not participate in these management responsibilities; instead, they provide

independent oversight and advice to ensure that the company's strategic objectives align with

shareholders' interests.

Choice C is incorrect. This statement correctly identifies a key difference between executive

and non-executive directors regarding their independence status. Executive directors are usually

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not considered independent as they are part of the management team of the company with

potential conflicts of interest due to their roles within it. In contrast, non-executives should be

independent to provide unbiased oversight on behalf of shareholders.

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Q.52 In which way can suppliers and customers reward good corporate governance?

A. Purchase from a competitor offering lower prices

B. Demanding a higher rate of return on their investment.

C. Actively doing business with the company in favorable terms.

D. Giving extra benefits to company executives.

The correct answer is C.

Good corporate governance can significantly enhance a company's reputation and trust among

its stakeholders, including suppliers and customers. When a company practices good corporate

governance, it demonstrates transparency, accountability, and fairness in its business operations.

This can lead to increased confidence among suppliers and customers, encouraging them to

actively do business with the company in favorable terms. They may offer better payment terms,

discounts, or other benefits, recognizing the reduced risk and increased reliability associated

with doing business with a well-governed company. This choice correctly identifies how suppliers

and customers can reward a company for good corporate governance.

Choice A is incorrect. Purchasing from a competitor offering lower prices does not express

appreciation for good corporate governance. Instead, it indicates a preference for lower prices

over the quality of governance.

Choice B is incorrect. Demanding a higher rate of return on their investment does not show

appreciation for good corporate governance. It rather suggests dissatisfaction with the current

returns and may put undue pressure on the company, potentially leading to poor decision-

making.

Choice D is incorrect. Giving extra benefits to company executives can be seen as an attempt

to influence decisions rather than an appreciation of good corporate governance. Good corporate

governance promotes transparency and fairness, which could be compromised by such actions.

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Q.53 Which of the following committees is charged with approving and authorizing compensation
of top company executives?

A. Audit committee.

B. Risk Management committee.

C. Compensation committee.

D. Audit Function

The correct answer is C.

After the financial crisis of 2007/2009, it became evident that the compensation schemes in place

at many institutions were encouraging excessive risk-taking without due consideration for long-

term risks. Executives were incentivized to prioritize short-term profits, front-loading fees while

back-loading risks. This realization led to the establishment of compensation committees on most

boards. The primary role of the compensation committee is to oversee all matters related to

remuneration. The committee ensures that compensation schemes take into account the risks

faced by the company, thereby safeguarding its long-term financial health.

Choice A is incorrect. The Audit committee is primarily responsible for overseeing the financial

reporting process of a company, not for approving and authorizing the compensation of top

executives. They ensure that the financial statements are accurate and in compliance with

regulatory requirements.

Choice B is incorrect. The Risk Management committee's role involves identifying, assessing,

and managing risks that could potentially affect a company's operations or profitability. It does

not have any direct involvement in determining executive compensation.

Choice D is incorrect. The Audit Function refers to an internal department within a company

that conducts audits to assess whether the organization's processes are compliant with internal

policies and external regulations. This function does not include deciding on executive

compensation.

Q.54 The effective oversight role of the audit committee least likely contributes to:

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 A. Reliable financial reporting

B. More effective corporate governance

C. Credible audit functions

D. Monitoring the firm's risk limits

The correct answer is D.

The audit committee's primary responsibilities revolve around the accuracy of financial and

regulatory reporting of the firm and the quality of processes that underlie such activities. It

ensures that a bank complies with standards in regulatory, risk management, legal, and

compliance activities. It also verifies the activities of the firm to see if the reports outline the

same. Therefore, the audit committee contributes to the accuracy of financial reporting and

ensuring compliance with the minimum standards in other key activities. It also contributes to

more effective corporate governance. However, monitoring the firm's risk limits is not typically

within the purview of the audit committee. This responsibility usually falls under the role of the

Chief Risk Officer (CRO). The CRO is responsible for identifying, analyzing, and mitigating

internal and external events that could threaten the organization. The CRO ensures that the

organization is in compliance with applicable regulations, that it has enough capital to cover

potential losses, and that it is following its risk appetite. Therefore, the audit committee's

oversight role is least likely to contribute to monitoring the firm's risk limits.

Choice A is incorrect. The audit committee plays a significant role in ensuring reliable

financial reporting. It oversees the financial reporting process to ensure that the financial

statements are accurate and complete, and comply with accounting standards and regulatory

requirements.

Choice B is incorrect. The audit committee also contributes to more effective corporate

governance by providing an independent check on management, ensuring transparency in

operations, and enhancing accountability.

Choice C is incorrect. Ensuring credible audit functions is another key responsibility of the

audit committee. It appoints, compensates, and oversees the work of any registered public

accounting firm employed by the organization.

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Q.55 Explain the meaning of a 'fiduciary duty' within the bounds of corporate governance.

A. A duty that arises out of a contractual agreement.

B. A duty that is not stipulated in a company's constitution, but nonetheless expected to

be performed by management.

C. A duty imposed on a person because of the position of trust and confidence in which
they stand in relation to another.

D. The duty to prioritize the interests of the government over those of one's clients

The correct answer is C.

A fiduciary duty is a legal obligation that is imposed on an individual due to the position of trust

and confidence they hold in relation to another. This duty is not just a moral obligation, but a

legal one that binds the individual to act in the best interest of the other party. The individual,

often referred to as the fiduciary, is entrusted with the responsibility of making decisions or

managing assets that belong to the other party. The fiduciary is expected to act with utmost good

faith, honesty, and loyalty, prioritizing the interests of the other party over their own. This duty is

often seen in various professional relationships, such as between a trustee and a beneficiary, a

director and a corporation, or an attorney and a client. Breach of fiduciary duty can lead to legal

consequences, including damages and disgorgement of profits.

Choice A is incorrect. While fiduciary duties can be part of a contractual agreement, they are

not exclusively derived from contracts. Fiduciary duties arise due to the position of trust and

confidence that an individual holds, which may or may not be contractually defined.

Choice B is incorrect. Fiduciary duty does not necessarily have to be explicitly stated in a

company's constitution for it to exist. It arises from the relationship between two parties where

one party has placed trust in another who has a superior knowledge or power. This duty exists

regardless of whether it is stipulated in the company's constitution.

Choice D is incorrect. Fiduciary duty does not involve prioritizing the interests of the

government over those of clients. Rather, it involves acting in the best interest of another party

(such as clients or shareholders), often at personal expense or sacrifice.

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Q.56 The large-scale corporate collapses witnessed in the early 2000s, including the Global
Financial crisis of 2007/08, all had important themes (causal factors) that risk professionals must
understand if we are to avoid a recurrence of such financially crumbling events. Which of the
following statements about these past crises is inaccurate?

A. Most collapses occurred as a result of executives abusing their trust and a lack of
oversight.

B. Incentive payments and greed did not play any role in the collapses.

C. There was a tendency of management to take on risks that were not fully understood.

D. The collapses had a negative impact on the accounting profession.

The correct answer is B.

Incentive payments, particularly those tied to short-term performance, played a significant role

in the corporate collapses of the early 2000s. These incentives encouraged employees to take

excessive risks to generate short-term gains, often without adequate consideration for the long-

term consequences. This was particularly evident in the banking and investment sectors.

Furthermore, corporate executives, driven by greed and the prospect of inflated bonuses and

other forms of remuneration linked to short-term performance, took on huge risks that they did

not fully understand. This behavior was especially apparent in the case of Enron, where

executive greed and fraud were key factors in the company's collapse.

Choice A is incorrect. The statement accurately reflects the circumstances of these events.

Many of the collapses in the early 2000s were indeed due to executives abusing their trust and a

lack of oversight, as evidenced by scandals such as Enron and WorldCom.

Choice C is incorrect. This statement also accurately reflects the circumstances leading up to

these financial disasters. There was indeed a tendency for management to take on risks that

were not fully understood, particularly in relation to complex financial instruments like

derivatives.

Choice D is incorrect. The collapses did have a negative impact on the accounting profession,

with many questioning its role and effectiveness in preventing such disasters from occurring.

Therefore, this statement does accurately reflect the circumstances of these events.

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Q.57
Most companies now have several subsets of the board called 'board committees'.

Why are such committees formed?

A. To directly report to shareholders on specific issues.

B. To enable the directors to reduce their individual liability and therefore serve more
confidently.

C. To enhance the overall effectiveness of the board.

D. To introduce independence, thereby enabling verification of decisions/materials

brought to the attention of the entire board.

The correct answer is C.

The primary reason for the formation of board committees within a company is to enhance the

overall effectiveness of the board. The board of directors in a company is responsible for making

key decisions and setting the strategic direction of the company. However, the board is often

comprised of individuals with diverse backgrounds and expertise, and it can be challenging for

the board to effectively manage all aspects of the company's operations. Therefore, board

committees are formed to distribute the workload and allow for more detailed consideration of

specific issues. These committees are typically focused on specific areas such as compensation,

nomination, management, and others. By delegating specific tasks to these committees, the

board can ensure that these issues receive the necessary attention and are handled effectively.

This, in turn, enhances the overall effectiveness of the board in its entirety.

Choice A is incorrect. While board committees may occasionally report to shareholders on

specific issues, this is not their primary purpose. Their main role is to enhance the overall

effectiveness of the board by focusing on specific areas of responsibility and providing detailed

oversight and guidance.

Choice B is incorrect. The formation of board committees does not necessarily reduce the

individual liability of directors. Directors are still legally responsible for their actions and

decisions, regardless of whether they serve on a committee or not.

Choice D is incorrect. Although introducing independence can be one benefit of forming board

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committees, it's not the primary reason for their formation. The main objective remains

enhancing the overall effectiveness of the board by allowing more focused attention on key

areas.

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Q.58 The following are examples of agency costs, except:

A. Dividends

B. Monitoring fees

C. Audit fees

D. Delegated authorities

The correct answer is A.

Dividends are not considered an agency cost. They are a form of profit distribution to

shareholders for their investment in the company. Agency costs, on the other hand, are the costs

incurred due to the potential conflicts of interest between the principal (shareholders) and the

agent (management). These costs arise when the agent makes decisions that may not align with

the best interests of the principal. While dividends can be influenced by agency costs, they are

not a direct cost of the principal-agent relationship. For instance, if agency costs are high, the

profits available for distribution as dividends may be reduced. However, dividends themselves do

not constitute an agency cost.

Choice B is incorrect. Monitoring fees are a type of agency cost. They are incurred when the

principal needs to supervise or monitor the agent's activities to ensure they align with their

interests.

Choice C is incorrect. Audit fees also constitute an agency cost. These costs arise when an

external party is hired to review and verify the agent's actions and financial reports, ensuring

that they are in line with the principal's expectations and requirements.

Choice D is incorrect. Delegated authorities can lead to agency costs as well. When authority

is delegated, there may be a risk of misuse or misalignment of interests between the principal

and agent, leading to potential conflicts and additional costs for resolution.

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Q.59 Which of the following statements about the board of directors' remuneration is correct?

A. Directors may award themselves such salary payments as they think fit

B. Directors must receive a salary, just like other junior employees of the company

C. Directors only receive a salary if the constitution of the company explicitly allows it

D. Directors salaries are set by the HR department of the firm

The correct answer is C.

Directors only receive a salary if the constitution of the company explicitly allows it. This

statement is accurate because the remuneration of directors is governed by the constitution of

the company. A director is entitled to receive a salary only if they have a contractual right to

remuneration. The board of directors has the power to award contracts to directors and other

personnel, but this is subject to the company's articles. There are companies that do not have

written agreements that can allow directors to receive any form of salary payment. In essence,

the constitution is the sole determinant on matters of remuneration. Therefore, it is crucial for

companies to have clear and explicit provisions in their constitution regarding the remuneration

of directors to ensure transparency and accountability.

Choice A is incorrect. Directors cannot award themselves salaries as they see fit. This would

lead to a conflict of interest and potential misuse of company funds. The remuneration of

directors is usually determined by the board's remuneration committee or as per the company's

constitution.

Choice B is incorrect. It is not mandatory for directors to receive a salary like other employees

of the company. The compensation structure for directors can include various components such

as fees, salary, bonuses, benefits in kind, pensions and share options depending on the

constitution of the company.

Choice D is incorrect. The HR department does not set director salaries in most organizations.

This responsibility typically lies with either a dedicated remuneration committee within the

board or it may be outlined in the company's constitution.

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Q.60 Muhammad Ismail, a research analyst, has recently learned in a seminar on the quality of
research report writing that the firm's corporate governance is as important as the valuation of
the firm's assets. He has noted the following points regarding the implication of good corporate
governance. Which of them are not considered best practices of corporate governance?

A. The board of director should be comprised of a majority of independent members.

B. A director from outside of the industry should be provided training before joining the
board.

C. The board will consider the interests of stakeholders, including debtholders, while
taking decisions.

D. The CEO of the firm must also be the chairman of the board of directors in order to
bring consistency in the board decisions.

The correct answer is D.

The CEO of the firm must not also be the chairman of the board of directors. This is because

having the same person occupy both positions can lead to a lack of objectivity and independence

in decision-making. The roles of the CEO and the chairman of the board are distinct and should

be occupied by different individuals to ensure checks and balances. The CEO is responsible for

the day-to-day management of the company, while the chairman of the board is responsible for

overseeing the company's overall strategy and ensuring that the interests of shareholders are

protected. If the same person holds both positions, it can lead to a concentration of power and a

potential conflict of interest, as the person may prioritize their own interests over those of the

shareholders. Therefore, it is not considered a best practice in corporate governance for the CEO

to also be the chairman of the board of directors.

Choice A is incorrect. The board of directors being comprised of a majority of independent

members is indeed a best practice in corporate governance. Independent directors are not

involved in the day-to-day operations of the company and can therefore provide unbiased

oversight and decision-making.

Choice B is incorrect. Providing training to a director from outside the industry before they

join the board aligns with good corporate governance practices. This ensures that all board

members have an understanding of the industry, which enables them to make informed decisions

for the company.

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Choice C is incorrect. Considering the interests of all stakeholders, including debtholders,

while making decisions is also a best practice in corporate governance. This approach ensures

that decisions are made with consideration for their impact on all parties involved with or

affected by the company's operations.

Q.61 Which of the following combinations is most likely to affect the independence of the board?

A. Chief Executive Officer as a member of the board of directors.

B. Chairman of the board as a member of the remuneration committee.

C. Chief Executive Officer as the Chairman of the remuneration committee.

D. Chairman of the board as the Chairman of the ethics committee.

The correct answer is C.

A board that is comprised of a Chief Executive Officer (CEO) who is also the chairman of the
remuneration committee can potentially affect the independence and objectivity of the board and
also the quality of corporate governance. The other 3 combinations will have no effect on the
board's independence and objectivity.

Q.62 Woody Daren is an independent journalist who publishes his analysis on one blue-chip firm
every week on his blog. Recently, Woody published an article on the best practices of Arrow
Corp's risk management and its risk committee. Which of the following features that he
published is an incorrect practice?

A. The business practices and risk management activities of Arrow Corp. strive for
economic performance instead of accounting performance.

B. The compensation of the risk staff is based on risk-adjusted performance.

C. The members of the risk committee have deep knowledge of risk issues and
accounting practices.

D. Most individuals that sit on the risk committee should also sit on the audit committee
to align incentives between the two entities.

The correct answer is D.

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The assertion that most individuals that sit on the risk committee should also sit on the audit

committee to align incentives between the two entities is incorrect. The risk committee and the

audit committee should be two separate entities, each requiring different skills to meet its

respective responsibilities. The risk committee should have members with enough analytic

sophistication and business experience to properly analyze key risks. On the other hand, the

audit committee should comprise members that are both independent and financially literate.

Having the same individuals on both committees could lead to a conflict of interest and

compromise the effectiveness of each committee. Therefore, it is not a recommended practice in

risk management.

Choice A is incorrect. Striving for economic performance instead of accounting performance is

indeed a recommended practice in risk management. This approach ensures that the company's

risk management activities are aligned with its overall economic goals and not just focused on

meeting accounting standards.

Choice B is incorrect. The compensation of the risk staff based on risk-adjusted performance is

also a best practice in risk management. It aligns the incentives of the risk staff with those of the

company, encouraging them to manage risks effectively.

Choice C is incorrect. Having members on the risk committee who have deep knowledge of

both risk issues and accounting practices is highly recommended in effective risk management.

Such individuals can provide valuable insights into how different risks might impact both

financial statements and broader business operations.

Q.63 George Hitman is a Risk Advisory Director on the board of Temple Tools Inc. George has
passed FRM part 1 and is currently preparing for the FRM part 2 exam. Which of the following is
NOT a duty of the Risk Advisory Director?

A. To attend audit committee meetings and advise the committee to increase the firm's
effectiveness.

B. To Design the risk management program of a firm.

C. To review and analyze the firm's risk management policies and reports.

D. To review related parties and related-party transactions.

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The correct answer is B.

The responsibility of designing the risk management program of a firm does not fall under the

purview of a Risk Advisory Director. This task is typically assigned to the Chief Risk Officer

(CRO) of the company. The CRO is responsible for identifying, analyzing, and mitigating internal

and external events that could threaten the organization. The CRO works closely with other

executives such as the CEO, CFO, and COO to coordinate risk management efforts. The CRO's

duties include designing and implementing an overall risk management process for the

organization, which includes an impact and likelihood assessment, risk mitigation strategies, and

reporting mechanisms. Therefore, while the Risk Advisory Director may provide input and advice

on the risk management program, the design and implementation of the program is not their

primary responsibility.

Choice A is incorrect. Attending audit committee meetings and advising the committee to

increase the firm's effectiveness is indeed a part of a Risk Advisory Director's responsibilities.

They are expected to provide insights and recommendations based on their understanding of risk

management.

Choice C is incorrect. Reviewing and analyzing the firm's risk management policies and

reports are key responsibilities for a Risk Advisory Director. They need to ensure that these

policies align with regulatory requirements, industry standards, and best practices.

Choice D is incorrect. Reviewing related parties and related-party transactions also falls under

the purview of a Risk Advisory Director as it can have significant implications on an

organization’s risk profile.

Q.64 Due to the presence of agency risk in the majority of organizations, it is necessary for the
board to form a compensation committee to ensure appropriate risk is taken in relation to the
long-term risk objectives. Its principal role is to design and approve the remuneration plans of
management. Which of the following remuneration structures can be a potential cause of agency
risk?

A. Compensation with bonuses based on long-term revenues and objectives.

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 B. Compensation with no guaranteed bonuses.

C. Compensation with the clawback clause on previous bonuses if the long-term goals are
unachieved.

D. Compensation with the bonuses based on share prices.

The correct answer is D.

A remuneration structure that includes bonuses based on share prices can potentially lead to

agency risk. This is because such a structure may incentivize management to take on excessive

risk in an attempt to boost the company's stock prices. The desire to increase their personal

bonuses may lead managers to make decisions that are not in the best long-term interests of the

company or its shareholders. This misalignment of interests between the managers and the

shareholders is the essence of agency risk. Therefore, while such a compensation structure may

seem attractive in the short term, it can lead to significant agency risk in the long term.

Choice A is incorrect. Compensation with bonuses based on long-term revenues and objectives

is not likely to contribute to agency risk. This type of compensation structure aligns the interests

of management with those of the organization, as it incentivizes managers to work towards

achieving long-term goals and objectives.

Choice B is incorrect. Compensation with no guaranteed bonuses does not necessarily lead to

agency risk. In fact, this type of compensation structure can help mitigate agency risk by

ensuring that managers are only rewarded when they achieve certain performance targets or

meet specific objectives.

Choice C is incorrect. Compensation with a clawback clause on previous bonuses if the long-

term goals are unachieved actually helps in reducing agency risk rather than contributing to it.

The clawback clause acts as a deterrent for managers from taking excessive risks or engaging in

short-term profit-making activities at the expense of long-term organizational goals.

Q.65 David Lennon, a corporate trainer, has finalized some of the roles and responsibilities of the
audit committee of the organizations which he is going to add in his presentation on the subject
of the audit committee of the board. Which of the following is least likely a role of the audit

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committee?

A. Ensuring the accuracy of financial and regulatory reporting of the firm

B. Ensuring that the firm complies with standards in regulatory, risk management, and
compliance activities.

C. Ensuring that the remuneration of key management must be aligned with the goals of
other stakeholders

D. Verifying the activities of the firm to see if the reports outline the same

The correct answer is C.

The responsibility of ensuring that the remuneration of key management aligns with the goals of

other stakeholders is typically not a role of the audit committee. Instead, this responsibility

usually falls under the purview of the compensation committee. The compensation committee is

a separate entity within the organization that specifically focuses on determining and managing

the remuneration of key management personnel. Its primary goal is to ensure that the

compensation structure aligns with the organization's overall objectives and the interests of its

stakeholders. This alignment is crucial for maintaining a balanced and effective management

structure within the organization. Therefore, while the audit committee plays a significant role in

overseeing the organization's financial and regulatory activities, it does not typically involve

itself in matters related to compensation.

Choice A is incorrect. Ensuring the accuracy of financial and regulatory reporting of the firm is

indeed a key responsibility of the audit committee. The committee oversees the integrity of these

reports, ensuring they are accurate and comply with all relevant regulations.

Choice B is incorrect. Ensuring that the firm complies with standards in regulatory, risk

management, and compliance activities is also a core function of an audit committee. They play a

crucial role in overseeing that all operations are conducted within legal and ethical boundaries.

Choice D is incorrect. Verifying the activities of the firm to see if the reports outline them

accurately falls under an audit committee's purview as well. This involves checking whether

operational activities align with what has been reported in financial statements or other official

documents.

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Q.66 Which of the following is least likely a role of the Chief Risk Officer (CRO)?

A. Designing the risk management program of the firm

B. Oversee financial reporting and the dealings between the firm and its associates

C. An intermediary between the board and the management.

D. Monitoring the firm's risk limits set by the senior risk management

The correct answer is B.

The role of overseeing financial reporting and the dealings between the firm and its associates is

not typically a responsibility of the Chief Risk Officer (CRO). This task is more likely to be

handled by the Risk Advisory Director or a similar role within the organization. The CRO's

primary focus is on managing the firm's risk exposure and ensuring that the risk management

program is effective. This includes designing the risk management program, monitoring the

firm's risk limits set by senior risk management, and acting as an intermediary between the

board and management. While the CRO may have some involvement in financial reporting and

dealings with associates, this is not a primary responsibility and is therefore the least likely role

of the CRO among the options provided.

Choice A is incorrect. The CRO is indeed responsible for designing the risk management

program of the firm. This includes identifying potential risks, developing strategies to mitigate

these risks, and implementing these strategies across the organization.

Choice C is incorrect. The CRO acts as an intermediary between the board and management,

communicating risk-related issues and ensuring that both parties are aware of the firm's risk

exposure.

Choice D is incorrect. Monitoring the firm's risk limits set by senior management is a key

responsibility of a CRO. They need to ensure that all activities within the organization are

conducted within these established limits.

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Q.5308 Simon Harvey has recently assumed the role of chairman for the audit committee at his
bank. In their initial meeting, a member highlights the committee's responsibilities. Which of the
following statements accurately reflects their role?

A. Identifying and assessing the organization's risks, including operational, financial,

strategic, reputational, and compliance risks.

B. Reviewing and approving risk management strategies and plans to mitigate and
manage risks.

C. Overseeing the financial reporting process to ensure accuracy, completeness, and

transparency of financial statements and disclosures.

D. Communicating executive compensation decisions to shareholders and other

stakeholders in the organization.

The correct answer is C.

The primary responsibility of an audit committee, such as the one Simon Harvey has been

appointed to chair, is to oversee the financial reporting process. This involves ensuring the

accuracy, completeness, and transparency of the financial statements and disclosures made by

the bank. The audit committee plays a pivotal role in assessing the internal controls in place,

managing relationships with external auditors, and evaluating the risk management strategies

implemented by the bank. Furthermore, the committee is also tasked with monitoring

compliance with legal and regulatory requirements, thereby safeguarding the organization's

integrity and reputation. This role is critical in maintaining the trust of shareholders and other

stakeholders in the financial health and management of the bank.

Choice A is incorrect. While identifying and assessing the organization's risks is a crucial part

of risk management, it is not typically the responsibility of the audit committee. This task usually

falls under the purview of risk management teams or committees.

Choice B is incorrect. The audit committee does not generally review and approve risk

management strategies and plans to mitigate and manage risks. This role belongs to senior

management or a dedicated risk committee, who are responsible for developing and

implementing these strategies.

Choice D is incorrect. Communicating executive compensation decisions to shareholders and

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other stakeholders in the organization does not fall within the scope of an audit committee's

responsibilities. This task would typically be handled by either human resources or a

compensation committee.

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Q.5309 Jane Doe has just been promoted to the position of Chief Risk Officer. At the beginning of
her tenure, she is handed her job description by the board of directors and Chief Executive.
Which of the following statements gives a correct description of her new role?

A. Verify the activities of the firm to see if the reports outline the same

B. Define the level of risk the organization is willing to accept.

C. Review and approve the organization’s policies.

D. Ensure compliance with regulations and standards.

The correct answer is D.

The primary responsibility of a Chief Risk Officer (CRO) is to ensure that the organization

complies with all relevant laws, regulations, and industry standards related to risk management.

This involves developing and implementing effective risk management strategies and policies,

overseeing risk management activities across the organization, and ensuring that all business

activities are conducted in a manner that is compliant with regulatory requirements. The CRO is

also responsible for communicating and reporting on risk-related issues to the board of directors

and other key stakeholders. This role is critical in protecting the organization from potential

risks and liabilities, and in maintaining its reputation and credibility in the market.

Choice A is incorrect. While verifying the activities of the firm may be part of a CRO's role, it is

not their primary responsibility. The CRO's main duty is to manage and mitigate risk within the

organization, which goes beyond simply verifying reports.

Choice B is incorrect. Defining the level of risk an organization is willing to accept falls under

the purview of senior management or board of directors rather than that of a CRO. The CRO's

role would be more about managing and mitigating those defined risks.

Choice C is incorrect. Reviewing and approving policies can be part of a CRO’s responsibilities

but it isn't their primary duty. Their main task involves ensuring that these policies are in line

with regulatory standards and managing any associated risks.

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 Reading 4: Credit Risk Transfer Mechanisms

Q.3718 What are the contractual specifications for the protection seller of a credit default swap?

A. The protection buyer pays a premium to the protection seller at regular time intervals
until a credit event occurs, in which case the protection seller pays the protection buyer
compensation for the credit event.

B. If a credit event occurs, the protection seller is obliged to exchange contractually

specified assets for government bonds.

C. The protection seller pays a premium to the protection buyer at regular time intervals
until a credit event occurs, in which case the protection buyer pays the protection seller
compensation for the credit event.

D. If the underlying of the credit default swap is a bond issued by a specific corporation,
only this corporation can act as a protection seller.

The correct answer is A.

In a credit default swap (CDS), the protection seller is essentially selling insurance against the

default risk of a specific credit instrument, such as a bond or loan. The protection buyer pays a

premium to the protection seller at regular intervals. This premium is essentially the cost of the

insurance. If a credit event, such as a default, occurs, the protection seller is obligated to

compensate the protection buyer. The compensation is usually the face value of the credit

instrument. This arrangement allows the protection buyer to hedge against the risk of default.

The protection seller, on the other hand, earns a premium for taking on this risk.

Choice B is incorrect. In a credit default swap, the protection seller does not exchange assets

for government bonds in the event of a credit event. Instead, they are obligated to compensate

the protection buyer for their loss.

Choice C is incorrect. This choice incorrectly reverses the roles of the protection buyer and

seller. In reality, it's the protection buyer who pays premiums to the seller until a credit event

occurs, at which point it's then up to the seller to compensate them.

Choice D is incorrect. The underlying asset of a CDS can be any kind of debt instrument - not

just corporate bonds - and any party (not just corporations) can act as a protection seller as long

as they are willing and able to fulfill their obligations under contract terms.

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Q.3719 The practice of approving mortgages in order to sell them as mortgage-backed securities
is known as:

A. Originate-to-distribute

B. Originate-to-keep

C. Principal-agent engineering

D. A credit default swap

The correct answer is A.

The originate-to-distribute (OTD) business model is a practice where the originators of

mortgages or other types of loans repackage these assets and sell them to third parties. This

model is the opposite of the traditional originate-to-keep (OTK) model where the owners of

mortgages and other loans keep these assets in their balance sheets until maturity. The OTD

model has several benefits from the perspective of the originator, usually banks. It introduces

specialization in the lending process as functions initially designated for a single firm are now

split among several firms. It also reduces banks’ reliance on the traditional sources of capital,

such as deposits and rights issues. Furthermore, it introduces flexibility into banks’ financial

statements and helps them diversify some risks.

Choice B is incorrect. Originate-to-keep refers to the traditional banking model where banks

originate loans and keep them on their balance sheets until they are repaid. This is different

from the practice described in the question, which involves selling off the mortgages as

securities.

Choice C is incorrect. Principal-agent engineering does not refer to any specific practice in

financial markets. It's a term that might be used in discussions of agency theory, which deals

with issues like moral hazard and conflicts of interest between principals (like shareholders) and

agents (like managers or brokers). It doesn't have anything to do with mortgage origination or

securitization.

Choice D is incorrect. A credit default swap is a financial derivative contract that allows an

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investor to "swap" or offset their credit risk with that of another investor. It does not involve

originating mortgages or creating mortgage-backed securities.

Q.3720 Which of the following best explains why the 2001-2002 economic slowdown did NOT
result in heavy losses for the banking sector?

A. Rapid foreclosure of insolvent/loss-making corporate borrowers.

B. A substantial increase in investment in government bonds.

C. Cash injections by the Federal Reserve.

D. Hedging through credit derivatives and securitization of assets.

The correct answer is D.

The banking sector was able to avoid heavy losses during the 2001-2002 economic slowdown

largely due to the use of credit risk derivatives and securitization of assets. Banks that had lent

money to various corporations had purchased protection against default in the form of credit

default swaps and total return swaps. These financial instruments provided a hedge against the

risk of borrower default. In addition, some banks had securitized a significant portion of their

assets by issuing collateralized debt obligations and collateralized loan obligations. When

borrowers defaulted, banks that had bought protection through credit derivatives were

compensated. Meanwhile, banks that had securitized their assets had already received payments

from third-party investors, which helped offset the total loss. This strategy of hedging through

credit derivatives and securitization of assets was a key factor in the banking sector's resilience

during the economic slowdown.

Choice A is incorrect. Rapid foreclosure of insolvent/loss-making corporate borrowers would

not have necessarily contributed to the resilience of the banking sector during an economic

downturn. In fact, it could have potentially exacerbated the situation by causing a further decline

in asset values and increasing uncertainty in the market.

Choice B is incorrect. While a substantial increase in investment in government bonds may

provide a safe haven for banks during times of economic instability, it does not directly

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contribute to their resilience or ability to avoid heavy losses. It's more of a defensive strategy

rather than one that actively mitigates risk.

Choice C is incorrect. Cash injections by the Federal Reserve can provide temporary relief but

do not fundamentally address the underlying risks that banks face during an economic downturn.

Moreover, such measures are typically reactive and come into play after losses have already

been incurred.

Q.3721 Global Tech has declared its intention to bring to the market a 10-year senior bond issue
at par with a coupon rate of 23%, offering a spread of 1200 basis points over the corresponding
10-year Treasury issue. An investor is keen to enter into a total return swap that matures in one
year with the senior bonds that are about to be issued as the reference obligation. Under the
terms of the contract, payments will be exchanged semiannually, where the total return receiver
will pay the six-month Treasury rate plus 328 basis points. What is the 10-year Treasury rate at
the time the bonds are issued?

A. 10%

B. 12%

C. 11%

D. 13%

The correct answer is C.

We know that Global Tech will be coming to market with a 10-year senior bond issue at par with
a coupon rate of 23%, offering a spread of 1200 basis points over the 10-year Treasury issue.
Because 1200 basis points is 12%, this means the 10-year Treasury issue will have a rate of 23%
- 12% = 11%. At the time of issuance, therefore, the 10-year Treasury yield is 11%.
Note that the question has a bit of nugatory information.

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Q.3722 Credit derivatives played a significant role in the 2007/2009 financial crisis. Which of the
following statements is correct regarding credit derivatives in the context of 2007/2009 financial
crisis?

A. Credit derivatives were solely responsible for causing the financial crisis.

B. Credit derivatives were completely withdrawn from the market after the crisis.

C. The blame for the crisis was solely on the use of credit derivatives and not the
instruments themselves.

D. Complex credit derivatives like CDOs-squared and single-tranche CDOs were revived
after the crisis.

The correct answer is C.

Credit derivatives, such as credit default swaps (CDS) and collateralized debt obligations
(CDOs), received significant blame for the financial crisis, but the problem was not the
instruments themselves but how they were used. The crisis resulted from the misuse and
mismanagement of these instruments.

Choice A is incorrect. Credit derivatives were a contributing factor, but they were not the sole

cause of the financial crisis.

Choice B is incorrect. While some credit derivatives declined in popularity or faced increased

scrutiny after the crisis, others, like credit default swaps (CDS) and collateralized loan

obligations (CLOs), continued to be used in the financial markets.

Choice D is incorrect. Very complex instruments like collateralized debt obligations squared

(CDOs-squared) are unlikely to be revived.

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Q.3723 Which of the following statements are correct? Credit default swaps:

A. Present high levels of risk and are only be used by the wealthy

B. Allow lenders to insure themselves against the risk that a borrower will default.

C. It should only be used by people seeking high returns from low risk.

D. Do not require collateral to be posted by either the buyer or the seller of the
insurance.

The correct answer is B.

Credit default swaps (CDS) are a type of credit derivative contract that allows a lender to

transfer the credit risk of a borrower defaulting to another party. In a CDS contract, the buyer of

the protection (usually a lender) makes periodic payments to the seller of the protection. In

return, the seller agrees to compensate the buyer if a specified credit event, such as a default,

occurs. This mechanism allows lenders to insure themselves against the risk of a borrower

defaulting on their obligations. It's a form of risk management strategy that helps lenders

mitigate potential losses from credit risk.

Choice A is incorrect. Credit default swaps do not inherently present high levels of risk and are

not exclusively used by the wealthy. They are complex financial instruments used to manage

credit risk, and their usage depends on the risk appetite and strategy of the user, regardless of

wealth.

Choice C is incorrect. The statement that credit default swaps should only be used by people

seeking high returns from low risk is misleading. While it's true that CDS can potentially provide

high returns, they also carry significant risks including counterparty risk, liquidity risk, and legal

risks.

Choice D is incorrect. It's not accurate to say that credit default swaps do not require

collateral to be posted by either the buyer or seller of the insurance. In fact, collateral

agreements are common in CDS contracts as a way to mitigate counterparty credit risk.

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Q.3724 The purpose of credit derivatives is to:

A. Transfer the risk from one party to another.

B. Increase the risk, so that the return is larger.

C. Postpone the risk for both parties in the transaction.

D. Eliminate risk for both parties in the transaction.

The correct answer is A.

Credit derivatives are primarily used to transfer the risk from one party to another. They are

financial contracts that allow a creditor to transfer the credit risk of an underlying portfolio of

securities to another party without transferring the underlying portfolio itself. This is achieved

through a variety of credit derivative products, such as credit default swaps, credit linked notes,

and total return swaps. These products provide a mechanism for managing credit risk by

transferring it to another party who is willing and able to bear that risk. This transfer of risk can

help to reduce the potential for losses due to credit events such as default, bankruptcy, or

restructuring.

Choice B is incorrect. Credit derivatives are not used to increase the risk for larger returns.

They are primarily used as a tool for managing and mitigating credit risk, not amplifying it.

Choice C is incorrect. The purpose of credit derivatives is not to postpone the risk for both

parties in the transaction. Instead, they allow one party (the buyer) to transfer specific credit

risks to another party (the seller).

Choice D is incorrect. While credit derivatives can help manage risk, they do not eliminate it

entirely for both parties involved in the transaction. The seller of a credit derivative assumes the

potential default or downgrade risk from the buyer, hence there's still an element of risk

involved.

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Q.3726 Which of the following statements regarding Credit Default Swaps (CDS) is incorrect?

A. Their payoff is contingent upon the performance of an underlying instrument

B. Examples of CDS’s underlying assets include corporate bonds and emerging market
bonds.

C. Their value rises and falls as opinions change about the likelihood of default.

D. They will be paid out in case of bankruptcy.

The correct answer is D.

The statement that Credit Default Swaps (CDS) will be paid out in case of bankruptcy is

incorrect. While it is true that a CDS can be triggered by a bankruptcy event, it is not the only

credit event that can trigger a CDS. Other credit events such as failure to pay, restructuring, and

obligation acceleration can also trigger a CDS. Therefore, the payout of a CDS is not solely

contingent upon the declaration of bankruptcy. It is contingent upon the occurrence of a credit

event as defined in the terms of the CDS contract. This misunderstanding could lead to a

misinterpretation of the risk protection provided by a CDS.

Choice A is incorrect. The payoff of a Credit Default Swap (CDS) is indeed contingent upon the

performance of an underlying instrument. If the underlying asset defaults, the protection buyer

receives a payout from the protection seller.

Choice B is incorrect. Corporate bonds and emerging market bonds are common examples of

underlying assets for CDSs. These instruments can be used to hedge against credit risk

associated with these types of bonds.

Choice C is incorrect. The value of a CDS does rise and fall based on changing opinions about

the likelihood of default by the reference entity (the issuer of the underlying asset). As perceived

credit risk increases, so does the value or price of a CDS contract.

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Q.3727 In a credit default swap transaction:

A. The protection buyer is long on risk.

B. The protection seller is short on risk.

C. The protection seller makes periodic payments.

D. The protection buyer makes periodic payments.

The correct answer is D.

In a credit default swap (CDS) transaction, the protection buyer indeed makes periodic

payments. This is a fundamental aspect of a CDS transaction. The protection buyer, who is

seeking to hedge against the risk of a third party defaulting on its obligations, makes these

payments to the protection seller. In return, the protection seller promises to compensate the

protection buyer if the third party defaults. This arrangement allows the protection buyer to

transfer the credit risk associated with the third party to the protection seller. The periodic

payments made by the protection buyer are often referred to as 'premiums' or 'spreads' and are

typically calculated as a percentage of the notional amount of the CDS contract.

Choice A is incorrect. The protection buyer in a CDS transaction is actually short on risk, not

long. This is because the protection buyer pays a premium to the protection seller to take on the

credit risk of a reference entity. If that entity defaults, the protection seller compensates the

buyer, thus reducing their exposure to risk.

Choice B is incorrect. Contrary to this statement, the protection seller in a CDS transaction is

long on risk. They receive regular payments from the protection buyer and in return agree to

cover losses if a specified credit event occurs with respect to an underlying reference entity.

Choice C is incorrect. In fact, it's just opposite of what happens in reality; it's not the

protection seller but rather it's actually the Protection Buyer who makes periodic payments

(premiums) as part of their agreement with Protection Seller.

Q.3729 An investor wishes to purchase a 5-year BBB-rated bond issued by BAC Corporation but
does not want to bear the out-of-pocket costs and the inconvenience associated with long-term

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financing arrangements, actually going long the bond, and taking delivery. Suppose also that a
bank owns the same bond and would like to extend a loan to BAC Corporation but its loans to
BAC and investments in BAC debt instruments have fully exhausted its capacity to lend to BAC.
Which of the following instruments would best suit the two parties in these circumstances?

A. Credit spread swap option

B. Total return swap

C. Credit default swap

D. Collateralized loan obligation

The correct answer is B.

A total return swap is a financial derivative that transfers both the credit risk and market risk of

an underlying asset. It involves two parties: the total return payer (or buyer) and the total return

receiver (or seller). The total return payer receives the total return (including income and capital

gains or losses) from a specified asset, and in return, pays the total return receiver a regular

fixed or floating cash flow.

In this scenario, the investor can enter into a total return swap agreement with the bank. The

investor, acting as the total return payer, will receive the total economic return on the BAC

Corporation bond without actually purchasing it. This arrangement allows the investor to avoid

the costs and inconvenience associated with long-term financing arrangements and taking

delivery of the bond.

On the other hand, the bank, acting as the total return receiver, can reduce its risk exposure to

BAC Corporation as if it had sold the bond, without actually doing so. This arrangement allows

the bank to extend a loan to BAC Corporation without exceeding its lending capacity. Therefore,

a total return swap is the most suitable instrument for both parties in these circumstances.

Choice A is incorrect. A credit spread swap option would not be the most appropriate solution

in this scenario. This financial instrument allows the holder to swap the credit risk of a bond with

another party, but it does not address the investor's unwillingness to bear long-term financing

arrangements and physical ownership of the bond.

Choice C is incorrect. A credit default swap would also not be suitable in this case. While it

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provides protection against default risk, it does not solve the issue of physical ownership and

long-term financing arrangements that are concerning for the investor.

Choice D is incorrect. A collateralized loan obligation involves pooling various types of debt

into a single security sold to investors, which doesn't align with either party's needs in this

scenario. The bank has already reached its lending capacity to BAC and wouldn't benefit from

further exposure, while for an investor who doesn't want to physically own bonds or deal with

long-term financing arrangements, buying into a pool of loans isn't an attractive proposition.

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Q.3730 Two parties decide to engage in a 2-year credit default swap. Assume that the reference
entity is BAC Corporation. The notional amount of the contract is $10 million, and the contract is
cash-settled.
After one year, a default event occurs, and the bonds are valued at $8.5 million at the time of
default. Which of the following is most likely correct?

A. The protection buyer receives $1.5 million in compensation.

B. The protection buyer continues to pay premiums for one more year.

C. The protection buyer delivers the bond to the protection seller .

D. There is no compensation paid to the protection buyer.

The correct answer is A.

In a credit default swap (CDS), the protection seller compensates the protection buyer in the

event of a default. The compensation amount is typically the difference between the notional

amount of the contract and the market value of the defaulted bond. In this case, the notional

amount is $10 million and the market value of the bond at the time of default is $8.5 million.

Therefore, the protection buyer receives $1.5 million in compensation. This is the fundamental

principle of a CDS - it provides insurance against the risk of default. The protection buyer pays a

premium to the protection seller for this insurance, and in return, the protection seller agrees to

compensate the protection buyer if a specified credit event, such as a default, occurs.

Choice B is incorrect. The protection buyer does not continue to pay premiums for one more

year. In a credit default swap agreement, once a default event occurs, the contract is terminated

and no further premiums are required to be paid by the protection buyer.

Choice C is incorrect. The protection buyer does not deliver the bond to the protection seller in

this scenario as it's a cash-settled contract. In cash settlement, the difference between par value

and market value of defaulted bond (recovery rate) is paid by the seller to the buyer, there's no

physical delivery of bonds.

Choice D is incorrect. There indeed is compensation paid to the protection buyer in case of a

credit event such as default. This compensation equals to difference between notional amount

and recovery value which in this case amounts $1.5 million ($10 million - $8.5 million).

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Q.3731 An investor approaches a swap dealer wishing to engage in a total return swap. The
underlying asset is $10 million principal amount of a 9% BB-rated 5-year corporate bond that has
semiannual interest payments. The swap dealer agrees to pay the total return on this bond for
the coming 6 months in return for payments based on (1) an interest rate of 6-month LIBOR plus
a spread of 30 basis points and (2) a notional principal amount equal to the face value of the
underlying asset, $10 million.
At the swap date, the bond is worth par, and the 6-month LIBOR is 6%. Suppose that at the
termination date, the value of the bond has still not changed. Determine the net payment and the
party that is owed. (Use discrete compounding.)

A. Net payment = $315,000 ; owed party is the investor

B. Net payment = $450,000; owed party is the swap dealer

C. Net payment = $0; no owed party

D. Net payment = $135,000; owed party is the investor

The correct answer is D.

The easiest way to see this swap is that one party is swapping the 9% coupons + capital gains

against LIBOR + 0.3%.

Assumptions:

Asset: $10 million principal amount of a 9% BB-rated 5-year corporate bond

Floating rate: 6-month LIBOR plus a spread of 0.3% (the 6-month LIBOR on the swap

date is 6%)

Term of the swap: 6 months (just one interest period)

Value of the bond: Swap date: 100% of the face value

Termination date: 100% of the face value

Here’s how we calculate the cash payment:

0.09
Interest on the bond:$10 , 000, 000 × = $450, 000
2
(0.06 + 0.003)
Interest at LIBOR:$10 , 000, 000 = $315, 000
2

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Thus, the interest payment obligations are $315,000 for the investor and $450,000 for the swap

dealer. The swap dealer must, therefore, make a net payment to the investor of $135,000 (=

$315,000 - $450,000).

Had there been a capital gain or loss on the reference obligation, this would have impacted the

payments made by the two parties.

Note that, in a total return swap, the payer(protection buyer) agrees to pay the total return swap

receiver, the total return derived from the underlying asset. In return, the receiver(protection

seller) pays the asset owner a Libor-based interest rate during the life of the total return swap.

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Q.5310 ABC Bank has one of the best credit risk management strategies in the country. One way
it does this is by having a rigorous screening process at the application stage. Of the four ways
that banks deal with credit exposure, which one does the above strategy fall under?

A. Retain

B. Avoid

C. Mitigate

D. Transfer

The correct answer is C.

Mitigation in the context of credit risk management refers to the reduction of risk by

implementing measures that eliminate or reduce exposure. This can be achieved through various

strategies, one of which is the adoption of a rigorous screening process at the application stage.

This process helps the bank to assess the creditworthiness of potential borrowers, thereby

reducing the likelihood of default. By doing so, the bank can mitigate the potential losses that

may arise from non-payment of loans. This strategy is particularly effective as it allows the bank

to identify and address potential risks before they materialize, thereby enhancing the overall

effectiveness of the bank's credit risk management framework.

Choice A is incorrect. Retaining credit risk refers to the bank's decision to accept and manage

the risk internally, rather than transferring it to another party. It does not involve a stringent

screening process during the application phase.

Choice B is incorrect. Avoiding credit risk means that the bank chooses not to engage in any

transaction that might expose it to potential credit losses. While a stringent screening process

could potentially help avoid risky borrowers, this method generally involves abstaining from

certain types of transactions or sectors altogether.

Choice D is incorrect. Transferring credit risk involves shifting the potential loss from a default

event onto another party, typically through financial instruments such as derivatives or

securitization. This strategy does not directly involve a stringent screening process during the

application phase.

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Q.5311 John Thomas has recently learned about different derivative instruments he can use in
his stock trading business. He is particularly interested in an instrument that would give him the
option but not obligation to buy the underlying stock at an agreed upon strike price at the
maturity date. Which of the following derivative instruments is John Thomas referring to?

A. American call option

B. European put option

C. American put option

D. European call option

The correct answer is D.

A European call option is a type of derivative instrument that provides the holder with the right,

but not the obligation, to buy an underlying asset, such as a stock, at a predetermined price

(known as the strike price) on a specific date (the expiration date). This type of option can only

be exercised on the expiration date, not before. This characteristic aligns with the instrument

that John Thomas is interested in, as he wants the flexibility to decide whether to buy the

underlying stock at the agreed price on the maturity date, depending on the prevailing market

conditions.

Choice A (American call option) is incorrect. While an American call option does provide the

holder with the right, but not the obligation, to purchase an underlying asset at a predetermined

price, it can be exercised any time before its expiration date. This differs from John's

requirement of exercising only on the date of maturity.

Choice B (European put option) is incorrect. A European put option gives its holder the

right to sell an underlying asset at a predetermined price on or before its expiration date, not

buy it as John intends to do.

Choice C (American put option) is incorrect. Similar to a European put option, an American

put option also provides its holder with the right to sell an underlying asset at a predetermined

price any time before its expiration date. This does not align with John's intention of buying and

his requirement for exercising only on maturity.

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Q.5312 Coin Bank would like to decrease its credit risk by using credit derivatives. Which of the
following credit derivatives would the bank use to pool together multiple mortgage and bond
loans, package them into different tranches and sell them to investors?

A. Credit default swaps

B. Collateralized loan obligations

C. Collateralized debt obligations

D. Mortgage-backed security

The correct answer is C.

A Collateralized Debt Obligation (CDO) is a type of structured financial product that pools

together a variety of assets, such as mortgages, bonds, and loans, and organizes them into

different tranches based on their risk and return profiles. These tranches are then sold to

investors. The tranches are structured in such a way that the senior tranches (those with the

lowest risk) receive payment first from the cash flows generated by the underlying assets. The

junior tranches (those with higher risk) receive payment only after the senior tranches have been

fully paid. This structure allows investors to choose the level of risk and return that best suits

their investment objectives. By using CDOs, Coin Bank can effectively distribute its credit risk

among a variety of investors, thereby reducing its overall exposure.

Choice A is incorrect. Credit default swaps are a type of credit derivative, but they do not

allow for the consolidation and tranching of multiple loans. Instead, they act as a form of

insurance against the default risk of a specific reference entity or credit instrument.

Choice B is incorrect. Collateralized loan obligations (CLOs) are indeed used to consolidate

multiple loans into various tranches based on risk and return, but these are specifically for

corporate loans rather than mortgage and bond loans.

Choice D is incorrect. Mortgage-backed securities (MBS) involve the pooling of mortgages

which are then sold to investors as securities. However, MBS do not involve categorizing these

pooled mortgages into various tranches based on risk and return like collateralized debt

obligations do.

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Reading 5: Modern Portfolio Theory (MPT) and the Capital Asset Pricing
Model (CAPM)

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Q.38 Henry Ellen, an FRM candidate, has recently studied William Sharpe's Capital Asset Pricing
Model (CAPM) as part of the FRM books. As per his understanding of the model, he has come up
with a list of broad assumptions. Which of the following assumptions of the CAPM model is
INCORRECT?

A. CAPM assumes that all capital markets are perfectly competitive.

B. As per CAPM, investors should not be concerned with unsystematic risk.

C. CAPM does not consider transaction costs.

D. Beta can be decreased via diversification.

The correct answer is D.

The statement that 'Beta can be decreased via diversification' is incorrect in the context of the

Capital Asset Pricing Model (CAPM). Beta, in the CAPM, represents systematic risk, which is the

risk inherent to the entire market or market segment. Systematic risk, also known as non-

diversifiable risk, is the risk that affects all companies, regardless of the industry or sector they

belong to. This risk cannot be eliminated through diversification. Diversification, a risk

management strategy that mixes a wide variety of investments within a portfolio, is effective in

reducing unsystematic risk, also known as company-specific or idiosyncratic risk. Unsystematic

risk pertains to a specific company or industry and can be nearly eliminated through

diversification. Therefore, the assumption that beta, which represents systematic risk, can be

decreased through diversification is incorrect.

Choice A is incorrect. The CAPM does indeed assume that all capital markets are perfectly

competitive. This means that all investors have the same information and can buy or sell any

amount of securities without affecting the market price.

Choice B is incorrect. According to the CAPM, investors should not be concerned with

unsystematic risk because it can be eliminated through diversification. Unsystematic risk refers

to company-specific or industry-specific risks that can be mitigated by holding a diversified

portfolio.

Choice C is incorrect. The CAPM does not consider transaction costs in its assumptions, which

implies that buying and selling securities do not incur any costs for the investor.

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Q.179 A property development company faces the following problems:
I. Labor costs
II. Interest rate risk
III. Environmental challenges
IV. Poor project management
V. Inflation

Which of the above risks would be taken into account when estimating the company's beta?

A. I, II, & IV

B. II & IV

C. II & V

D. I, III, & IV

The correct answer is C.

Things to Remember

1. Beta is a measure of a company's systematic risk, which is the risk that cannot be eliminated

through diversification. It is a key component in the Capital Asset Pricing Model (CAPM), which

is used to calculate the expected return on an investment given its systematic risk.

2. Systematic risks affect the entire market and include factors such as interest rate fluctuations

and inflation. These risks are relevant to all companies and cannot be eliminated through

diversification.

3. Company-specific risks, also known as unsystematic risks, can be eliminated through

diversification. These risks are specific to a particular company and do not affect the entire

market. Examples include labor costs, poor project management, and environmental challenges.

4. When estimating a company's beta, it is appropriate to consider only the systematic risks that

the company faces. Company-specific risks are not taken into account.

Q.180 Which of the following is NOT an assumption of the standard Capital Assets Pricing Model
(CAPM)?

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 A. Investors incur some transactional costs when trading assets.

B. There are no taxes, making investors indifferent between capital gains and
dividends/income.

C. Assets can be divided infinitely, making it possible to hold fractional shares.

D. There's unlimited short selling/ a perfectly liquid market.

The correct answer is A.

The standard Capital Asset Pricing Model (CAPM) assumes that there are no transaction costs.

This assumption is made to simplify the model and make it more tractable. In reality, investors do

incur transaction costs when they trade assets. These costs can include brokerage fees, bid-ask

spreads, and other costs associated with buying and selling securities. If transaction costs were

included in the CAPM, the model would become more complex as the return on an investment

would then be a function of these costs. This would require estimating the transaction costs,

which can vary widely depending on the type of asset, the trading platform, and other factors.

Therefore, the assumption of no transaction costs is a simplifying assumption that makes the

CAPM more manageable, even though it does not accurately reflect the realities of investing.

Choice B is incorrect. This statement accurately represents an assumption of the standard

CAPM. The model assumes that there are no taxes, which means investors are indifferent

between capital gains and dividends/income. This simplifies the model by eliminating tax

considerations from investment decisions.

Choice C is incorrect. This statement also accurately represents an assumption of the standard

CAPM. The model assumes that assets can be divided infinitely, allowing investors to hold

fractional shares if desired. This makes it possible for all investors to hold the market portfolio

regardless of their wealth level.

Choice D is incorrect. Again, this statement accurately represents an assumption of the

standard CAPM. The model assumes unlimited short selling and a perfectly liquid market,

meaning that any amount of securities can be bought or sold without affecting their price.

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Q.181 Consider a graph with expected return on the vertical axis and standard deviation on the
horizontal axis. What's the name of the line that connects the risk-free rate and the optimal risky
portfolio?

A. The efficient frontier

B. The characteristic line

C. The indifference curve

D. The capital market line

The correct answer is D.

The CML is a line that illustrates the trade-off between expected return and standard deviation

(risk) for efficient portfolios. It is derived from the Modern Portfolio Theory and is an important

concept in financial investment. The CML starts from the point representing the risk-free rate

and extends to the point representing the optimal risky portfolio. This line shows the relationship

between risk (as measured by standard deviation) and return of efficient (market) portfolios. The

line appears as a tangent from the intercept point on the efficient frontier to the point where the

risk-free rate of return equals the expected return. The slope of the CML represents the market

price of risk, or the additional expected return per unit of standard deviation that an investor can

expect to earn by moving from a risk-free investment to a risky one. The CML is used by

investors to choose their optimal portfolio, given their level of risk tolerance.

Choice A is incorrect. The efficient frontier is not a line but a set of optimal portfolios that offer

the highest expected return for a defined level of risk or the lowest risk for a given level of

expected return. It does not originate from the point representing the risk-free rate.

Choice B is incorrect. The characteristic line is used in the Capital Asset Pricing Model

(CAPM) to depict the systematic risk of an individual security as its correlation with market

returns, and it's not related to visualizing relationship between overall portfolio risk and return.

Choice C is incorrect. An indifference curve represents combinations of risk and return that an

investor views as equally preferable, which doesn't necessarily extend from the point

representing the risk-free rate to optimal risky portfolio.

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Q.182 The difference between the capital market line (CML) and the efficient frontier (EF) is
that:

A. The CML represents possible combinations of portfolios consisting of all possible

proportions between the market portfolio and a risk-free asset while the EF represents
all possible combinations of efficient portfolios, taking into account only risky assets in
varying proportions.

B. The EF represents possible combinations of portfolios consisting of all possible

proportions between the market portfolio and a risk-free asset while the CML represents
all possible combinations of efficient portfolios, taking into account only risky assets in
varying proportions.

C. The CML represents a few possible combinations of portfolios consisting of various

proportions between the market portfolio and a risk-free asset while the EF represents
all possible combinations of efficient portfolios, taking into account only risk-free assets
in varying proportions.

D. The EF represents possible combinations of portfolios consisting of all possible

proportions between the market portfolio and a risk-free asset while the CML represents
all possible combinations of efficient portfolios, taking into account only risky assets in
fixed proportions.

The correct answer is A.

The Capital Market Line (CML) represents the trade-off between risk and return for efficient

portfolios that include a risk-free asset. The CML is a straight line that originates from the point

of the risk-free rate and is tangent to the efficient frontier. The slope of the CML represents the

market price of risk, or the reward per unit of risk that the market is offering. Any point along

the CML represents a portfolio that includes some combination of the market portfolio and the

risk-free asset.

On the other hand, the Efficient Frontier (EF) represents the set of optimal portfolios that offer

the highest expected return for a defined level of risk or the lowest risk for a given level of

expected return. The EF only includes portfolios of risky assets. The EF is a curve that forms the

boundary of the set of feasible portfolios. Any point along the EF represents a portfolio that is

efficient, i.e., it offers the highest possible expected return for its level of risk.

Therefore, the key difference between the CML and the EF is that the CML includes the risk-free

asset in its portfolio combinations, while the EF only includes risky assets.

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Choice B is incorrect. The Efficient Frontier (EF) does not represent combinations of portfolios

consisting of all possible proportions between the market portfolio and a risk-free asset. Instead,

it represents all possible combinations of efficient portfolios, taking into account only risky

assets in varying proportions. On the other hand, the Capital Market Line (CML) represents

possible combinations of portfolios consisting of all possible proportions between the market

portfolio and a risk-free asset.

Choice C is incorrect. The Capital Market Line (CML) does not represent just a few possible

combinations but rather all potential combinations of portfolios consisting of various proportions

between the market portfolio and a risk-free asset. Additionally, EF does not take into account

only risk-free assets in varying proportions; it considers only risky assets.

Choice D is incorrect. Similar to choice B, this option incorrectly states that EF represents

potential combinations involving both the market portfolio and a risk-free asset while CML

involves only risky assets in fixed proportions which contradicts with their actual definitions.

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Q.183 An investor holds a portfolio comprised of a risk-free asset and a market portfolio. Given
the following information, compute the expected return of the portfolio.
Risk-free rate = 5%
Expected market return = 25%
Standard deviation of market portfolio = 10%
Standard deviation of portfolio = 5%

A. 0.25

B. 0.0015

C. 0.1

D. 0.15

The correct answer is D.

R m −Rf
The equation of the CML is R p = Rf + { } σp
σm

Where:
R p is the expected portfolio return
R f is the risk-free rate
R m is the expected market return
And σm , σp are the standard deviations of the market and the portfolio, respectively

Therefore,

(25 − 5)
E(Rp ) = 5 + ×5
10
= 5+ 2 ×5
= 15%

Note: Any risk-free asset has a known, certain return (5% in this case). This is the result of its

standard deviation being 0. Thus, the covariance of the risk-free asset with any risky asset,

including the market portfolio, is zero. With a zero covariance, the correlation between the risky

asset and the market portfolio is also zero.

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Q.184 According to the CAPM, the risk premium expected to be received by a stockholder
increases:

A. Directly with beta.

B. Inversely with beta.

C. Inversely with systematic risk.

D. Directly with total risk.

The correct answer is A.

The risk premium, according to the Capital Asset Pricing Model (CAPM), increases directly with

beta. Beta is a measure of a stock's systematic risk, or the sensitivity of the stock's returns to

changes in the market. A beta of 1 indicates that the stock's price will move with the market,

while a beta less than 1 indicates that the stock will be less volatile than the market, and a beta

greater than 1 indicates that the stock will be more volatile than the market. Therefore, a higher

beta implies a higher risk, and investors require a higher risk premium for taking on this

additional risk. This is consistent with the fundamental principle of finance that higher risk

requires higher return as compensation. Therefore, as beta increases, the risk premium expected

by a stockholder also increases directly.

Choice B is incorrect. The risk premium does not change inversely with beta. According to the

CAPM, the risk premium (the expected return above the risk-free rate) of a security increases as

its beta (systematic risk) increases. Therefore, there is a direct relationship between beta and

the expected risk premium, not an inverse one.

Choice C is incorrect. The statement that the risk premium changes inversely with systematic

risk contradicts CAPM's fundamental principle. Systematic Risk, represented by Beta in CAPM,

directly influences the Risk Premium - higher systematic risks lead to higher expected returns or

premiums and vice versa.

Choice D is incorrect. According to CAPM, it's not total risk but rather systematic or market-

related risks (beta) that influence a security's expected return or Risk Premium directly. Total

Risk includes unsystematic risks which can be diversified away and hence do not contribute

towards earning additional premiums.

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Q.185 Under the CAPM, if a stock has a beta of 2, then for every percentage point performance
attained by the market over above the risk-free rate, we would expect the stock to achieve:

A. 1 percentage point return.

B. 2 percentage points extra return.

C. 1 percentage points lower return.

D. Impossible to determine.

The correct answer is B.

The beta coefficient in the Capital Asset Pricing Model (CAPM) measures the sensitivity of a

stock's returns to changes in the market returns. A beta of 1 indicates that the stock's price will

move with the market. A beta less than 1 indicates that the stock will be less volatile than the

market, while a beta greater than 1 indicates that the stock will be more volatile than the

market. In this case, a beta of 2 means that the stock is expected to return twice the market's

excess return over the risk-free rate. Therefore, for every percentage point performance attained

by the market over above the risk-free rate, we would expect the stock to achieve 2 percentage

points extra return. This is because the stock's returns are twice as sensitive to market

movements as indicated by its beta of 2.

Choice A is incorrect. A beta value of 2 indicates that the stock's return is expected to change

by 2 percentage points for every percentage point change in the market, not just 1 percentage

point.

Choice C is incorrect. The beta value does not indicate a lower return but rather a higher

sensitivity to market movements. In this case, a beta of 2 suggests that the stock's return would

increase or decrease by twice as much as any given market movement.

Choice D is incorrect. The CAPM model and its use of beta provide a clear method for

estimating expected returns based on market performance and risk relative to the market,

making it possible to determine an expected response.

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Q.186 A beta close to zero indicates:

A. A stock with a less stable return than the market as a whole.

B. A stock with a more stable return than the market as a whole.

C. An ETF replicating the corporate bond market.

D. A stock with historically higher returns compared to the market as a whole.

The correct answer is B.

A beta close to zero indicates a stock with a more stable return than the market as a whole. Beta

is a measure of a stock's volatility in comparison to the market as a whole. A beta of 1 indicates

that the stock's price will move with the market. A beta less than 1 indicates the stock will be

less volatile than the market, while a beta greater than 1 indicates the stock will be more volatile

than the market. Therefore, a beta close to zero would indicate a stock that is less volatile than

the market, meaning it has a more stable return. This could be due to a variety of factors, such

as the company's strong financial health, stable earnings, or a lack of exposure to market and

economic fluctuations.

Choice A is incorrect. A stock with a beta close to zero does not imply less stability in returns

compared to the market. In fact, it suggests that the stock's returns are largely uncorrelated

with the market, and hence its volatility is independent of market movements.

Choice C is incorrect. While an ETF replicating the corporate bond market may have a beta

close to zero due to its low correlation with equity markets, this choice does not necessarily

describe a characteristic of a stock with a beta close to zero. Beta measures the sensitivity of an

asset's returns relative to changes in the overall market return, and it can be applied across

different types of assets including stocks and bonds.

Choice D is incorrect. A stock's beta value does not provide information about its historical

returns compared to those of the overall market. Rather, it measures how much the stock's

return tends to move relative to changes in overall market return. Therefore, having a beta close

to zero doesn't necessarily mean that this particular stock has historically higher or lower

returns than those of the overall market.

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Q.188 An asset has a standard deviation of 30% and 0.8 as its correlation coefficient of returns
with the market index. Given that the standard deviation of the market return is 20%, calculate
the asset's beta.

A. 0.24

B. 2.4

C. 1.4

D. 1.2

The correct answer is D.

The formula for calculating the beta for stock i is:

σi
βi = ρi ,m ( )
σm

Where i is the stock and m is the market.

Thus,

0.3
βi = 0.8 ( ) = 1.2
0.2

Q.189 You have been given the following asset weights and betas for a 4-asset portfolio:

Asset Beta Portfolio Weight

1 1.3 30%
2 0.97 23%
3 1.7 37%
4 1.4 10%

If the market risk-free rate is 5%, what is the portfolio beta?

A. 1.6

B. 2.3

C. 1.4

D. 0.3

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The correct answer is C.

The beta for a portfolio is the weighted average of the betas of individual assetsThus, the beta
for the 4-asset portfolio above = 1.3 * 0.3 + 0.97 * 0.23 + 1.7 * 0.37 + 1.4 * 0.1 = 1.4Note: The
market risk-free rate is useless in this question.

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Q.191 When a security is plotted on the security market line (SML) chart and found to appear
above the SML, it's considered:

A. Undervalued and a profitable buy for investors.

B. Overvalued and a profitable buy for investors.

C. Undervalued and a profitable short sell for investors.

D. Overvalue and a profitable short sell for investors.

The correct answer is A.

A security that is plotted above the Security Market Line (SML) on a chart is considered

undervalued and a profitable buy for investors. The SML is a representation of the Capital Asset

Pricing Model (CAPM), which is used to determine the appropriate required rate of return of an

asset. If a security is plotted above the SML, it means that the security's expected return is

greater than the required return given its level of risk as per the CAPM. This indicates that the

security is undervalued, as it is providing a higher return than what would be expected given its

risk level. Therefore, it would be a profitable buy for investors, as they would be receiving a

higher return for the level of risk they are taking on.

Choice B is incorrect. An overvalued security that plots above the SML would not be a

profitable buy for investors. Overvalued securities are typically considered to be priced higher

than their intrinsic value, meaning that they may not provide a good return on investment.

Choice C is incorrect. While an undervalued security could potentially be a profitable short sell

if its price were expected to decrease, this scenario contradicts the assumption of the SML and

CAPM models which suggest that securities plotted above the SML are providing higher returns

than expected given their level of systematic risk, indicating they are undervalued and therefore

likely to increase in price.

Choice D is incorrect. An overvalued security would not plot above the SML as it would offer

lower returns than what would be expected given its level of systematic risk. Therefore, it

wouldn't necessarily present a profitable short selling opportunity for investors as its price may

already reflect its true value.

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Q.192 You have been provided with the following information regarding the stock of Translink,
an international air transport company:

Risk-free rate = 3%

Expected market risk premium = 5%

Translink beta = 1.5

Use the capital asset pricing model to determine the expected return of Translink.

A. 7.5%

B. 10.5%

C. 6%

D. 8%

The correct answer is B.

According to CAPM, the expected return on an asset is given by:

E(Ri ) = Rf + (E(Rm ) − R f ))βi

Where (E(Rm ) − R f ) is the difference between the expected market return and the risk-free rate

(market risk premium) and βi is the beta for the stock.

Thus,

E(R i) = 3% + 5% × 1.5 = 10.5%

Note that, what we are given in the question is the expected market risk premium and it should

not be confused with the expected market return.

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Q.193 John Powel gathers the following information regarding the stock of Swisscom, an internet
service provider:

Beta for Swisscom = 0.8

Risk-free rate = 5%

Powel's expected rate of return for Swisscom = 7%

Use this information to determine the expected market return.

A. 8%

B. 12%

C. 7.5%

D. 5%

The correct answer is C.

According to CAPM,

E(R i ) = R f + (E(Rm ) − Rf )βi

7% = 5% + (E(R m ) − 5%)0.8
2% = (E(Rm ) − 5%)0.8
2%
= E(Rm ) − 5%
0.8
E(Rm ) = 2.5% + 5% = 7.5%

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Q.194 Which of the following is NOT included in the underlying assumptions of the Capital Asset
Pricing Model (CAPM)?

A. There are no income taxes, which is why investors are indifferent between dividends
and capital gains.

B. Short selling is not allowed.

C. There are no transactions costs.

D. Investors can borrow and lend unlimited amounts at the risk-free rate.

The correct answer is B.

CAPM assumes that unlimited short selling is allowed so the investors can short as many assets

they want.

Option A is an appropriate assumption because CAPM does not assume income tax, which is

why an individual investor is indifferent between dividend income and capital gain.

Assumption C is also true because CAPM assumes there are no transaction costs and investors

can make unlimited transactions to balance their portfolios.

Option D is also an appropriate assumption. CAPM assumes that there is no limit on borrowing

and lending.

Q.195 Julia and Frank are two traders that have recently joined the New York Stock Exchange
(NYSE). During their daybreak, they discussed their understanding of the Capital Market Line
(CML) and Market Portfolio Theory.
Julia, who is a senior trader, stated that the capital market line (CML) is the tangent line drawn
from the point of the risk-free asset to the feasible region for risky assets, and all investors invest
in some combination of risk-free assets and market securities, which lies on the CML.

Frank added that the market portfolio is a universally agreed upon optimal risky portfolio that
lies on the CML.

Determine if the explanations of Julia and Frank are correct.

A. Julia is correct, and Frank is also correct.

B. Julia is incorrect, while Frank is correct.

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 C. Julia is correct, while Frank is incorrect.

D. Julia is incorrect, and Frank is also incorrect.

The correct answer is A.

Both Julia and Frank's statements are accurate.

The Capital Market Line (CML) is indeed the tangent line drawn from the point of the risk-free

asset to the feasible region for risky assets. This line represents the risk-return tradeoff for

efficient portfolios, considering the inclusion of a risk-free asset. All investors, according to the

theory, invest in some combination of risk-free assets and market securities, which lies on the

CML. This is because the CML represents the best possible set of portfolios an investor can

obtain, given the risk-free rate and the market portfolio.

Frank's statement about the market portfolio is also correct. The market portfolio is a universally

agreed upon optimal risky portfolio that lies on the CML. This portfolio includes all risky assets,

and each asset is weighted by its market value as a proportion of total market value. The market

portfolio is considered the optimal risky portfolio because it offers the highest expected return

for a given level of risk, according to the Market Portfolio Theory.

Choice B is incorrect. Julia's explanation of the Capital Market Line (CML) is correct. The CML

is indeed a tangent line drawn from the point of the risk-free asset to the feasible region for risky

assets, and all investors invest in some combination of risk-free assets and market securities,

which lies on the CML.

Choice C is incorrect. Frank's explanation about market portfolio theory is also correct. The

market portfolio does represent an optimal risky portfolio that lies on the CML, as it includes all

investable assets in proportion to their market values.

Choice D is incorrect. Both Julia and Frank provided accurate explanations regarding their

respective topics - Capital Market Line (CML) and Market Portfolio Theory.

Q.196 Steven Thomson is the head of the portfolio risk management team. His team has recently
forwarded him an intra-departmental valuation report that contains expected return and

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standard deviation calculations of one of the diversified portfolios he manages. Given that the
team has used different measures to compute the expected return of the portfolio, determine
which of the following is appropriate for measuring the expected return of individual securities.

A. Sharpe ratio

B. CML

C. CAPM

D. Beta

The correct answer is C.

The Capital Asset Pricing Model (CAPM) is the most appropriate measure for calculating the

expected return of individual securities. The CAPM is a model that describes the relationship

between systematic risk and expected return for assets, particularly stocks. It is used to

determine a theoretically appropriate required rate of return of an asset, if that asset is to be

added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The model

takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk

or market risk), often represented by the quantity beta (β) in the financial industry, as well as the

expected return of the market and the expected return of a theoretical risk-free asset. CAPM is a

more comprehensive measure as it considers the risk-free rate, the beta of the security, and the

expected market return.

Choice A is incorrect. The Sharpe ratio is a measure of risk-adjusted return, not a measure for

determining the expected return of individual securities within a portfolio. It is used to

understand the portfolio's performance by adjusting for its risk.

Choice B is incorrect. The Capital Market Line (CML) represents portfolios that optimally

combine risk and return. CML is used in the capital asset pricing model to depict rates of return

for efficient portfolios depending on the risk-free rate of interest and levels of risk (standard

deviation). However, it does not directly determine the expected returns of individual securities.

Choice D is incorrect. Beta measures a security's sensitivity to market movements and can be

used as part of CAPM to calculate expected returns, but Beta itself does not provide an estimate

for expected returns.

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Q.197 During an employment interview, a candidate is given the question to select the
appropriate formulas for the computation of an asset's beta. Out of the four following formulas
for the beta, one of them is INCORRECT. Which one?

A. Covariance of asset's return with the market return / Variance of the market returns.

B. (Correlation of asset's return and market return * Standard deviation of asset returns *
Standard deviation of market returns)/Variance of the market returns.

C. Correlation of asset's return and market return * (Standard deviation of asset returns /
Standard deviation of market returns).

D. Covariance of asset's return and market return * (Standard deviation of asset returns /
Standard deviation of market returns).

The correct answer is D.

The beta of an asset is a measure of its systematic risk in relation to the market. It is calculated

as the covariance of the asset's return with the market return divided by the variance of the

market return. This formula is used to quantify the asset's sensitivity to market movements. The

formula in Option D incorrectly multiplies the covariance of the asset's return and market return

with the ratio of the standard deviation of asset returns to the standard deviation of market

returns. This is not a recognized formula for calculating beta and does not provide a valid

measure of systematic risk.

Choice A is incorrect. The formula for beta as the covariance of the asset's return with the

market return divided by the variance of the market returns is correct. This formula accurately

captures how an asset's returns move in relation to changes in market returns, which is what

beta measures.

Choice B is incorrect. The formula provided here, which involves multiplying correlation of

asset's return and market return with standard deviation of both and then dividing by variance of

market returns, also correctly calculates beta. It essentially breaks down covariance into its

components (correlation and standard deviations), but still provides a valid measure for beta.

Choice C is incorrect. This choice correctly states that beta can be calculated as correlation

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between asset's return and market return multiplied by ratio of their standard deviations. This

formula also accurately reflects how an asset’s risk compares to that of the overall market.

Q.198 Huma Ahmed is a junior portfolio analyst who has recently switched from the fixed income
portfolio management unit to his firm's equity portfolio management unit. On her first day, she
was asked by her senior portfolio analyst to compute the portfolio's beta that contains 5 assets.
Using the data provided in the table, determine the beta of the portfolio.

Asset Return Weight Beta

1 1.3% 0.10 0.35
2 10% 0.25 0.20
3 6% 0.25 0.15
4 9% 0.30 0.60
5 16% 0.10 0.40

A. 1.7

B. 0.34

C. 0.09

D. -1.1

The correct answer is B.

The beta (β) of the portfolio is calculated as:

βp = W1 β1 + W2 β2 + W 3 β3 + W4 β4 + W5 β5
βp = 0.10 × 0.35 + 0.25 × 0.20 + 0.25 × 0.15 + 0.30 × 0.60 + 0.10 × 0.40 = 0.3425

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Q.199 According to CAPM, which of the following risks should an investor be compensated for?

A. Systematic risk only.

B. Unsystematic risk only.

C. Both systematic and unsystematic risk.

D. Both systematic risk and asset-specific-risk.

The correct answer is A.

The Capital Asset Pricing Model (CAPM) is a model used in finance to determine a theoretically
appropriate required rate of return of an asset, given that asset's systematic, non-diversifiable
risk. Systematic risk, also known as market risk or non-diversifiable risk, is the risk that affects
all companies in the market. It is the risk that cannot be eliminated by diversification. Examples
of systematic risk include interest rate changes, inflation, recessions, or political instability.
According to the CAPM, investors should be compensated for taking on systematic risk because
it cannot be eliminated through diversification. The model assumes that the total risk of a
portfolio can be divided into systematic risk and unsystematic risk. Unsystematic risk, also
known as specific risk, diversifiable risk, idiosyncratic risk, or residual risk, is the risk associated
with individual assets - it is the risk that can be eliminated by diversification. Since the model
assumes that investors hold diversified portfolios, it argues that they should not expect to receive
compensation for bearing unsystematic risk because it can be eliminated by diversification.

Choice B is incorrect. Unsystematic risk, also known as idiosyncratic risk or specific risk, is

unique to a particular company or industry. According to the CAPM, investors are not

compensated for bearing unsystematic risk because it can be eliminated through diversification.

Choice C is incorrect. The CAPM assumes that investors are compensated for systematic risk

only and not for unsystematic risk. This is because unsystematic risks can be diversified away by

holding a well-diversified portfolio of investments.

Choice D is incorrect. Asset-specific-risk falls under the category of unsystematic risks which

can be diversified away according to the CAPM model and hence investors should not expect

compensation for this type of risk.

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Q.200 Assume you are a junior portfolio analyst for a Chinese asset management company based
in Beijing and you are given the task to evaluate the stock of Sun Cruise Inc. using CAPM. If the
expected return of the market is 17%, the stock beta is 0.89, the risk-free rate is 6%, and the
market risk premium is 11%, then the computed expected rate of return of Sun Cruise Inc. is:

A. 17%

B. 15.8%

C. 10.45%

D. 11%

The correct answer is B.

According to the Capital Asset Pricing Model (CAPM):

Expected return of a stock = Risk-free rate + Beta(Expected market return − Risk-free rate)

Expected return of Sun Cruise Inc. = 6% + 0.89(17% − 6%) = 15.79%

Note that,

Expected return = Beta ∗ Market risk premium + Risk-free rate

Q.201 Which of the following is a major difference between Treynor and Sharpe measures?

A. While the Treynor measure uses beta as the risk measure to assess the volatility of a
portfolio relative to the market, the Sharpe measure takes into account the total risk
exposure and hence uses the standard deviation.

B. While the Sharpe measure uses beta as the risk measure to assess the volatility of a
portfolio relative to the market, the Treynor measure takes into account the total risk
exposure, hence uses the standard deviation.

C. The Treynor measure is more straightforward and easier to calculate as compared to

the Sharpe measure.

D. All of the above.

The correct answer is A.

The Treynor measure and the Sharpe measure are both used to evaluate the performance of a

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portfolio by comparing the risk-adjusted returns. However, they differ in the way they measure

risk. The Treynor measure uses beta as the risk measure. Beta measures the volatility of a

portfolio relative to the market, thus it only considers systematic risk. Systematic risk is the risk

that affects all securities in the market and cannot be eliminated through diversification. On the

other hand, the Sharpe measure uses the standard deviation as the risk measure. The standard

deviation measures the total risk of the portfolio, including both systematic and unsystematic

risk. Unsystematic risk is the risk that is unique to a particular security and can be eliminated

through diversification. Therefore, the Sharpe measure takes into account the total risk exposure

of the portfolio, while the Treynor measure only considers the systematic risk.

Choice B is incorrect. The Sharpe measure does not use beta as the risk measure to assess the

volatility of a portfolio relative to the market. Instead, it uses standard deviation which considers

total risk including both systematic and unsystematic risks. On the other hand, Treynor measure

uses beta which only accounts for systematic risk.

Choice C is incorrect. The complexity of calculation between Treynor and Sharpe measures is

not a primary distinction between them. Both measures are relatively straightforward to

calculate given that required data (returns, beta or standard deviation) are available.

Choice D is incorrect. As explained above, choices B and C do not accurately describe the

primary distinction between Treynor and Sharpe measures.

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Q.202 The Jensen portfolio evaluation measure:

A. is a measure of return per unit of risk, as measured by standard deviation.

B. is an absolute measure of return over and above that predicted by the CAPM.

C. is a measure of return per unit of risk, as measured by beta.

D. B and C

The correct answer is B.

The Jensen's measure, or Jensen's alpha, is indeed an absolute measure of return over and above

that predicted by the Capital Asset Pricing Model (CAPM). The CAPM is a model that describes

the relationship between systematic risk and expected return for assets, particularly stocks. It is

used in the pricing of risky securities, generating expected returns for assets given the risk of

those assets and calculating costs of capital. The Jensen's measure takes this a step further by

comparing the actual returns of a portfolio or an investment with the returns predicted by the

CAPM. If the actual returns are higher than the predicted returns, the Jensen's measure is

positive, indicating that the portfolio or investment has outperformed the market. Conversely, if

the actual returns are lower than the predicted returns, the Jensen's measure is negative,

indicating underperformance. Therefore, the Jensen's measure provides an absolute measure of

the portfolio's or investment's performance, taking into account the risk as measured by the

CAPM.

Choice A is incorrect. Jensen's measure is not a measure of return per unit of risk as measured

by standard deviation. This description fits more with the Sharpe ratio, which measures excess

return per unit of total risk (standard deviation).

Choice C is incorrect. Jensen's alpha does not measure return per unit of systematic risk

(beta). This description aligns more with the Treynor ratio, which measures excess return per

unit of systematic risk.

Choice D is incorrect. As explained above, Jensen's alpha does not fit the descriptions provided

in both options B and C.

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Q.203 John Cook, a retired surgeon, has the following assets:
A house and land worth $150,000 in total
An undiversified securities portfolio worth $700,000
A fleet of automobiles worth $160,000

Between the Treynor and the Sharpe measures, which measure would be of more concern to Mr.
Cook?

A. The Treynor measure

B. The Treynor measure for the portfolio and the Sharpe measure for the other assets

C. The Sharpe measure

D. None of the two measures

The correct answer is C.

The Sharpe ratio is a measure of risk-adjusted return, which helps investors understand the
return of an investment compared to its risk. The ratio is the average return earned in excess of
the risk-free rate per unit of volatility or total risk. In the context of Mr. Cook's assets, the Sharpe
measure would be more relevant because it takes into account the total risk - both systematic
and unsystematic risks. This is important because Mr. Cook's securities portfolio, which
constitutes the major proportion of his assets, is undiversified. This means it is exposed to both
types of risks. Therefore, the Sharpe measure would provide a more comprehensive assessment
of the risk and return of his portfolio. Furthermore, as a retired surgeon, Mr. Cook would be
interested in the safety of both income and principal, regardless of the source of volatility. The
Sharpe measure, by considering both systematic and unsystematic risks, would provide a more
accurate measure of the total risk to his income and principal.

Choice A is incorrect. The Treynor measure is not the most relevant for Mr. Cook's situation

because it only considers systematic risk, which is more applicable to well-diversified portfolios.

Mr. Cook's portfolio, however, is not diversified.

Choice B is incorrect. While it might seem logical to use the Treynor measure for the portfolio

and the Sharpe measure for other assets, this approach would be inappropriate given that Mr.

Cook's securities portfolio isn't diversified and therefore contains unsystematic risk which isn't

captured by the Treynor measure.

Choice D is incorrect. It suggests that neither of these measures would be relevant in

assessing the risk and return of his investments which isn't true as Sharpe ratio can provide a

useful assessment of his investment's performance on a risk-adjusted basis.

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Q.204 A 10-year research on 3 distinct portfolios and the market reveals the following
information:

Portfolio Average Standard Beta

Annual Deviation
Return
1 14% 21 1.15
2 16% 24 1.00
3 20% 28 1.25
S&P500 12% 20

If the risk-free rate is 6%, then use the Treynor measure to rank the portfolios from the lowest to
the highest.
A. 1, 2, 3

B. 2, 3, 1

C. 3, 2, 1

D. 1, 3, 2

The correct answer is A.

The Treynor measure of a portfolio,

(E(Rp ) − R f )
Tp =
βp

Hence:

(14% − 6%)
T1 = = 0.07
1.15
(16% − 6%)
T2 = = 0.1
1.0
(20% − 6
T3 = = 0.112
1.25

Q.206 A 10-year research on 3 distinct portfolios and the market reveals the following
information:

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 Portfolio
Average Standard Beta
Annual Deviation
Return
1 14% 21 1.15
2 16% 24 1.00
3 20% 28 1.25
S&P 500 12% 20

Given that the risk-free rate of return is 6%, use the Sharpe measure to rank the portfolios from
the lowest to the highest.
A. 1, 3, 2

B. 2, 3, 1

C. 2, 1, 3

D. 1, 2, 3

The correct answer is D.

E (R p)−R f
The formula for calculating the Sharpe ratio for a portfolio, Sp = Hence,
σp

(14% − 6%)
S1 = = 0.38
21%
(16% − 6%)
S2 = = 0.42
24%
(20% − 6%)
S3 = = 0.50
28%

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Q.207 Under Jensen's differential return measure, which of the following indicates superior
market timing on the part of the manager?

A. A zero alpha.

B. A positive alpha.

C. Statistically significant negative alpha.

D. Statistically significant positive alpha.

The correct answer is D.

Alpha is a measure of the excess return or value that has been added or subtracted by a fund
manager. The alpha coefficient indicates the performance of a portfolio relative to its benchmark.
A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%.
Correspondingly, a similar negative alpha would indicate an underperformance of 1%. When we
say that the alpha is statistically significant, it means that the chances of this alpha being a
result of random chance (luck) are very low. Therefore, a statistically significant positive alpha
indicates that the manager has consistently outperformed the market, which is a clear sign of
superior market timing. The statistical significance is usually tested using the t-statistic, which is
the estimated value of alpha divided by its standard deviation. A t-statistic greater than 2 is
generally considered statistically significant at the 95% confidence level.

Choice A is incorrect. A zero alpha indicates that the portfolio manager has neither

underperformed nor outperformed the market, implying no superior market timing skills.

Choice B is incorrect. While a positive alpha does indicate that the portfolio manager has

outperformed the market, it does not necessarily signify superior market timing skills. It could be

due to other factors such as stock selection or sector allocation.

Choice C is incorrect. A statistically significant negative alpha suggests that the portfolio

manager has consistently underperformed compared to what would be expected given their level

of systematic risk exposure, indicating poor performance rather than superior market timing

skills.

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Q.208 Suppose you have two portfolios with the same average return, the same standard
deviation of returns, but portfolio Y has a lower beta than portfolio X. Which of the following
statements is true according to the Sharpe measure?

A. Portfolio X performs better than portfolio Y.

B. Portfolios X and Y perform equally.

C. Portfolio Y outperforms portfolio X.

D. None of these are correct.

The correct answer is B.

The Sharpe ratio is a measure of risk-adjusted return, which is calculated as the average return

of a portfolio in excess of the risk-free rate, divided by the total risk of the portfolio. The total

risk is measured by the standard deviation of the portfolio's returns, not its beta. In this scenario,

both portfolios X and Y have the same average return and the same standard deviation of

returns, which means they have the same total risk. Therefore, according to the Sharpe ratio,

portfolios X and Y perform equally. The lower beta of portfolio Y does not affect the Sharpe ratio

because the Sharpe ratio does not consider systematic risk, which is what beta measures.

Instead, the Sharpe ratio considers total risk, which includes both systematic and unsystematic

risk. Therefore, even though portfolio Y has a lower beta, it does not outperform portfolio X

according to the Sharpe ratio.

Choice A is incorrect. The Sharpe ratio measures the excess return per unit of risk, which in

this case is represented by standard deviation. Since both portfolios have the same average

returns and standard deviation, their Sharpe ratios would be equal regardless of their beta

values. Therefore, portfolio X does not perform better than portfolio Y according to the Sharpe

ratio.

Choice C is incorrect. Similarly, despite having a lower beta value (which indicates less market

risk), portfolio Y does not outperform portfolio X according to the Sharpe ratio because they have

identical average returns and standard deviations.

Choice D is incorrect. As explained above, portfolios X and Y perform equally according to the

Sharpe ratio due to their identical average returns and standard deviations.

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Q.209 You have been given the following data for a managed portfolio:

Beta = 1.2

Alpha = 1%

Average return = 14%

Risk-free rate = 4%

Calculate the return on the market portfolio basing your calculations on Jensen's measure of
portfolio performance.

A. 15.45%

B. 13%

C. 11.5%

D. 1.3%

The correct answer is C.

According to Jensen's measure of performance:

α p = E(Rp ) − [Rf + [E(R m ) − R f ]βp ]

1% = 14% − [4% + 1.2(x − 4%)]
1% = 14% − [4% + 1.2x − 4.8%]
1% = 14% − 4% − 1.2x + 4.8%
1.2x = 13.8%
x = E(Rm ) = 11.5%

Q.210 The Treynor, Sharpe, and Jensen measures of portfolio performance are derived from
CAPM. Which of the following statements is correct regarding measures of portfolio
performance?

A. All three measures are equally efficient at evaluating the performance of a manager.

B. All three measures have the same denominator.

C. Unlike the Treynor and Jensen measures, the Sharpe measure takes into account the
total risk of a portfolio.

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 D. The Treynor and Sharpe measures use systematic risk, as represented by beta.

The correct answer is C.

The Sharpe ratio, unlike the Treynor and Jensen measures, takes into account the total risk of a

portfolio. The Sharpe ratio is a measure of risk-adjusted return, which compares the portfolio's

excess return (or risk premium) over the risk-free rate to the standard deviation of the portfolio's

return. The standard deviation is a measure of total risk, including both systematic and

unsystematic risk. Therefore, the Sharpe ratio provides a more comprehensive measure of risk

compared to the Treynor and Jensen measures, which only consider systematic risk as

represented by beta. Systematic risk is the risk that affects all securities in the market, while

unsystematic risk is the risk that is specific to a particular security. By considering total risk, the

Sharpe ratio provides a more accurate measure of a portfolio's performance, especially for non-

diversified portfolios.

Choice A is incorrect. All three measures are not equally efficient at evaluating the

performance of a manager. The efficiency of these measures depends on the specific

circumstances and the type of risk being considered. For example, Sharpe ratio is more

appropriate when evaluating diversified portfolios as it considers total risk, while Treynor and

Jensen's alpha are more suitable for non-diversified portfolios as they consider only systematic

risk.

Choice B is incorrect. All three measures do not have the same denominator. The Sharpe ratio

uses standard deviation (total risk) in its denominator, while both Treynor measure and Jensen's

alpha use beta (systematic risk) in their denominators.

Choice D is incorrect. It's not accurate to say that both Treynor and Sharpe measures use

systematic risk, as represented by beta. While it's true for Treynor measure, Sharpe measure

uses total portfolio risk (standard deviation), not just systematic risk (beta).

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Q.211 What is the tracking error?

A. The standard deviation of the return of the benchmark portfolio.

B. The average of the differences between the returns of the risky portfolio and the
benchmark return.

C. The standard deviation of the differences between portfolio return and the benchmark
return.

D. The difference between the return based on the Treynor measure and Jensen's
measure.

The correct answer is C.

Tracking error is indeed the standard deviation of the differences between the portfolio return

and the benchmark return. This measure is used to quantify the risk associated with active

management. Active management involves making investment decisions that deviate from the

benchmark index in an attempt to generate excess returns. However, these decisions can also

lead to underperformance, which is captured by the tracking error. A higher tracking error

indicates a greater deviation from the benchmark returns, implying a higher level of active

management and, consequently, a higher level of risk. Therefore, tracking error serves as a

useful tool for investors to assess the risk-return trade-off of an actively managed fund.

Choice A is incorrect. The standard deviation of the return of the benchmark portfolio does not

represent tracking error. Tracking error is a measure of how closely a portfolio follows its

benchmark, not the volatility of the benchmark itself.

Choice B is incorrect. The average difference between the returns of the risky portfolio and

the benchmark return does not accurately define tracking error. While it may give an indication

about performance relative to a benchmark, it doesn't account for variability in those differences

over time which is crucial in calculating tracking error.

Choice D is incorrect. The difference between Treynor's measure and Jensen's measure has

nothing to do with tracking error. These are both measures used to evaluate portfolio

performance based on risk-adjusted returns, but they do not provide information about how

closely a portfolio tracks its benchmark.

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Q.212 Typically, the manager is required to keep the tracking error ______ a stated threshold. In
this regard, transaction costs should be _______.

A. Below, minimized

B. Above, minimized

C. Below, eliminated

D. Above, maximized

The correct answer is A.

In portfolio management, the tracking error is a measure of how closely a portfolio follows the
index to which it is benchmarked. The smaller the tracking error, the closer the portfolio is
following the benchmark. Therefore, the tracking error should be kept below a stated threshold
to ensure that the portfolio's performance does not deviate significantly from the benchmark. On
the other hand, transaction costs refer to the costs incurred when buying or selling securities.
These costs can significantly impact the portfolio's returns, especially in the case of frequent
trading. Therefore, it is crucial for the manager to minimize these costs to maximize the
portfolio's net returns.

Choice B is incorrect. While it is true that transaction costs should be minimized, the tracking

error should not be kept above a specified threshold. The tracking error measures the deviation

of the portfolio return from the benchmark return, and keeping it below a certain limit ensures

that the portfolio does not deviate too much from its benchmark.

Choice C is incorrect. Although it would be ideal to eliminate transaction costs entirely, this is

often not feasible in practice due to various factors such as brokerage fees, bid-ask spreads etc.

Therefore, while efforts should be made to reduce these costs as much as possible, they cannot

typically be completely eliminated. Furthermore, similar to choice B, tracking error should

ideally be kept below a specified threshold.

Choice D is incorrect. This option contradicts both principles of effective portfolio

management mentioned in the question - tracking error should ideally be kept below (not above)

a specified threshold and transaction costs need to minimized (not maximized). Maximizing

transaction costs would lead to lower net returns for investors which goes against basic

principles of investment management.

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Q.213 A certain fund manager typically generates an alpha of 1% and a tracking error of 2.25%.
Determine the information ratio.

A. 0.3

B. 0.5

C. 2.25

D. 0.444

The correct answer is D.

(Expected return of the portfolio − Expected return of the benchmark

The information ratio =
Tracking error
Alpha
=
Tracking error
1
=
2.25
= 0.444

Q.217 Sean and Adam are two asset managers in a specific firm. During their discussion with
regard to portfolio performance measures, Adam made the following statements:
Statement 1: If the Sharpe ratio of the portfolio is greater than the Sharpe ratio of the market
portfolio, it indicates the portfolio performs better for every additional unit of risk.
Statement 2: Jensen's alpha measure for the market portfolio is always 0.

Which of these statements is/are correct?

A. Statement 1 is correct, while statement 2 is incorrect

B. Statement 1 is incorrect, while statement 2 is correct

C. Both statements are correct

D. Both statements are incorrect

The correct answer is C.

Both statements made by Adam are indeed correct. The Sharpe ratio is a measure used to

understand the return of an investment compared to its risk. The formula for the Sharpe ratio is

(Expected return of the portfolio - Risk-free rate) / Standard deviation of the portfolio's excess

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return.

(E(Rp ) − R f )
Sharpe ratio =
σp

If a portfolio's Sharpe ratio is higher than that of the market portfolio, it indicates that the

portfolio is performing better for each additional unit of risk compared to the market portfolio.

This means that the portfolio is providing a higher risk-adjusted return than the market portfolio.

Jensen's alpha is a risk-adjusted performance measure that represents the average return on a

portfolio or investment above or below that predicted by the capital asset pricing model (CAPM)

given the portfolio's or investment's beta and the average market return.

Jensen measure = α p = E(R p ) − [R f + [E(R m ) − Rf ]βp )

. For the market portfolio, the beta is always 1 and the expected return of the portfolio is the

same as the expected return of the market. Therefore, the Jensen's alpha for the market portfolio

will always be zero as the entire equation cancels out to zero.

Choice A is incorrect. While the first statement is correct, the second statement is also correct.

Jensen's alpha measure for the market portfolio is always 0 because it measures the excess

return over what would be predicted by CAPM, and since the market portfolio is used as a

benchmark in CAPM, its alpha would naturally be zero.

Choice B is incorrect. Both statements are correct. The first statement correctly describes that

a higher Sharpe ratio indicates better performance per unit of risk compared to another portfolio

or benchmark (in this case, the market portfolio). The second statement correctly states that

Jensen's alpha for the market portfolio will always be zero.

Choice D is incorrect. As explained above both statements are accurate descriptions of these

performance measures in finance.

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Q.218 As an analyst, you are analyzing the portfolio that focuses on the automotive industry. The
portfolio contains 12 stocks in total with 6 stocks from the automotive industry, 3 stocks from car
financing firms, and 3 stocks from car lubricant manufacturers. The expected return of the
portfolio is 31% with a standard deviation of 19% while the expected return of the market is 22%
with a standard deviation of 16%. Given that the risk-free rate is 5% and the portfolio's beta is
0.9, compute the Treynor ratio of the portfolio.

A. 0.1

B. 1.37

C. 0.19

D. 0.29

The correct answer is D.

(E(R p ) − R f ) (0.31 − 0.05)

Treynor ratio of portfolio = = = 0.288
βp 0.9

Q.219 The expected return of an investor's portfolio is 31% with a standard deviation of 19%
while the expected return of the market is 22% with a standard deviation of 16%. Given that the
risk-free rate is 5% and the portfolio's beta is 0.9, determine the difference between the Sharpe
ratio of the portfolio and the Sharpe ratio of the market.

A. 0.31

B. 0.5

C. 1.06

D. 0.12

The correct answer is A.

(E(R p ) − R f )
(0.31 − 0.05)
Sharpe ratio of the investor's portfolio = = = 1.37
σp 0.19
(E(Rm ) − Rf ) (0.22 − 0.05)
Sharpe ratio of market portfolio = = = 1.06
σm 0.16
Difference = 1.37 − 1.06 = 0.31

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Q.220 Ross Linn is analyzing the performance of different stocks of a portfolio using the alpha
measure of performance. Linn has compiled the following data regarding UUA:
Covariance = 0.027
Variance of the stock = 12%
Risk-free rate of return = 6%
Expected market return = 13%
Actual stock's return = 14.5%
Beta =1.1

Determine the correct alpha of UUA's stock and its appropriate interpretation.

A. The alpha of UUA is 0.8% and the stock has underperformed the market.

B. The alpha of UUA is 0.8% and the stock has outperformed the market.

C. The alpha of UUA is -4.625% and the stock has underperformed the market.

D. The alpha of UUA is -4.625% and the stock has outperformed the market.

The correct answer is B.

Jensen alphas or alpha of the stock = Actual return of stock − CAPM

Alpha = A(R) − [R f + [E(R m ) − Rf ]βp ]
= 0.145 − [0.06 + [0.13 − 0.06]1.1]
= 0.008 or 0.8%

Since UUA has a positive alpha of 0.8%, it suggests that the stock has outperformed the market

by 0.8%.

Q.221 Paul Thomson is the Chief Investment Officer (CIO) of Continental Investments Inc., an
asset management company that supervises three portfolios managed by three different portfolio
managers. All the portfolios have the same level of risk as the benchmark index. If Thomson is
interested in knowing which of the three portfolio managers possess the best stock-picking skills,
then which of the following statement is true?

A. The manager with the highest tracking error has the best stock-picking skills.

B. The manager with the lowest tracking error has the best stock-picking skills.

C. The manager with the lowest information ratio has the best stock-picking skills.

D. The manager with the lowest Sharpe ratio has the best stock-picking skills.

The correct answer is B.

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The tracking error is a measure used to evaluate a manager's stock-picking skills. It is defined as

the standard deviation of the difference between the returns of the portfolio and the benchmark.

Given that the risk level of the portfolio is the same as that of the benchmark index or portfolio, a

lower tracking error indicates superior stock-picking skills. Managers often strive to keep the

tracking error below a certain limit, taking into account transaction costs and other portfolio

management-related expenses to maintain a low tracking error.

Choice A is incorrect. The tracking error is a measure of how closely a portfolio follows the

index to which it is benchmarked. The higher the tracking error, the more the portfolio's

performance deviates from the benchmark. Therefore, a manager with a high tracking error does

not necessarily possess better stock-picking skills; instead, they may be taking on more risk than

necessary or deviating significantly from their benchmark.

Choice C is incorrect. The information ratio measures a portfolio manager's ability to generate

excess returns relative to a benchmark but also considers the consistency of this performance

and penalizes volatility. A lower information ratio indicates that either the manager has not been

able to generate sufficient excess returns or has taken on too much risk, neither of which are

indicative of good stock-picking skills.

Choice D is incorrect. The Sharpe ratio measures risk-adjusted performance and does not

specifically reflect stock-picking skills. A lower Sharpe ratio could indicate poor overall

investment strategy rather than poor stock selection.

Q.222 Bella Sean is a senior portfolio manager in a UK-based firm. She has recently rejoined the
office after her maternity leave. During her absence, her subordinate, Vikram Singh, was
managing one of her portfolios. She now notices that Vikram has significantly deviated from the
benchmark portfolio in order to earn higher gains than the portfolio. If Bella wants to assess if
Singh's deviation from the benchmark has reaped appropriate returns, then which of the
following measures must she use?

A. Tracking error

B. Information ratio

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 C. Sortino ratio

D. Jensen alpha

The correct answer is B.

The Information Ratio (IR) is a measure that portfolio managers use to evaluate the returns that

they have achieved above the returns of a benchmark, compared to the volatility of those

returns. The IR is calculated as the active return divided by the tracking error. The active return

is the return of the portfolio minus the return of the benchmark. The tracking error is the

standard deviation of the active return. In this case, Bella Sean would use the Information Ratio

to assess whether Vikram Singh's deviation from the benchmark portfolio has resulted in

appropriate returns. If the Information Ratio is high, it means that Vikram has managed to

achieve higher returns than the benchmark, taking into account the additional risk he has taken

on by deviating from the benchmark. If the Information Ratio is low, it means that the additional

returns achieved do not justify the additional risk taken.

Choice A is incorrect. Tracking error measures the standard deviation of the difference

between the returns of an investment and its benchmark. While it does provide a measure of risk

associated with deviating from a benchmark, it does not directly measure whether this deviation

has resulted in appropriate returns.

Choice C is incorrect. The Sortino ratio measures the risk-adjusted return of an investment,

but it specifically focuses on downside risk. It doesn't take into account how well or poorly an

investment performs relative to a specific benchmark, which is what Bella needs to evaluate in

this case.

Choice D is incorrect. Jensen's alpha measures the excess return that a portfolio generates

over its expected return as predicted by the Capital Asset Pricing Model (CAPM). Although

Jensen's alpha can indicate whether Vikram has generated positive or negative excess returns, it

doesn't provide information about how these returns compare to those of the benchmark

portfolio.

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Q.3469 A portfolio manager is constructing a portfolio composed of two assets. Asset A is a risky
asset with an expected return of 14% and a standard deviation of 22%, and asset B is a risk-free
asset with an expected return of 9%. If the portfolio manager increases the weight of the risky
asset to 130%, then the expected return of the portfolio is closest to:

A. 0.182

B. 0.155

C. 0.167

D. 0.1123

The correct answer is B.

Expected return of the portfolio = (Weight of Asset A * Return of Asset A) + (Weight of Asset B *
Return of Asset B) = (1.3 * 14%) + (-0.3 * 9%) = 15.5%

Detailed explanation:

Recall that the capital market line represents the portfolios that optimally combine risk and

return by combining the risk-free asset with the risky asset(market portfolio). An investor can

move up or down this line by varying the weights that they invest in the risk-free asset and the

risky asset. Rather than just split their money between the two assets, an investor who is willing

to take more risk can borrow more money at the risk-free rate and invest it in the risky asset.

Borrowing puts a negative weight on the risk-free asset. Let's see how this comes about: Let the

return on the risk-free rate be X, and the return on the risky asset be Y. Let's say you have $100

in your pocket and here's your initial plan: To invest $50 in the risk-free asset To invest $50 in

risky asset But then you decide to take more risk; you will borrow $80 at the risk-free rate X and

invest it in the risky asset What’s your total investment? Risk-free asset: = $50 - $80 = -$30

(essentially a “give and take” scenario) Risky asset; $50 + $80 = $130 Thus, Expected Return = -

$30/(-$30+$130)*X + $130/(-$30+$130)*Y = -0.3*X + 1.3*Y In our case, X = 9%, Y = 14%

Expected return = -0.3 * 0.09 + 1.3 * 0.14 = 0.155

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Q.3470 The expected return of the Karachi Stock exchange is 17%, and the rate on Pakistan's
risk-free bonds is 7.5%. Suppose the beta of Bata Corporation shares is 0.75, what is the
required rate of return on Bata Corporation's shares?

A. 0.1263

B. 0.2025

C. 0.1673

D. 0.1463

The correct answer is D.

The required rate of return on shares is calculated using the Capital Asset Pricing Model
(CAPM).
Required rate of return = Risk-free rate + Beta (Market Return - Risk-free rate) = 7.5% + 0.75*
(17%7.5%) = 14.63%

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Q.3471 Which of the following portfolios is/are most appropriately priced?
I. A portfolio with an estimated return above the securities market line (SML).
II. A portfolio with an estimated return plotted on the SML.
III. A portfolio with an estimated return below the SML.

A. Portfolios I & II

B. Portfolio II

C. Portfolios II & III

D. All of the above

The correct answer is B.

The Securities Market Line (SML) is a graphical representation of the market's risk and return

trade-off. In other words, it shows the expected return for each unit of risk (beta). When a

portfolio's estimated return is plotted on the SML, it indicates that the portfolio is appropriately

priced. This is because the portfolio's expected return is in line with the market's risk-return

trade-off. Therefore, the portfolio is neither overpriced nor underpriced. It is important to note

that the SML is based on the Capital Asset Pricing Model (CAPM), which assumes that investors

are rational and markets are efficient. Therefore, any deviations from the SML would present

arbitrage opportunities, which should not exist in an efficient market.

Statement I s incorrect. A portfolio with an estimated return above the SML indicates that the

portfolio is underpriced, as it offers a higher return than what the CAPM would predict, given its

level of systematic risk (beta).

Statement III is incorrect. An estimated return below the SML suggests that the portfolio is

overpriced - it offers a lower return than what should be expected for its level of systematic risk,

according to CAPM.

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Q.3472 Which of the following measures of risk-adjust returns does NOT use beta?

A. Treynor measure

B. Jensen's alpha

C. Sharpe ratio

D. None of the above

The correct answer is C.

The Sharpe ratio measure of risk-adjust returns use standard deviation or total risk. Treynor and
Jensen's alpha use beta or systematic risk.

Q.3473 Two portfolios have the following characteristics:

Portfolio Return Beta

A 8% 0.7
B 7% 1.1

Given a market return of 10% and a risk-free rate of 4%, calculate Jensen's Alpha for both
portfolios and comment on which portfolio has performed better.

A. -0.2% and -3.6% respectively

Portfolio A has performed better than Portfolio B.

B. -0.2% and -3.6% respectively

Portfolio B has performed better than Portfolio A.

C. 0.2% and 3.6% respectively

Portfolio B has performed better than Portfolio A.

D. 3.6% and 0.2% respectively

Portfolio A has performed better than Portfolio B.

The correct answer is A.

Jensen's Alpha is calculated as follows:

Jensen's Alpha = Rp - [Rf + Bp (Rm - Rf)]
Jensen's AlphaPortfolio A = 0.08 - [0.04 + 0.7(0.1 - 0.04)] = -0.002
Jensen's AlphaPortfolio B = 0.07 - [0.04 + 1.1(0.1 - 0.04)] = -0.036
Jensen's Alpha is -0.2% and -3.6% for A and B, respectively. A higher Alpha indicates that a
portfolio has performed better.

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Q.3474 Which of the following portfolio performance evaluation measures is (are) only based on
systematic risk?

A. Sharpe ratio

B. Treynor ratio

C. All of the above

D. None of the above

The correct answer is B.

The Treynor ratio is a performance metric for determining how well an investment has

compensated for each unit of systematic risk. It is calculated by subtracting the risk-free rate

from the portfolio's returns and then dividing by the portfolio's beta, which is a measure of

systematic risk. The higher the Treynor ratio, the better the portfolio's performance has been on

a risk-adjusted basis. The Treynor ratio is particularly useful for comparing the performance of

different portfolios or funds that are exposed to similar levels of systematic risk. It is important

to note that the Treynor ratio does not take into account unsystematic risk, as it assumes that

the portfolio is well-diversified and that any unsystematic risk has been eliminated.

Choice A is incorrect. The Sharpe ratio is not solely based on systematic risk. It measures the

excess return (or Risk Premium) per unit of deviation in an investment asset or a trading

strategy, typically referred to as risk (and correspondingly standard deviation). It considers both

systematic and unsystematic risks.

Choice C is incorrect. As explained above, the Sharpe ratio does not solely base on systematic

risk, thus it's not correct to say all of the above measures are based only on systematic risk.

Choice D is incorrect. The Treynor ratio, which is one of the options provided, does measure

portfolio performance using only systematic risk. Therefore, it cannot be said that none of the

options are based solely on systematic risk.

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Q.3476 The line that shows all portfolios that an investor can create once we allow for a risk-free
asset is called the:

A. Efficient frontier

B. Capital allocation line

C. Capital market line

D. Beta

The correct answer is C.

The Capital Market Line (CML) is the line that represents all the portfolios that an investor can

create once we allow for a risk-free asset. The CML is derived from the Capital Allocation Line

(CAL), which shows the risk and return trade-off for a specific investor. However, the CML is a

special case of the CAL where all investors have homogeneous expectations of risk and return.

This means that all investors agree on the expected returns, variances, and covariances of all

assets. Therefore, they all hold the same optimal risky portfolio, which when combined with a

risk-free asset, results in the CML. The CML is a critical component of the modern portfolio

theory and plays a significant role in determining an investor's optimal portfolio.

Choice A is incorrect. The Efficient Frontier refers to the set of optimal portfolios that offer the

highest expected return for a defined level of risk or the lowest risk for a given level of expected

return. Portfolios that lie below the efficient frontier are sub-optimal, because they do not

provide enough return for the level of risk. Portfolios that cluster to the right of the efficient

frontier are also sub-optimal, because they have a higher level of risk for the defined rate of

return.

Choice B is incorrect. The Capital Allocation Line (CAL) is a line created in graph where on

one axis there is portfolio risk (standard deviation), and on another axis there is expected return.

This line illustrates all possible mixes between risky and risk-free assets, but it does not

represent portfolios including only risky assets as required by our question.

Choice D is incorrect. Beta measures an investment's sensitivity to market movements and it's

used in CAPM model to determine an asset's expected returns based on its beta exposure to

market returns. It does not represent a range or line where different portfolios can be

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constructed with inclusion of a risk-free asset.

Q.3477 Which of the following is NOT an assumption of the capital asset pricing model?

A. Investors require higher returns with higher risks

B. Unlimited short-selling is permissible

C. All investors have the same one period time horizon

D. Investors are subject to taxes and transaction costs

The correct answer is D.

The Capital Asset Pricing Model (CAPM) assumes that there are no taxes and no transaction

costs. This assumption is made to simplify the model and focus on the relationship between risk

and return. In reality, investors do face taxes and transaction costs which can significantly

impact their investment decisions and returns. However, in the context of CAPM, these factors

are ignored to allow for a more straightforward analysis of risk and return. This assumption is

one of the main criticisms of the CAPM as it does not accurately reflect the real-world

investment environment.

Choice A is incorrect. This statement accurately represents an assumption of the Capital Asset

Pricing Model (CAPM). According to CAPM, there is a positive relationship between risk and

return, meaning that investors require higher returns for taking on higher risks.

Choice B is incorrect. This statement also accurately represents an assumption of the CAPM.

The model assumes that there are no restrictions on borrowing or lending, including unlimited

short-selling.

Choice C is incorrect. The CAPM does indeed assume that all investors have the same one

period time horizon for their investments. This simplifying assumption allows the model to focus

on risk and return without considering differing investment horizons.

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Q.3478 Which of the following uses systematic risk on the X-axis?

A. Security market line

B. Capital market line

C. Capital allocation line

D. Capital asset pricing model

The correct answer is A.

The Security Market Line (SML) uses systematic risk, measured by Beta, on its X-axis. The SML

is a graphical representation of the Capital Asset Pricing Model (CAPM), which depicts the

relationship between the expected return of a security and its systematic risk. The Y-axis

represents the expected return of a security, while the X-axis represents its systematic risk,

measured by Beta. Beta is a measure of a security's sensitivity to market movements. A Beta of 1

indicates that the security's price will move with the market, while a Beta less than 1 indicates

that the security will be less volatile than the market, and a Beta greater than 1 indicates that

the security will be more volatile than the market. Therefore, the SML helps investors

understand the risk-return tradeoff for a particular security in relation to the overall market.

Choice B is incorrect. The Capital Market Line (CML) uses total risk, which includes both

systematic and unsystematic risk, on its X-axis. It does not solely represent the relationship

between expected return and systematic risk.

Choice C is incorrect. The Capital Allocation Line (CAL) also uses total risk on its X-axis to

depict the trade-off between expected return and risk for a specific portfolio combined with a

risk-free asset. It does not specifically use systematic or market risk.

Choice D is incorrect. The Capital Asset Pricing Model (CAPM) is not a line or model that

graphically represents the relationship between expected return and any form of risk on an axis.

Instead, it's an equation that calculates the expected return of an asset based on its beta

(systematic risk), but it doesn't plot this relationship graphically like the Security Market Line

does.

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Q.3479 The standard deviation of an asset's return is 10%, and the standard deviation of markets
return is 14%. If the correlation of returns with the market index is 0.7, then what is the beta of
the asset?

A. 1

B. 0.1

C. 1.8

D. 0.5

The correct answer is D.

Assets beta = Correlation of markets return * (Standard deviation of the asset / Standard
deviation of market returns) = 0.7 * 10% / 14% = 0.5

Q.3480 The expected return of a portfolio is 17% and the return on risk-free assets in the
portfolio is 8%. The beta of the portfolio is 1.2, and the standard deviation of the portfolio is
5.5%. Assuming that an investor invests 115% of his savings in this portfolio, what is his
expected return?

A. 18.35%.

B. 19.55%.

C. 12.5%.

D. 0.1345

The correct answer is A.

Since the weight of the market portfolio is more than 100%, the investor is borrowing 15% of
funds at the risk-free rate and investing 115% in the market portfolio.
E[r] = (-15%)(8%) + (115%)(17%) = 18.35%

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Q.3481 Kate Williams is a portfolio risk analyst for Hampton Funds. She is assigned to calculate
the beta of Lion Inc. shares. What is its beta if the standard deviation of market returns is 19%
and the covariance of Lions returns with the market return is 0.163?

A. 0.85

B. 4.51

C. 0.0451

D. 2.55

The correct answer is B.

Beta = Covariance of Asset's return with market return / Variance of market returns
Beta = 0.163/0.192 = 4.51

Q.3482 What is the expected return of a stock if the expected market return is 11%, the risk-free
rate is 9%, and the stock's beta is 0.91?

A. 0.11

B. 0.1991

C. 0.1082

D. 0.1753

The correct answer is C.

According to CAPM:
Expected return of stock = Risk-free rate + beta (Market risk - Risk-free rate)

E[r] = 9% + 0.91(11%-9%) = 10.82%

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Q.3483 What is the covariance of an asset's returns with the market if the beta of the asset is 1.7
and the variance of market returns is 0.20?

A. 0.34

B. 0.85

C. 0.12

D. 8.5

The correct answer is A.

Covariance of asset returns with the market = Beta * Variance of market returns = 1.7 * 0.20 =
0.34

Q.3484 What is the market risk premium if the expected return on the market is 13%, the
average stock's beta is 1, and the risk-free rate is 8%?

A. 9%

B. 13%

C. 5%

D. 0%

The correct answer is C.

Market risk premium = Expected return of market - Risk-free rate of return.

Risk premium = 13% - 8% = 5%

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Q.3485 What is the market risk premium if the expected return on a stock is 12% while its beta
is 1.5? Assume the risk-free rate is 6% and the return on the market, i.e. market risk is 10%.

A. 6%

B. 4%

C. 10%

D. 12%

The correct answer is B.

Expected return on stock = Risk-free rate + Beta*Risk premium

Note: Market risk - Risk-free rate = Risk premium

Expected return on stock = Risk-free rate + Beta*(Market return - Risk-free rate)

12% = 6% + 1.5(10% - 6%)
Market return = (12% - 6%)/1.5 + 6% = 10%

Risk premium = Market return - Risk-free rate = 10% - 6% = 4%

Q.3486 What is the beta of a certain stock with a risk-free rate of 2.1% and a return of 14.2%,
given that the expected return of the market is 17%?

A. 1

B. 1.5

C. 1.2

D. 0.81

The correct answer is D.

The expected return on the stock is given by:

rf + β(rm − rf )

⇒ 14.2% = 2.1% + β (17% − 2.1%)

⇒ β = 0.81

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Q.3487 The standard deviation of a portfolio is 15%. If the portfolio's return is 22%, and the risk-
free return is 6%, then what is the Sharpe ratio of the portfolio?

A. 0.91

B. 1.07

C. 1.46

D. 1.98

The correct answer is B.

Sharpe ratio = (Portfolio return - Risk-free return) / Standard deviation of portfolio = (22% - 6%)
/ 15% = 1.07

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Q.3488 Which of the following measures excess return per unit of total risk?

A. Jensen's alpha

B. Treynor ratio

C. Sharpe ratio

D. Sortino ratio

The correct answer is C.

The Sharpe ratio is a risk-adjusted performance metric that measures the excess return of an

investment or portfolio relative to its total risk. The total risk is measured by the standard

deviation of the investment or portfolio's returns. The Sharpe ratio is calculated by subtracting

the risk-free rate from the expected return of the investment or portfolio, and then dividing the

result by the standard deviation of the investment or portfolio's returns. This ratio provides a

measure of the excess return earned per unit of total risk, which includes both systematic and

unsystematic risk. The higher the Sharpe ratio, the better the investment or portfolio's risk-

adjusted performance.

Choice A is incorrect. Jensen's alpha is a risk-adjusted performance measure that represents

the average return on a portfolio over and above that predicted by the capital asset pricing

model (CAPM), given the portfolio's beta and the average market return. This metric does not

specifically measure excess return per unit of total risk.

Choice B is incorrect. The Treynor ratio, also known as reward-to-volatility ratio, measures

returns earned in excess of that which could have been earned on a riskless investment per each

unit of market risk. It does not take into account total risk but only systematic risk.

Choice D is incorrect. The Sortino ratio differentiates harmful volatility from total overall

volatility by using the asset's standard deviation of negative portfolio returns—downside

deviation instead of total standard deviation used in Sharpe Ratio. Therefore, it doesn't measure

excess return per unit of total risk but rather focuses on downside or harmful volatility.

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Q.3489 The 10-year US Treasury rate is 5% and the return on the S&P 500 index is 10%. If the
beta of Orange Inc. is 1.2, what is the expected return on shares of Orange Inc.?

A. 11%

B. 15%

C. 17%

D. 8%

The correct answer is A.

According to CAPM,
Expected return of stock = Risk-free rate + Beta(Market risk - Risk-free rate)
E[r] = 5% + 1.2(10%-5%) = 11%
Note that the 10-year US Treasury bonds are considered the risk-free rate and the S&P 500
return is considered the market return.

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Q.3490 Which of the following statements is appropriate regarding the plot of undervalued
stocks on the security market line?

A. Undervalued stocks plot above the SML

B. Undervalued stocks plot under the SML

C. Stocks always plot on the SML

D. Valuation can not be determined.

The correct answer is A.

Undervalued stocks plot above the Security Market Line (SML). The SML is a graphical

representation of the Capital Asset Pricing Model (CAPM), which is used to determine the

expected return of an investment given its level of systematic risk, or beta. The SML plots the

expected return of a security against its beta, providing a benchmark for assessing the

performance of an investment. Stocks that plot above the SML are considered undervalued

because they offer a higher return than what the CAPM would predict given their level of risk.

This means that these stocks are providing more return for their level of risk than what is

considered fair or average, making them attractive investments. Investors seeking to maximize

their returns for a given level of risk would therefore look for stocks that plot above the SML.

Choice B is incorrect. Undervalued stocks do not plot under the SML. If a stock plots below

the SML, it indicates that it is overvalued, as its expected return is less than what would be

predicted by the CAPM given its level of systematic risk (beta). This suggests that investors are

overpaying for the amount of risk they are taking on.

Choice C is incorrect. It's not accurate to say that stocks always plot on the SML. While the

SML represents an equilibrium condition where all securities are fairly priced, in reality, due to

various market imperfections and investor irrationality, some stocks may be undervalued or

overvalued at any given time and thus plot above or below the SML.

Choice D is incorrect. Valuation can indeed be determined using the Security Market Line

(SML). The position of a stock relative to this line provides valuable information about whether it

might be undervalued or overvalued based on its expected return and systematic risk.

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Q.3491 Company ABC is expected to return 15% per year to its investors, the market expected
return is 8%, and the risk-free rate is 3.5%. What is ABC's stock beta?

A. 1.4375

B. 1.875

C. 2.5556

D. 3.3333

The correct answer is C.

E(R i ) = R f + E(Rm − R f )βi

15% = 3.5% + (4.5%)βi
11.5% = (4.5%)βi
⇒ βi = 2.5556

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Q.5314 What would be the portfolio's beta, given that its return correlation with the benchmark
is 0.65, the portfolio's return volatility is 6%, and the benchmark's return volatility is 3%?

A. 0.117

B. 1.3

C. 0.325

D. 14.08

The correct answer is B.

σ (portfolio)
β=ρ
σ (benchmark)

Where:

β = beta of the portfolio

ρ = correlation between the portfolio and the benchmark

σ (portfolio) = standard deviation (volatility) of the portfolio

σ (benchmark) = standard deviation of the benchmark

0.06
β = 0.65 × = 1.3
0.03

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Q.5315 Tom Peters has been evaluating the performance of his company’s portfolio. He has the
access to the below information.

Portfolio’s expected return 8.5%

Risk-free rate 4%
Beta of the portfolio 1.25
Return on the benchmark portfolio 7%
Standard deviation of returns of the portfolio 6%

From the above information, the Sharpe Performance Index (SPI) is closest to?

A. 0.75

B. 0.036

C. 0.025

D. 0.65

The correct answer is A.

The Sharpe Performance Index (SPI), also known as the Sharpe Ratio, measures the risk-

adjusted return of a portfolio. To calculate the Sharpe Ratio, use the following formula:

E (Rp ) − R f
SP I =
σ(Rp )

where:

E (R p ) = Expected return of the portfolio

R f = Risk-free rate

σ(Rp ) = Standard deviation (volatility) of the portfolio

8.5% − 4%
SP I = = 0.75
6%

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Q.5317 What is the Treynor Performance Index of a portfolio, given its expected return of 7.7%,
volatility of 17%, beta of 0.4, and a risk-free rate of 2.5%, as calculated by an investment
performance analyst?

A. 0.305

B. 0.052

C. 0.13

D. 3.72

The correct answer is C.

The Treynor Performance Index (TPI), also known as the Treynor Ratio, measures the risk-

adjusted return of a portfolio considering its systematic risk (beta). To calculate the Treynor

Ratio, use the following formula:

E (R p ) − R f
TPI =
βp

where:

E (R p ) = Expected return of the portfolio

R f = Risk-free rate

βp = Beta of the portfolio

7.7% − 2.5%
TPI = = 0.13
0.4

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Q.5318 An analyst examined the past performance of two commodity funds that follow the
S&P500 as a benchmark. The analyst collected monthly return data and utilized the Information
Ratio (IR) to evaluate which fund generated greater returns more effectively. The analyst then
presented the results as follows:

Fund A Fund B Benchmark

Average monthly return 2.63% 2.54% 2.35%
Average excess return 0.28% 0.19% 0.00%
Standard deviation of returns 0.51% 0.48% 0.45%
Tracking error 0.56% 0.53% 0.00%

What is the Information Ratio (IR) for each fund?

A. Fund A Information Ratio (IR) = 0.54, Fund B Information Ratio (IR) = 0.39

B. Fund A Information Ratio (IR) = 0.50, Fund B Information Ratio (IR) = 0.35

C. Fund A Information Ratio (IR) = 0.46, Fund B Information Ratio (IR) = 0.47

D. Fund A Information Ratio (IR) = 0.91, Fund B Information Ratio (IR) = 0.90

The correct answer is B.

The information ratio can be computed by comparing the residual return to the residual risk or

the excess return to the tracking error. The greater the IR, the better the management is at

selecting assets to invest in.

E (R p − Rb )
IR =
Tracking error

Fund A:

2.63% − 2.35%
IR = = 0.50
0.56%

Fund B:

2.54% − 2.35%
IR = = 0.35
0.53%

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Reading 6: The Arbitrage Pricing Theory and Multifactor Models of Risk
and Return

Q.223 The following are inputs to a multifactor return model for any stock, EXCEPT:

A. Firm-specific return.

B. Deviation of macroeconomic factors from the expected values.

C. The expected return for the stock.

D. Aggregate market risk.

The correct answer is D.

Aggregate market risk is not an input to a multifactor return model for a stock. The multifactor

model, unlike the Capital Asset Pricing Model (CAPM), does not consider aggregate market risk.

Instead, it uses factor loadings, also known as factor sensitivities or factor betas, to evaluate the

impact of certain dominant factors on the return of the stock. The model is expressed as follows:

Ri = E(R i) + βi1 F1 + βi2 F2 + ⋯ + βik Fk + ei

Where:

R i = rate of return on stock i

E(R i ) = expected return on stock i

βik = sensitivity of the stock’s return to a one-unit change in factor k

Fk = Macroeconomic factor k

ei = the firm-specific return/portion of the stock’s return unexplained by macro factors

The expected value of the firm-specific return is always zero. Therefore, aggregate market risk is

not a factor in this model.

Choice A is incorrect. Firm-specific return is indeed an input to a multifactor return model for

a stock. This factor represents the unique characteristics of the firm that may affect its stock

returns, such as its financial performance, industry position, and management quality.

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Choice B is incorrect. Deviation of macroeconomic factors from the expected values is also an

input to this model. Macroeconomic factors such as inflation rate, GDP growth rate, and interest

rates can significantly influence stock returns. The deviation of these factors from their expected

values can cause unexpected changes in stock returns.

Choice C is incorrect. The expected return for the stock is another important input to this

model. It represents the average return that investors expect to earn from holding the stock over

a certain period.

Choice D (Aggregate market risk) was correctly identified as not being an input into a

multifactor return model for stocks. Aggregate market risk refers to risks that affect all firms

in the market rather than specific individual firms or sectors which are typically considered in

multifactor models.

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Q.224 Define arbitrage as used in the context of security trading.

A. The exploitation of undervalued assets so as to increase returns.

B. The exploitation of security mispricing aimed at making risk-free profits.

C. The skill of accurately timing returns so as to obtain optimal profit from a security.

D. The exploitation of illegal trading channels aimed at making tax-free profits.

The correct answer is B.

Arbitrage, in the context of security trading, refers to the exploitation of security mispricing with

the aim of making risk-free profits. This is achieved by simultaneously buying and selling the

same security in different markets to take advantage of the price difference. The key element of

arbitrage is that it involves no risk. The profit is made from the price discrepancy and not from

the movement of the security's price. Therefore, it is considered a risk-free profit. The

arbitrageur, or the person conducting the arbitrage, is essentially providing a service to the

market by ensuring that prices across different markets are in line with each other. If there is a

price discrepancy, the arbitrageur will step in to take advantage of the situation, thereby

bringing the prices back into alignment. This is why arbitrage is considered an important

mechanism in maintaining market efficiency.

Choice A is incorrect. While the exploitation of undervalued assets can lead to increased

returns, this does not necessarily constitute arbitrage. Arbitrage specifically involves taking

advantage of price discrepancies in different markets for the same asset to make risk-free

profits, not simply investing in undervalued assets.

Choice C is incorrect. Timing returns accurately to obtain optimal profit from a security refers

more to trading strategies based on market timing and prediction rather than arbitrage.

Arbitrage does not rely on timing or predicting market movements but rather exploits existing

price discrepancies between markets.

Choice D is incorrect. The exploitation of illegal trading channels for tax-free profits falls

under illicit activities and has nothing to do with the concept of arbitrage in security trading

which is a legal and commonly used strategy.

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Q.226 The common stock of Swisscom Inc. is examined with a single factor model using
unexpected percent changes in GDP as the single factor. You have been provided with the
following data:
Expected return for Swisscom = 10%
GDP factor-beta = 2
Expected GDP growth = 2%

Revised macroeconomic information strongly suggests that the GDP will grow by a whopping 5%
as opposed to the original prediction of 2%. Assuming there's no new information regarding firm-
specific events, calculate the revised expected return using a single factor model.

A. 10.6%

B. 6%

C. 20%

D. 16%

The correct answer is D.

The equation for a single factor model for stock i is given by:

Ri = E(R i ) + βi,j Fj + ei

Where:

R i = revised return for stock i

E(R i ) = the expected return for stock i

βi,j = the jth factor beta for stock i

Fj = the deviation of the factor j from its expected value

ei = the firm-specific return for stock i

In our case:

R i = 0.10 + 2(0.05 − 0.02) = 0.10 + 0.06 = 0.16 or 16%

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Q.227 ShipLink, a United States cargo company, considers the return earned on its stock as
heavily sensitive to GDP and consumer sentiments. You have been given the following data:
Expected return for Shiplink stock = 10%
GDP factor beta = 2
Expected growth in GDP = 3%
Consumer sentiment factor beta = 2.5
Expected growth in consumer sentiment = 2%

Suppose revised macroeconomic data suggests the GDP will grow by 4% rather than 3% and that
consumer sentiments will grow by 3% rather than 2%. Determine the revised return for Shiplink
stock, assuming no new information is available regarding the firm-specific return.

A. 18%

B. 25%

C. 14.5%

D. 4.5%

The correct answer is C.

This is a multifactor model where the revised return, Ri will be given by:

Ri = E(R i ) + βS,G DP FG DP + βS,CS FCS + ei

= 0.10 + 2(0.04 − 0.03) + 2.5(0.03 − 0.02)
= 0.10 + 0.02 + 0.025
= 0.145 or 14.5%

Q.228 A manager uses a two-factor model to examine the returns of two assets, X and Y. The two
factors are unexpected percentage changes in inflation (IF) and consumer sentiment (CS). The
following data has also been given:

E(R X ) = 10%

E(R Y ) = 12%

βX,IF = βY ,IF = 2

βX,CS = βY ,CS = 2

All other factors constant, which of the following statements is true?

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 A. Asset Y is more sensitive to inflation than asset X.

B. Inflation and consumer sentiment have different effects on the returns of X and Y.

C. An arbitrage opportunity exists.

D. None of the above are true.

The correct answer is C.

An arbitrage opportunity exists. Arbitrage is the practice of taking advantage of a price

difference between two or more markets, striking a combination of matching deals that

capitalize upon the imbalance, the profit being the difference between the market prices. In this

case, the two assets, X and Y, have identical systematic risks as indicated by their beta

coefficients. However, they have different expected returns, with asset Y having a higher

expected return than asset X. This discrepancy creates an arbitrage opportunity. An investor can

exploit this by shorting asset X (i.e., selling asset X now with the intention of buying it back later

at a lower price) and using the proceeds to take a long position in asset Y (i.e., buying asset Y

now with the expectation that its price will increase in the future). This strategy allows the

investor to make a risk-free profit, as they are essentially borrowing at a lower rate (the expected

return of asset X) and investing at a higher rate (the expected return of asset Y).

Choice A is incorrect. The sensitivity of an asset to inflation is measured by its beta coefficient

with respect to inflation. Given that both Asset X and Asset Y have the same beta coefficient for

inflation (βX,IF = βY ,I F = 2), it implies that they are equally sensitive to unexpected changes in

inflation. Therefore, it is not correct to say that Asset Y is more sensitive to inflation than Asset

X.

Choice B is incorrect. The effect of a factor on the returns of an asset is determined by its beta

coefficient with respect to that factor. Since both assets have the same beta coefficients for both

factors (βX,I F = βY ,I F = 2 and βX,CS = βY ,CS = 2 ), it means that unexpected changes in either

inflation or consumer sentiment will have the same effect on the returns of Assets X and Y. Thus,

this statement is false.

Choice D is incorrect. As explained above

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Q.229 What is the three-factor model proposed by Eugene Fama and Kenneth French primarily
used to explain?

A. The stock market's return volatility

B. The long-term performance of a company

C. The relationship between risk and return

D. The stock market's direction of movement

The correct answer is C.

The three-factor model proposed by Eugene Fama and Kenneth French is an extension of the

Capital Asset Pricing Model (CAPM). This model is used to explain the relationship between risk

and expected return in portfolio investments, by introducing two additional factors - size and

value - that are said to be associated with higher returns for investors. It states that, aside from

market risk (beta), size (smaller companies) and value (or book-to-market) have significant

effects on expected returns, which explains why certain portfolios may outperform others over

time.

A is incorrect.The stock market's return volatility is not explained by the three-factor model
proposed by Eugene Fama and Kenneth French as it does not account for changes in volatility
over time.
B is incorrect.The long-term performance of a company is not explained by the three-factor
model as it does not focus on individual companies but rather how different portfolio
combinations behave over time.
D is incorrect.The stock market's direction of movement is also not explained by the three-
factor model as this depends on other factors such as economic news or investor sentiment,
which are outside its scope of analysis.

Q.230 Consider a single factor APT. Portfolio X has a beta of 1.2 and an expected return of 18%.
Portfolio Y has a beta of 1.0 and an expected return of 14%. You are further provided with a risk-
free rate of 6%. Assuming you wanted to exploit an arbitrage opportunity, you would take a short
position in:

A. Y and use the proceeds to take a long position in X.

B. Y and use the proceeds to take a long position in the risk-free asset.

C. X and use the proceeds to take a long position in Y.

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 D. X and use the proceeds to take a long position in the risk-free asset.

The correct answer is A.

The Arbitrage Pricing Theory (APT) is a multifactor model of asset pricing that holds that the

expected return of a financial asset can be modeled as a linear function of various

macroeconomic factors, where sensitivity to changes in each factor is represented by a factor-

specific beta coefficient. In this case, the expected return of a portfolio is calculated as the sum

of the risk-free rate and the product of the portfolio's beta and the factor premium. For portfolio

X, the expected return is 18%, which equals 1.2F (where F is the factor premium) plus the risk-

free rate of 6%. Solving for F gives us a factor premium of 10%. For portfolio Y, the expected

return is 14%, which equals 1.0F plus the risk-free rate of 6%. Solving for F in this case gives us

a factor premium of 8%. Since the factor premium for portfolio X is higher than that for portfolio

Y, an arbitrage opportunity exists. By shorting portfolio Y (selling it) and using the proceeds to

take a long position in portfolio X (buying it), you can exploit this arbitrage opportunity and earn

a risk-free profit.

Choice B is incorrect. Selling Portfolio Y and using the proceeds to take a long position in the

risk-free asset would not provide an arbitrage opportunity. This is because the expected return of

Portfolio Y (14%) is higher than the risk-free rate (6%). Therefore, this strategy would result in a

lower return rather than an arbitrage profit.

Choice C is incorrect. Shorting Portfolio X and using the proceeds to take a long position in

Portfolio Y would not yield an arbitrage opportunity either. The expected return of Portfolio X

(18%) exceeds that of Portfolio Y (14%), despite having a higher beta value, which indicates more

systematic risk. Thus, this strategy would lead to lower returns instead of exploiting any pricing

inefficiencies for arbitrage gains.

Choice D is incorrect. Shorting portfolio X and investing in the risk-free asset also does not

present an arbitrage opportunity as it will result in lower returns due to difference between

expected return on portfolio X(18%) and risk free rate(6%).

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Q.231 When the equilibrium price relationship is violated, an investor will try to take as large a
position as possible. This is an example of:

A. Risk-free arbitrage.

B. The capital asset pricing model.

C. The mean-variance frontier.

D. The single factor security market line.

The correct answer is A.

Violation of the equilibrium price relationship will prompt an investor to buy the lower-priced

asset and simultaneously place an order to sell the higher-priced asset. This is an example of

risk-free arbitrage. In fact, the larger the long position taken, the greater the risk-free profits.

Option B is incorrect: CAPM explains that the market equilibrium is attained when all

investors hold portfolios whose constituents are a combination of riskless asset and the market

portfolio

Option C is incorrect: The mean-variance frontier is a combination of securities that offer the

best possible returns at a minimum variance possible.

Option D is incorrect: a single-factor model assumes there’s just one macroeconomic factor.

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Q.232 What is the major difference between CAPM and the APT?

A. APT places more emphasis on systematic risks.

B. APT downplays the importance of diversification.

C. APT recognizes multiple systematic factors.

D. APT recognizes multiple unsystematic factors.

The correct answer is C.

The Arbitrage Pricing Theory (APT) indeed recognizes multiple systematic factors. Unlike the

Capital Asset Pricing Model (CAPM), which is a single-factor model that only considers market

risk, APT is a multi-factor model. It assumes that the return of a financial asset can be modeled

as a linear function of various macroeconomic factors. These factors could include GDP growth,

inflation rates, interest rates, and others. Each of these factors has an associated sensitivity or

'beta' that measures the asset's responsiveness to changes in that factor. By considering multiple

systematic factors, APT provides a more comprehensive view of the risks affecting asset returns.

This recognition of multiple systematic factors is the primary distinction between CAPM and APT.

Choice A is incorrect. Both CAPM and APT place emphasis on systematic risks. Systematic

risk, also known as market risk, affects the overall market and cannot be eliminated through

diversification. It is a key component in both models.

Choice B is incorrect. The statement that APT downplays the importance of diversification is

not accurate. In fact, both CAPM and APT assume that investors hold diversified portfolios to

eliminate unsystematic risk.

Choice D is incorrect. Neither CAPM nor APT recognizes multiple unsystematic factors as they

are based on the assumption that unsystematic risks can be diversified away by holding a well-

diversified portfolio.

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Q.233 Which of the following statements is true regarding the security market line derived from
the arbitrage pricing theory?

A. It shows the expected return in relation to portfolio variance, represented by σ 2.

B. It has a downward slope.

C. The x-axis intercept is equal to the expected return on the market portfolio.

D. Any well-diversified portfolio may serve as the benchmark portfolio.

The correct answer is D.

The arbitrage pricing theory (APT) posits that the expected return of a financial asset can be

modeled as a linear function of various macroeconomic factors, where sensitivity to changes in

each factor is represented by a factor-specific beta coefficient. The model-derived rate of return

will then be used to price the asset correctly - the asset price should equal the expected end of

period price discounted at the rate implied by the model. If the price diverges, arbitrage should

bring it back into line. In the context of APT, the benchmark portfolio does not necessarily have

to be the market portfolio. It can be any well-diversified portfolio. This is because, in APT, we are

looking at multiple factors that influence the return of a security, not just the market return.

Therefore, the benchmark portfolio can be any portfolio that is well-diversified across these

factors. This means that the portfolio should have a mix of securities that are influenced by these

factors in different ways, so that the overall risk of the portfolio is minimized.

Choice A is incorrect. The security market line (SML) does not show the expected return in

relation to portfolio variance. Instead, it depicts the relationship between systematic risk (beta)

and expected return of a security or a portfolio.

Choice B is incorrect. The SML does not have a downward slope; rather, it has an upward

slope indicating that higher risk (beta) is associated with higher expected returns.

Choice C is incorrect. The x-axis intercept of the SML is equal to the risk-free rate, not the

expected return on the market portfolio.

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Q.234 The following are factors used by Fama and French in their multifactor model, EXCEPT:

A. The Return on the market index (R m − Rf ).

B. The Return earned by small stocks over and above the return on large stocks.

C. The Return earned by high book-to-market stocks over and above the low book-to-
market stocks.

D. None: All the above factors are used.

The correct answer is D.

The Fama-French 3-factor model indeed includes all the factors listed in the options. The model

was developed by Eugene Fama and Kenneth French to better explain asset returns. The three

factors used in the model are: (1) The return on the market index (R m − Rf ), which represents the

excess return of the market over the risk-free rate. This factor is also used in the Capital Asset

Pricing Model (CAPM). (2) The return earned by small stocks over and above the return on large

stocks, also known as the size premium. This factor is based on the observation that smaller

companies tend to have higher returns than larger companies. (3) The return earned by high

book-to-market stocks over and above the low book-to-market stocks, also known as the value

premium. This factor is based on the observation that companies with high book-to-market ratios

(value stocks) tend to outperform companies with low book-to-market ratios (growth stocks).

Therefore, all the factors listed in the options are used in the Fama-French 3-factor model.

Choice A is incorrect. The return on the market index (Rm − R f ) is indeed a factor in the Fama-

French 3-factor model. This factor represents the excess return of the market portfolio over the

risk-free rate, which captures systematic risk.

Choice B is incorrect. The return earned by small stocks over and above that of large stocks,

also known as size premium, is another factor included in this model. It reflects that smaller

firms tend to have higher returns than larger firms due to their higher risk.

Choice C is incorrect. The return earned by high book-to-market stocks over and above low

book-to-market stocks, or value premium, is also a part of this model. It indicates that value

stocks (high book-to-market ratio) tend to outperform growth stocks (low book-to-market ratio).

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Q.235 A portfolio Z is subject to two risk factors, A and B, with factor betas of 0.3 and 0.5,
respectively. A fund manager wishes to hedge away all of the exposure to both A and B, yet he's
not ready to sell the portfolio at any cost. Choose the strategy best placed to achieve the
manager's desired goal.

A. Short sell a hedge portfolio with 50% allocation to factor A portfolio, 30% allocation to
factor B portfolio, and 20% allocation to the risk-free asset.

B. Short sell a hedge portfolio with 30% allocation to factor A portfolio, 50% allocation to
factor B portfolio, and 20% allocation to the risk-free asset.

C. Buy a hedge portfolio with 50% allocation to factor A portfolio, 30% allocation to
factor B portfolio, and 20% allocation to the risk-free asset.

D. Buy a hedge portfolio with 30% allocation to factor A portfolio, 50% allocation to
factor B portfolio, and 20% allocation to the risk-free asset.

The correct answer is B.

The correct strategy to hedge away all of the exposure to both risk factors A and B without

selling the portfolio is to short sell a hedge portfolio with 30% allocation to factor A portfolio,

50% allocation to factor B portfolio, and 20% allocation to the risk-free asset. This strategy is

based on the concept of factor portfolios. A factor portfolio is a well-diversified portfolio designed

to have a beta equal to 1 for one of the risk factors and betas equal to zero for all the remaining

factors. By short selling the hedge portfolio, the investor can offset the 0.30 and the 0.50

exposures to risk factors A and B respectively. The hedge portfolio also has similar exposures to

the two factors, which means that the risks inherent in the original portfolio can be effectively

offset without the need to sell the portfolio. This strategy allows the fund manager to maintain

the portfolio while eliminating the exposure to the risk factors.

Choice A is incorrect. Short selling a hedge portfolio with 50% allocation to factor A and 30%

allocation to factor B would not effectively eliminate the exposure to these risk factors. The

allocations are reversed in relation to the factor betas of the risks, which means that this

strategy would over-hedge risk A and under-hedge risk B.

Choice C is incorrect. Buying a hedge portfolio with 50% allocation to factor A and 30%

allocation to factor B would increase rather than decrease the exposure of portfolio Z to these

risks. This is because buying increases exposure while short selling reduces it.

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Choice D is incorrect. Similar to choice C, buying a hedge portfolio with 30% allocation to

factor A and 50% allocation to factor B would also increase the exposure of portfolio Z, which

contradicts the manager's objective of eliminating risk exposures.

Q.236 Which of the following best explains why the APT is considered more flexible than the
CAPM?

A. It uses multiple systematic factors, not just a single aggregated factor, to represent the
total market risk.

B. Just like the CAPM, the APT allows for the use of a single factor through the single
factor model which can be extended to include more factors.

C. With the APT, the benchmark portfolio in the security market line does not have to be
the true market portfolio.

D. None of the above.

The correct answer is C.

The Arbitrage Pricing Theory (APT) is indeed more flexible than the Capital Asset Pricing Model

(CAPM) because the benchmark portfolio used in the security market line does not have to be

the true market portfolio. This is a significant advantage of the APT over the CAPM. In the

CAPM, the benchmark return used to establish the security market line is typically the market

portfolio, which is often unobservable and therefore a source of potential error. However, the

APT allows for any well-diversified portfolio to be used as the benchmark, which provides a great

deal of flexibility. This flexibility is particularly useful when there are concerns about the

accuracy of the index portfolio as a proxy for the true market portfolio. Therefore, the APT's

ability to use any well-diversified portfolio as the benchmark makes it more flexible than the

CAPM.

Choice A is incorrect. While it's true that the APT uses multiple systematic factors to represent

total market risk, this does not necessarily make it more flexible than the CAPM. The flexibility of

a model is determined by its ability to adapt and adjust to different scenarios and conditions, not

just by the number of factors it considers.

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Choice B is incorrect. Although both APT and CAPM can use a single factor model, this doesn't

inherently make APT more flexible than CAPM. The single factor model in both theories can be

extended to include more factors but this extension doesn't provide additional flexibility in terms

of adjusting for different market conditions or scenarios.

Choice D is incorrect. As explained above, choices A and B do not accurately describe why the

Arbitrage Pricing Theory (APT) might be considered more flexible than the Capital Asset Pricing

Model (CAPM). Therefore, stating that none of these reasons are correct would also be

inaccurate.

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Q.238 Suzy Ye is a junior equity research analyst at a research firm based in South Korea. For
the first time, she is using the multifactor model to compute the stock return of the Wong Kong
Corp (WK). She has compiled the following data for the computation of the return:
Wong Kong's expected stock return: 7%
Expected GDP growth: 4.5%
Expected Inflation: 2.5%
GDP factor beta: 1.5
Inflation factor beta: 2
Risk-free rate: 2%

Suppose the actual GDP growth and actual inflation of South Korea are 3% and 2.9%,
respectively, then which of the following is an accurate estimate of the stock return?

A. 7.55%

B. 10.05%

C. 5.55%

D. 18.75%

The correct answer is C.

A multifactor model (2-factor model in the given question) only includes the expected return of

the stock, macroeconomic factor and the factor-beta, and firm-specific risk, which in this case is

zero.

RW K = E(R W K ) + βG DP FG DP + βI FI
= 0.07 + 1.5(0.03 − 0.045) + 2(0.029 − 0.025)
= 0.07 − 0.0225 + 0.008
= 5.55%

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Q.239 The single-factor model indicates that the return is based on a firm-specific variable and a
macroeconomic variable such as inflation, GDP growth, interest rates, consumer sentiments, etc.
These factors combined with the expected return of the asset allow hedging the risk of those
assets whose returns change with the changes in macroeconomic variables. In the single-factor
model, the macroeconomic variables are used as inputs in the form of:

A. Deviation of the macroeconomic variable from its expected value.

B. Actual value of the macroeconomic variable multiplied by its sensitivity to the asset.

C. Expected value the macroeconomic variable multiplied by the beta factor.

D. Deviation of the macroeconomic variable from its expected value multiplied by the
beta factor.

The correct answer is A.

The single-factor model uses the deviation of the macroeconomic variable from its expected

value as an input. This is because the model is designed to capture the impact of unexpected

changes in the macroeconomic variable on the asset's return. The expected return of the asset is

already factored into the model, so what matters is how the actual macroeconomic variable

deviates from what was expected. This deviation represents the 'surprise' element in the

macroeconomic variable that could potentially affect the asset's return. Therefore, the model

uses this deviation as an input to capture this effect.

Choice B is incorrect. The actual value of the macroeconomic variable multiplied by its

sensitivity to the asset is not how these variables are incorporated in a single-factor model. In

this model, it's not about the actual value but rather about the deviation of this value from its

expected one that matters.

Choice C is incorrect. The expected value of the macroeconomic variable multiplied by the

beta factor is also not how these variables are incorporated in a single-factor model. Again, it's

about deviations from expectations, not just expectations themselves.

Choice D is incorrect. While this choice seems close to being correct as it includes both

deviation and beta factor, it still misses out on an important aspect - there's no multiplication

involved between these two elements in a single-factor model.

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Q.240 As an analyst, you are analyzing a number of stocks of German Tech companies trading on
the TecDAX. You come across two stocks DESolars AG and GERTech Co., with expected returns
of 4.9% and 5.1%, respectively. In order to assess if an arbitrage opportunity exists between two
stocks, you compile the following data to be used in the two-factor model:
Actual GDP Growth: 2%
Expected GDP Growth: 2%
Actual CPI: 1.7%
Expected CPI: 1.5%
DESolars (GDP) beta: 1.1
DESolars (CPI) beta: 0.9
GERTech (GDP) beta: 1.1
GERTech (CPI) beta: 0.9

Considering the given data, identify which of the following statement is true?

A. An arbitrage opportunity does not exist because both stocks have different expected
returns.

B. An arbitrage opportunity exists because both firms have the same beta factor.

C. An arbitrage opportunity does not exist because both firms have the same beta.

D. An arbitrage opportunity exists because both firms have different returns for the same
systematic risk.

The correct answer is D.

An arbitrage opportunity exists because both firms have different returns for the same

systematic risk. Arbitrage opportunities arise when there is a discrepancy between the price of a

security and its intrinsic value. In this case, both DESolars AG and GERTech Co. have the same

systematic risk, as indicated by their identical beta values. However, they offer different returns.

DESolars AG has an expected return of 4.9%, while GERTech Co. offers a higher return of 5.1%.

This difference in returns for the same level of risk indicates an arbitrage opportunity. An

investor could exploit this by short selling the lower-return stock (DESolars AG) and using the

proceeds to buy the higher-return stock (GERTech Co.). This would allow the investor to pocket

the difference in returns (0.2%) as risk-free profit.

Choice A is incorrect. The existence of an arbitrage opportunity is not determined by whether

the stocks have different expected returns. Two stocks can have different expected returns but

still not present an arbitrage opportunity if their risk-return profiles are in line with each other.

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Choice B is incorrect. The presence of an arbitrage opportunity does not solely depend on both

firms having the same beta factor. While it's true that identical betas suggest similar systematic

risk, this doesn't automatically imply an arbitrage opportunity unless there's a discrepancy in

their returns given this same level of risk.

Choice C is incorrect. Similar to Choice B, the fact that both firms have the same beta does not

necessarily mean there isn't an arbitrage opportunity. An arbitrage situation arises when there's

a possibility to make a risk-free profit due to price discrepancies for equivalent risks and returns,

which isn't directly related to whether or not two firms share identical betas.

Q.241 Creative Investments Co. holds a brainstorming and strategy-building session before the
trading hours in order to prepare the analysts and traders for the day. While conducting the
session Craig Lee, head of the equity department, made the following statements regarding the
impact of diversification on the residual risk of a portfolio:
Statement 1: "The part of the asset's risk that is uncorrelated with the volatility of the market
portfolio is called nonsystematic risk."
Statement 2: "The part of the asset's risk that is due to the positive covariance of that asset's
returns with market returns is called the systematic risk or diversifiable risk."
Statement 3: "As the number of assets in a portfolio increases, the systematic risk of the portfolio
decreases."

Which of the following statement is/are correct?

A. Statement 1 only

B. Statement 3 only

C. Statements 1 and 2

D. Statements 2 and 3

The correct answer is A.

Nonsystematic risk, also known as specific risk, diversifiable risk, idiosyncratic risk, or residual

risk, is the part of an asset's risk that is uncorrelated with the volatility of the market portfolio.

This type of risk is unique to a particular asset or a small group of assets. Nonsystematic risk can

be reduced through diversification. By investing in a variety of assets, the impact of any one

asset's performance on the overall portfolio is minimized. This is because the positive

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performance of some assets will, ideally, offset the negative performance of others. Therefore,

the more diversified the portfolio, the less impact any one asset (or group of assets) will have on

the overall performance of the portfolio.

Choice B is incorrect. Statement 3 is not correct because systematic risk, also known as non-

diversifiable risk, does not decrease with an increase in the number of assets in a portfolio.

Systematic risk is inherent to the entire market or market segment and cannot be eliminated

through diversification.

Choice C is incorrect. Although Statement 1 is correct, Statement 2 contains an error. The part

of the asset's risk due to positive covariance with market returns is indeed called systematic risk

but it's not diversifiable. It's actually non-diversifiable or market risk which cannot be eliminated

by adding more assets to a portfolio.

Choice D is incorrect. As explained above both statement 2 and statement 3 are incorrect

hence this choice can't be correct.

Q.242 During a Securities Analysis seminar at one of the top business schools in Mumbai, a
student asked the moderator to define the assumptions that constitute the single-factor security
market line. The moderator stated that the following assumptions are made while drawing the
single-factor security market line:
I. Returns follow a k-factor process
II. A mean-variance efficient market portfolio exists
III. Well-diversified portfolios can be created
IV. No arbitrage opportunities exist

Which of the above assumptions do(es) NOT hold true in the creation of the single-factor security
market line?

A. Assumption I only

B. Assumption IV only

C. Assumptions I and II

D. Assumptions II and III

The correct answer is C.

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The assumptions that do not hold true while drawing the single-factor security market line are

Assumptions I and II. The single-factor security market line is based on three primary

assumptions:

1. Security returns can be explained by the single-factor model

2. Well-diversified portfolios can be created

3. No arbitrage opportunities exist

Assumption I, that returns follow a K-factor process, is not an assumption of the single-factor

security market line but is instead related to the Arbitrage Pricing Theory (APT). The APT is a

multi-factor model that explains the expected return of a security or a portfolio of securities as a

linear function of various macroeconomic factors. Each factor has a sensitivity and a risk

premium associated with it. The K-factor process implies that there are multiple factors

influencing the returns, which contradicts the single-factor model assumption.

Assumption II, that a mean-variance efficient market portfolio exists, is also not an assumption of

the single-factor security market line. This assumption is a part of the Capital Asset Pricing

Model (CAPM). The CAPM is a model that describes the relationship between systematic risk and

expected return for assets, particularly stocks. The mean-variance efficient portfolio is a portfolio

that has the highest expected return for a given level of risk (standard deviation). The existence

of such a portfolio is not a requirement for the single-factor security market line.

Choice A is incorrect. The assumption that returns follow a k-factor process is not applicable to

the single-factor security market line. The single-factor model assumes that the return of a

security is dependent on a single factor, usually the market return, and not multiple factors (k-

factors). Therefore, this assumption does not apply when constructing the single-factor security

market line.

Choice B is incorrect. The absence of arbitrage opportunities is an assumption that applies to

most financial models including the single-factor security market line. This assumption ensures

that no investor can earn risk-free profits by simultaneously buying and selling securities at

different prices in different markets.

Choice D is incorrect. The existence of a mean-variance efficient market portfolio and

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possibility of creating well-diversified portfolios are both assumptions relevant to portfolio theory

but they do not specifically apply to the construction of a single-factor security market line which

focuses on individual securities rather than portfolios.

Q.243 Kevin Brett is an American portfolio manager who manages an emerging factor market
portfolio that focuses on the blue-chip firms from Brazil. He fears that the stocks of these blue-
chip firms are highly dependent on factors like the GDP of Brazil and the value of the Brazilian
Real. He believes his portfolio can decline in value due to changes in these two main factors. The
portfolio's Brazilian GDP beta is 0.40 and the Brazilian Real beta is 0.3. Which of the following
strategies should Brett accept in order to hedge both factors?

A. Short sell a hedge portfolio that allocates 40% exposure to the Brazilian GDP factor
portfolio, 30% to the Brazilian Real factor portfolio, and 30% to the risk-free asset.

B. Buy a hedge portfolio that allocates 40% exposure to the Brazilian GDP factor
portfolio, 30% to the Brazilian Real factor portfolio, and 30% to the risk-free asset.

C. Buy a hedge portfolio that allocates 30% exposure to the first Brazilian GDP factor
portfolio, 40% to the Brazilian Real factor portfolio, and 30% to the market portfolio.

D. Short sell a hedge portfolio that allocates 70% exposure to the risk-free asset and 30%
to the market portfolio.

The correct answer is A.

A factor portfolio can be hedged by opening opposite positions with the same factor exposure. A

factor portfolio has a factor-beta equal to one for a single risk factor, and factor betas equal to

zero on the remaining factors. By shorting the hedge portfolio, the investor will offset the factor

risks of the original portfolio. Since Kevin has a 0.4 exposure to the Brazilian GDP factor and a

0.3 exposure to the Brazilian Real factor, he can hedge the risk by shorting a factor portfolio that

allocates 40% exposure to the Brazilian GDP factor portfolio, 30% to the Brazilian Real factor

portfolio, and the rest to the risk-free assets. This strategy will effectively neutralize the risks

associated with the Brazilian GDP and the Brazilian Real, thereby protecting the value of his

portfolio from potential losses due to fluctuations in these two factors.

Choice B is incorrect. Buying a hedge portfolio that allocates 40% exposure to the Brazilian

GDP factor portfolio and 30% to the Brazilian Real factor portfolio would increase Brett's

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exposure to these factors, not decrease it. This strategy would therefore amplify the risks

associated with fluctuations in these two factors, rather than hedging against them.

Choice C is incorrect. This choice suggests buying a hedge portfolio that misallocates

exposures to the Brazilian GDP and Real factors (30% and 40%, respectively), which does not

align with Brett's existing beta exposures (0.4 for GDP and 0.3 for Real). Moreover, allocating

part of the hedge to the market portfolio does not specifically address his concerns about these

two particular risk factors.

Choice D is incorrect. Short selling a hedge portfolio that primarily exposes Brett to risk-free

assets does not provide an effective hedge against his specific risks related to Brazilian GDP and

Real fluctuations. The allocation of only 30% exposure towards market portfolios also fails in

providing adequate protection against his specific concerns.

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Q.4452 All the following are factors of the Fama-French Model, EXCEPT:

A. Market factor.

B. The difference in expected returns of high-beta stocks minus small-beta stocks.

C. The difference in expected returns of a portfolio of high book-to-market stocks minus a

portfolio of low book-to-market stocks.

D. The difference in expected returns of small stocks minus big stocks.

The correct answer is B.

The difference in expected returns of high-beta stocks minus small-beta stocks is not a factor in

the Fama-French three-factor model. The Fama-French model was developed by Eugene Fama

and Kenneth French to better predict the returns of stocks and portfolios. It does this by adding

two factors to the original single-factor capital asset pricing model (CAPM). These two additional

factors are size and value. Size is measured by the market capitalization of a company, with

smaller companies expected to yield higher returns. Value is measured by the book-to-market

ratio, with companies having a high book-to-market ratio expected to yield higher returns. The

original factor from the CAPM, the market factor, is also included in the Fama-French model.

Therefore, the three factors of the Fama-French model are the market factor, the size factor, and

the value factor. The difference in expected returns of high-beta stocks minus small-beta stocks

is not one of these factors.

Choice A is incorrect. The market factor, which is the excess return on the market portfolio

over the risk-free rate, is indeed one of the three factors in the Fama-French three-factor model.

Choice C is incorrect. The difference in expected returns of a portfolio of high book-to-market

stocks minus a portfolio of low book-to-market stocks represents value risk and it's one of the

factors included in this model.

Choice D is incorrect. The difference between expected returns on small-cap stocks and large-

cap stocks represents size risk, which also forms part of this asset pricing model.

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Q.4454 In the Fama-French three-factor model, in addition to the market factor and the HML
factor, what is the other factor and what does it refer to?

A. The momentum factor, WML, which captures the outperformance of past winners in
relation to past losers.

B. The SMB factor, which captures the outperformance of high book-to-market stocks in
relation to low book-to-market stocks.

C. The SMB factor, which captures the outperformance of small firms in relation to the
larger firms.

D. The momentum factor, WML, which captures the outperformance of high-growth

stocks in relation to low-growth stocks.

The correct answer is C.

In the Fama-French three-factor model, one of the factors is the SMB, which refers to small stock
returns minus big stock returns (Small Minus Big). The market capitalization of the stocks gives
rise to small and big stocks.
The last factor is the outperformance of small firms in relation to the large firms. This is
captured by the SMB factor (Small Minus Big).

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Q.5319 The following estimates for the factor betas are prepared by an analyst who is estimating
the sensitivity of the return of stock X to different macroeconomic factors.

βindustrial production = 1.45

βinterest rate = 0.81

With a 4% increase in industrial production and a 2.5% interest rate, the projected return for
Stock X is predicted to be 6.0%. This is under the baseline expectations. The economic research
department predicts that economic activity will pick up in the coming year, with GDP growing
5.2% and interest rates rising to 2.85%. According to this forecast, what is the projected return
on Stock X for next year?

A. 7.55%

B. 8.02%

C. 11.93%

D. 14.05%

The correct answer is B.

Stock X's expected return equals the stock's expected return under the baseline scenario plus

the impact of “shocks,” or excess returns. Because the baseline scenario assumes 4% industrial

production growth and a 2.5% interest rate, the “shocks” for the GDP factor are 1.2% and 0.35%,

respectively.

Expected return for the new scenario = Baseline scenario expected return
+ (βIndustrial production × Industrial production shock)
+ (βinterest rate × Interest rate shock)
= 6% + (1.45 × 1.2%) + (0.81 × 0.35%)
= 0.06 + 0.0174 + 0.002835 = 8.02%

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Q.5320 An equities analyst at an asset management business is evaluating a prospective
investment in ABC Bank stock using an internal three-factor model. Each of the three factors is
represented by an exchange-traded fund (ETF) with a factor beta of one and a factor beta of zero
for the others. The analyst gathers the following data:

Factor A Factor B Factor C

Expected annual return of ETF factor 6.5% 7.7% 4.0%
Factor beta for ABC Bank stock 0.88 −0.55 1.40

What is the predicted yearly return on ABC Bank shares using the internal model if the
annualized risk-free interest rate is 3.20% and the alpha is 0.60%?

A. 1.549%

B. 5.349%

C. 4.749%

D. 2.149%

The correct answer is B.

The first step is to determine the expected excess return for each element by subtracting the

risk-free rate from the expected return, as shown below:

Factor A: 6.5% − 3.20% = 3.30%

Factor B: 7.7% − 3.20% = 4.50%

Factor C: 4.0% − 3.20% = 0.80%

Multiplying the relevant factor betas for ABC Bank stock yields the factor exposures'

contribution to the stock's projected return:

0.88 × 3.30% + (−0.55) × 4.50% + 1.40 × 0.80% = 1.549%

The total expected return for ABC Bank stock is calculated by adding the alpha and risk-free rate

to the stock's expected return from its factor exposures, yielding 1.549% + 0.60% + 3.20% for a

total expected return of 5.349%.

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Q.5321 Greystone Asset Managers' investment analyst argues that a company's Fama-French
main dependencies are:

Value
HML −0.66
SMB 1.36
Beta 0.35

Because of its advantages over its competitors, the analyst believes the company can produce an
additional 2.5% return every year. The market forecast is as follows:

Expected return on equities 11.5%

SMB 3.2%
HML 0.0%
Risk free rate 1.7%

The expected return of the company is closest to?

A. 10.87%

B. 11.98%

C. 11.91%

D. 15.5%

The correct answer is B.

E (Rc ) = α + βc,M [E (RM ) − r] + βc,SM BE (SMB) + βC, HM L E (HML)

= 1.7% + 2.5% + 0.35 [11.5% − 1.7%] + 1.36 × 3.2% − 0.66 × 0.0
E (Rc ) = 11.98%

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Reading 7: Risk Data Aggregation and Reporting Principles

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Q.245 The following are some of the benefits of having an effective risk data aggregation and
reporting system, EXCEPT:

A. An increased ability to avoid losses.

B. An increased ability to identify the routes to return to financial health after a

tumultuous period.

C. An increased ability to make strategic decisions, reduce the chances of loss, and
increases efficiency.

D. An increased ability to identify projects with optimal returns for investment purposes.

The correct answer is D.

An increased ability to identify projects with optimal returns for investment purposes is not a

direct benefit of an effective risk data aggregation and reporting system. While these systems

can provide useful information to guide investment decisions, their primary goal is to identify

and manage risks rather than maximize investment returns. They are designed to provide a

comprehensive view of risk exposures, enabling organizations to anticipate business problems,

identify routes back to good financial health, make strategic decisions, and attain smooth

resolvability in the event of duress or failure. However, they do not directly contribute to the

identification of projects with optimal returns for investment purposes. This task is typically the

responsibility of investment analysts and strategists who use a variety of tools and techniques,

including but not limited to risk data, to identify profitable investment opportunities.

Choice A is incorrect. An effective risk data aggregation and reporting system indeed

increases the ability to avoid losses. It does so by providing comprehensive and timely

information about various risks, enabling the organization to take preventive measures.

Choice B is incorrect. Risk data aggregation and reporting systems also increase an

organization's ability to identify routes back to financial health after a tumultuous period. They

provide insights into risk exposures, which can guide recovery strategies.

Choice C is incorrect. The systems do enhance strategic decision-making capabilities, reduce

chances of loss, and increase efficiency by providing accurate, timely, and comprehensive risk

data that informs management decisions.

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Q.247 Prime Bank, a global systematically important bank (G-SIB) has incurred big losses
resulting from a range of issues, including too many bad debts due to improper lending decisions
and investment in futures without prior due diligence. The bank is now in deep capital problems
and struggling to meet day-to-day funding needs. The bank's management turns to an expert of
the Basel committee recommendations for advice. Which of the following potential benefits
would result from risk data aggregation, particularly taking into account the bank's current
situation?

A. Increased bank efficiency.

B. A clearer definition of the bank's risk appetite.

C. Improved resolvability of the bank's problems.

D. Improved data confidentiality, integrity and availability.

The correct answer is C.

Aggregating risk data can significantly enhance the ability of regulators to resolve the current

undercapitalization and liquidity issues that Prime Bank is facing. Risk data aggregation involves

the consolidation of data from various sources to provide a comprehensive view of the risk

profile of an organization. This holistic view can help identify areas of vulnerability, assess the

potential impact of various risk scenarios, and develop effective mitigation strategies. In the

context of Prime Bank, risk data aggregation could provide valuable insights into the root causes

of its current capital and liquidity problems, thereby facilitating the development of targeted

solutions. Moreover, it could also aid in the identification of potential future risks, enabling the

bank to take proactive measures to prevent similar problems from arising in the future.

Choice A is incorrect. While aggregation of risk data can lead to better decision-making and

potentially increase bank efficiency, it does not directly address the immediate capital and

funding problems that Prime Bank is facing. The benefit of increased efficiency would likely be

realized over a longer term, rather than providing an immediate solution to the bank's current

predicament.

Choice B is incorrect. Aggregation of risk data could help in defining the bank's risk appetite

by providing a clearer picture of its overall risk exposure. However, this again does not directly

address the urgent issues at hand - namely, the capital and funding challenges that are

threatening the bank's solvency.

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Choice D is incorrect. Improved data confidentiality, integrity and availability are important

aspects of information security management but they do not necessarily contribute to resolving

financial or operational problems faced by a G-SIB like Prime Bank. These benefits are more

related to preventing cyber threats or ensuring compliance with data protection regulations

rather than addressing issues related to bad debts or inadequate due diligence in investment

decisions.

Q.248 After making losses in two consecutive financial years, the board of a G-SIB bank directs
the bank's chief supervisor to submit a report containing position and risk exposure information
for all relevant risks. The supervisor proceeds to summarize a report that includes detailed
information about specific risks such as credit risk, operational risk, and market risk. However,
the report falls short of adequate stress tests and forecasts. Which of the following effective risk
data aggregation principle set forth by the Basel Committee on Banking Supervision did the
supervisor most likely violate?

A. Principle 3 - Accuracy and integrity

B. Principle 8 - Comprehensiveness

C. Principle 9 - Clarity and usefulness

D. Principle 4 - Completeness

The correct answer is B.

The Basel Committee on Banking Supervision's Principle 8, known as the 'Comprehensiveness'

principle, stipulates that risk management reports should cover all material risk areas within an

organization. The depth and breadth of these reports should be commensurate with the size,

complexity, and risk profile of the bank's operations, as well as the requirements of the

recipients. In this scenario, the supervisor's report, despite detailing specific risks, falls short on

adequate stress tests and forecasts. This omission violates the comprehensiveness principle as it

fails to provide a complete picture of the bank's risk exposure, thereby hindering informed

decision-making.

Choice A is incorrect. Principle 3 - Accuracy and integrity refers to the need for data to be

accurate, reliable and maintained with integrity. The question does not provide any information

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suggesting that the data in the report was inaccurate or lacked integrity.

Choice C is incorrect. Principle 9 - Clarity and usefulness refers to the need for risk

management data to be presented in a clear, concise, and useful manner for decision-making

purposes. There's no indication from the question that the supervisor's report was unclear or not

useful.

Choice D is incorrect. Principle 4 - Completeness refers to capturing all material risk data

across the banking group. While it might seem like this principle has been violated due to lack of

stress tests and forecasts, it actually falls under Principle 8 - Comprehensiveness which includes

conducting stress tests and scenario analyses as part of a comprehensive view on risk exposure.

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Q.249 Mike Harvey is the risk management supervisor at an Indian bank. He wishes to establish
principles for effective risk data aggregation in line with Basel committee recommendations. The
bank has historically been lenient regarding risk data gathering and processing and Harvey
intends to remedy the situation. Which of the following statements is incorrect concerning the
accuracy principle?

A. Risk reports should exclude mathematical descriptions and logistical relationships so

as to make them less sophisticated and enhance comprehension.

B. Error reports should be created to highlight and explain errors in the data.

C. The bank should clearly define the process used to create risk reports.

D. The risk reports should include reasonable checks of the data.

The correct answer is A.

The statement that risk reports should exclude mathematical descriptions and logistical

relationships to simplify them and improve understanding is incorrect. According to the accuracy

principle, these elements should be included in a report if their inclusion significantly affects the

comprehension of the report's content. These relationships ensure the accuracy of the data and

figures presented. Therefore, excluding them would not enhance the accuracy of the report, but

rather diminish it.

Choice B is incorrect. Error reports are indeed a crucial part of maintaining accuracy in risk

data aggregation. They help identify and rectify errors in the data, thereby enhancing the overall

accuracy of risk reports.

Choice C is incorrect. Clearly defining the process used to create risk reports is an essential

aspect of ensuring accuracy. It helps maintain consistency and reliability in the data, which are

key components of accurate risk reporting.

Choice D is incorrect. Including reasonable checks on the data forms an integral part of

ensuring its accuracy. These checks help verify that the data being used for risk reporting is

correct and reliable.

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Q.250 According to the committee, “A bank's risk data aggregation capabilities and risk
reporting practices should be subject to strong governance arrangements consistent with the
other principles and guidance established by the Basel Committee.” Which of the following
statements is in divergence with the governance principle?

A. Risk data aggregation should form an integral part of the risk management
framework.

B. It is ideal to have multiple sources of risk data for each type of risk facing the
organization so as to enhance reliability.

C. Timely integration of risk data should be carried out immediately a new firm is
acquired.

D. Human and financial resources should be directed towards risk data aggregation and
therefore the board should approve the framework.

The correct answer is B.

The statement that it is ideal to have multiple sources of risk data for each type of risk facing the

organization so as to enhance reliability is not in line with the governance principle established

by the Basel Committee. According to the principle, there should be only one source of risk data,

not multiple sources. This is because having multiple sources can lead to inconsistencies and

discrepancies in the data, which can in turn lead to inaccurate risk assessments and ineffective

risk management strategies. Therefore, it is crucial for banks to have a single, reliable source of

risk data that is subject to strong governance arrangements.

Choice A is incorrect. Risk data aggregation forming an integral part of the risk management

framework aligns with the governance principle set by the Basel Committee. It ensures that all

risk data is collected, processed and reported in a manner that supports risk management

decision-making.

Choice C is incorrect. Timely integration of risk data immediately after a new firm is acquired

aligns with the governance principle as it ensures continuity in monitoring and managing risks

across the organization.

Choice D is incorrect. The allocation of human and financial resources towards risk data

aggregation approved by the board also aligns with this principle as it demonstrates commitment

at highest level to effective risk management through proper resource allocation.

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Q.251 Olive Park is the head of risk management at a Korean Bank. She has been tasked with
preparing a report for the bank's board of directors scheduled to meet in the near future. The
report will inform several important decisions to be made by the board regarding relevant bank
risks.
In an email sent to the directors prior to the meeting, Park assures them of the accuracy,
reasonableness, and completeness of her submission. She points out that a large amount of
quantitative data in the report will make it hard for the report to be fully understood by non-risk
management professionals. She also plans to distribute the report to all the relevant parties in a
timely manner while still maintaining confidentiality. Which of the following effective risk data
aggregation principle set forth by the Basel Committee on Banking Supervision did Park most
likely violate?

A. Principle 11 - Distribution

B. Principle 9 - Clarity and usefulness

C. Principle 8 - Comprehensiveness

D. Principle 1 - Governance

The correct answer is B.

Principle 9 of the Basel Committee on Banking Supervision's effective risk data aggregation

principles emphasizes the importance of tailoring reports to meet the needs of the end user. In

her email, Park indicated that the report might not be tailored to the board's needs due to the

large amount of quantitative data that could be difficult for non-risk management specialists to

interpret. The board typically includes many financial experts, but not all of them are proficient

in risk management. It's crucial to recognize that different end users - managers, the board,

junior employees, interns, and others - have varying reporting needs. As the report ascends the

organization's leadership hierarchy, there is an increasing need for qualitative interpretation and

explanation.

Choice A is incorrect. Principle 11 - Distribution, states that risk management data should be

distributed among the relevant parties in a timely and secure manner. Park plans to distribute

the report promptly while ensuring confidentiality, which aligns with this principle.

Choice C is incorrect. Principle 8 - Comprehensiveness, requires that all material risk data be

accurately and completely captured. Park has assured the accuracy, reasonableness, and

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completeness of her report which complies with this principle.

Choice D is incorrect. Principle 1 - Governance involves establishing a strong governance

framework to oversee the bank's risk data aggregation capabilities. There's no information in the

question suggesting that Park breached this principle.

Q.252 Which of the following goes against the principle of accuracy and integrity as set forth by
the Basel Committee?

A. It's most desirable to have a single authoritative source of risk data for each type of
risk facing an organization.

B. Data should be aggregated manually at all times so as to minimize the probability of

errors.

C. Risk personnel should have direct access to risk data so as to effectively refine,
validate, reconcile, and process the data for use in reports.

D. Controls put in place to monitor risk data should be as robust as those used in
financial accounting.

The correct answer is B.

Data should be aggregated on a largely automated basis to reduce the risk of errors brought
about by human input. However, human intervention is necessary when professional judgment is
to be made.

Q.253 According to the Basel committee, who bears the responsibility of setting the frequency of
risk management report and distribution?

A. The chief risk officer only

B. The bank supervisor only

C. The board of directors and senior management

D. The risk management department

The correct answer is C.

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According to the Basel Committee, the responsibility of setting the frequency of risk

management reports and their distribution lies with the board of directors and senior

management. This is because these individuals are in a position of authority and have a

comprehensive understanding of the bank's operations and risk profile. They are responsible for

setting the strategic direction of the bank, including its risk management framework. This

involves determining how often risk reports should be produced and distributed, as well as

setting out guidelines on how to proceed in times of financial stress or crisis. The board and

senior management are also responsible for ensuring that the bank's risk management processes

are effective and that risks are appropriately managed.

Choice A is incorrect. While the chief risk officer plays a crucial role in risk management, the

responsibility of determining the frequency of risk management reports and their distribution is

not solely theirs according to Basel Committee guidelines. This task involves strategic decisions

that are typically made by higher-level entities within a bank, such as the board of directors and

senior management.

Choice B is incorrect. The bank supervisor's role primarily involves overseeing and ensuring

compliance with banking regulations rather than determining the frequency and distribution of

risk management reports within a bank. This responsibility lies with internal stakeholders like

the board of directors and senior management.

Choice D is incorrect. The risk management department does play an important role in

preparing these reports but it does not have sole authority to determine their frequency or

distribution according to Basel Committee guidelines. These decisions are typically made at

higher levels within a bank, specifically by the board of directors and senior management.

Q.254 In an attempt to promote and institute strong and effective data aggregation capabilities,
the Basel committee has put forth several principles. Which of the following principles is
correctly matched with a recommendation to be followed in accordance with the given principle?

A. The timeliness principle recommends that an organization should continually update

its system to accommodate changes in best practices.

B. The accuracy principle recommends that the risk data be reconciled with the
supervisor's estimates before aggregation.

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 C. The integrity principle recommends that only automated processes should be used
when aggregating risk data.

D. The completeness principle recommends that an organization should ensure it

captures all material risk exposures before risk data aggregation can be done.

The correct answer is D.

The completeness principle, as outlined by the Basel Committee, emphasizes the importance of

capturing all material risk exposures before proceeding with risk data aggregation. This

principle is crucial because it ensures that no significant risk is overlooked during the

aggregation process, which could potentially lead to inaccurate risk assessments and flawed

decision-making. The recommendation associated with this principle is accurately represented in

choice D, which states that an organization should ensure it captures all material risk exposures

before risk data aggregation can be done. This means that all relevant and significant risk data

should be included in the aggregation process, regardless of the source or type of risk. This

comprehensive approach to risk data aggregation is essential for providing a complete and

accurate picture of an organization's overall risk profile.

Choice A is incorrect. The timeliness principle does not recommend that an organization

should continually update its system to accommodate changes in best practices. Instead, it

recommends that risk data should be available when needed, even during times of stress/crisis.

Choice B is incorrect. The accuracy principle does not recommend that the risk data be

reconciled with the supervisor's estimates before aggregation. Rather, it suggests that risk data

should be accurate and reliable; it doesn't necessarily need to match with supervisor's estimates.

Choice C is incorrect. The integrity principle does not strictly recommend only automated

processes for aggregating risk data. It emphasizes on maintaining a strong governance

framework to ensure the integrity of risk data aggregation processes which can include both

automated and manual processes.

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Q.255 Which of the following principles states that "data should be available by business line,
legal entity, asset type, industry, region and other groupings, as relevant for the risk in question,
that permit identifying and reporting risk exposures, concentrations and emerging risks?"

A. Data architecture and infrastructure

B. Clarity and usefulness

C. Completeness

D. Inclusivity

The correct answer is C.

The principle of completeness in risk data management states that a bank should be able to

capture and aggregate all material risk data across the banking group. This principle emphasizes

the need for data to be available by business line, legal entity, asset type, industry, region, and

other relevant groupings. This organization is crucial for identifying and reporting risk

exposures, concentrations, and emerging risks. The completeness principle ensures that all

necessary data is included, leaving no room for gaps or omissions that could potentially lead to

inaccurate risk assessments or decisions based on incomplete information.

Choice A is incorrect. Data architecture and infrastructure refers to the design, structure, and

maintenance of data systems. While it does involve organizing data, it doesn't specifically

emphasize categorization for risk identification and reporting.

Choice B is incorrect. Clarity and usefulness are important aspects of data management but

they do not directly relate to the organization of data across various categories for risk

identification.

Choice D is incorrect. Inclusivity in this context would mean that all relevant data should be

included in the risk management process. However, it does not necessarily imply that the data

needs to be organized across various categories as described in the question.

Q.256 While working on a risk report, two senior risk professionals made the decision to forego
automation and fill data entries by hand. The two made that decision after a brainstorming
exercise alongside other junior employees. In their report, the pair gave details as to why it was

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necessary to forego automation and why they had full confidence in the accuracy and integrity of
the data. This scenario describes a:

A. The justified exception to the principle of accuracy and integrity

B. Breach of regulations

C. Manual workaround

D. Breach of confidentiality

The correct answer is C.

In the given scenario, the two senior risk professionals decided to bypass automation and

manually input data. This is referred to as a 'manual workaround'. A workaround is a method,

sometimes used temporarily, for achieving a task or goal when the usual or planned method isn't

working. In this case, the usual method would be automation. However, for reasons explained in

their report, the professionals decided to manually input the data. While automation is generally

preferred to minimize human error, it is up to the organization to find the right balance between

automation and manual input. Any manual workarounds should be well documented and

satisfactorily explained, as was done in this scenario.

Choice A is incorrect. The principle of accuracy and integrity in risk management refers to the

need for data to be accurate, complete, and reliable. In this scenario, the risk professionals have

not violated this principle as they have expressed their complete confidence in the accuracy and

integrity of the data. Therefore, their action cannot be considered a justified exception to this

principle.

Choice B is incorrect. There is no indication in the scenario that any regulations were

breached by manually inputting data instead of using automation. Regulations would typically

specify what needs to be done rather than how it should be done.

Choice D is incorrect. Breach of confidentiality refers to unauthorized disclosure of

confidential information. In this case, there's no mention or implication that any confidential

information was disclosed improperly or without authorization.

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Q.257 Which of the following is NOT a valid reason as to why senior management and the board
of directors should keep accurate and timely risk data aggregation reports?

A. The report helps the management to track the organization's risk exposure and ensure
risk limits are observed.

B. The board members may be asked to provide the reports during an impromptu visit by
the bank's supervisors.

C. The management uses the reports to make important decisions regarding risk and
investment opportunities.

D. Senior management need reliable, relevant and up-to-date information when making
decisions during periods of financial stress and/or crisis.

The correct answer is B.

The board members may be asked to provide the reports during an impromptu visit by the bank's

supervisors. This statement is incorrect because the board of directors and senior management

do not provide information directly to regulators or supervisors. Such requests are typically

made at the bank level, not at the board level. Therefore, this is not a valid reason for

maintaining accurate and timely risk data aggregation reports. The board's role is to oversee the

bank's operations and ensure that it is managed in a way that protects the interests of its

shareholders. While they need to be aware of the bank's risk profile, they are not responsible for

providing this information to regulators or supervisors.

Choice A is incorrect. The risk data aggregation reports are indeed used by management to

track the organization's risk exposure and ensure that risk limits are observed. This helps in

maintaining a balance between the risks taken and the potential returns, thereby ensuring

financial stability of the organization.

Choice C is incorrect. These reports are crucial for management as they provide insights into

various risks and investment opportunities. Based on these reports, management can make

informed decisions regarding investments, thereby optimizing returns while minimizing risks.

Choice D is incorrect. During periods of financial stress or crisis, senior management needs

reliable, relevant and up-to-date information to make critical decisions. Risk data aggregation

reports provide this necessary information in a consolidated manner which aids in effective

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decision making during such times.

Q.258 According to the principle of adaptability, "a bank should be able to generate aggregate
risk data to meet a broad range of on-demand, ad-hoc risk management reporting requests,
including requests during stress/crisis situations, requests due to changing internal needs and
requests to meet supervisory queries." Which of the following is NOT included in the adaptability
principle?

A. Data customization to fit the user's needs - takeaway, dashboards, anomalies, etc.

B. Flexible data aggregation processes that allow managers to swiftly assess risks for
decision-making purposes.

C. Capabilities to incorporate regulatory changes.

D. Capabilities to withhold some pieces of information that could paint the company in a
bad light.

The correct answer is D.

The principle of adaptability does not include the capability to withhold some pieces of

information that could paint the company in a bad light. This is because the risk data

aggregation process should be transparent and not withhold crucial information as long as such

information is accurate and based on facts. The process should instill confidence in regulators

and other stakeholders alike. Withholding information, especially if it is crucial to understanding

the risk profile of the bank, would be contrary to the principle of transparency, which is a key

aspect of risk management. Therefore, the ability to withhold information that could negatively

impact the company's image is not included in the adaptability principle.

Choice A is incorrect. Data customization to fit the user's needs - takeaway, dashboards,

anomalies, etc., is indeed a part of the adaptability principle. It allows for flexibility and

adaptability in presenting risk data according to the specific requirements of different users or

situations.

Choice B is incorrect. Flexible data aggregation processes that allow managers to swiftly

assess risks for decision-making purposes also fall under the purview of the adaptability

principle. This ensures that risk management can be responsive and adaptable to changing

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circumstances or demands.

Choice C is incorrect. The ability to incorporate regulatory changes into risk management

practices aligns with the adaptability principle as well. Regulatory environments are dynamic

and banks need to have systems in place that can quickly adjust and comply with new

regulations.

Q.259 Kevin Stanley, a senior risk consultant at Wansley Consultation Company, is currently
providing risk consultation to the RUSSBANK's recently opened retailed operations in Ukraine.
RUSSBANK is one the largest Russian banks that has recently started retail operations in the
Ukrainian market. Ukraine has a history of a large number of bank failures due to very low
recovery rates. Since RUSSBANK has entered the Ukrainian market for the first time and it is
not familiar with the retail market yet, Kevin referred the bank management and board to the
Basel Committee's recommendation to improve its aggregation and reporting of risk data. Given
that the effective risk data aggregation has several potential benefits, which of the following
benefits is essential to RUSSBANK's success?

A. Increased ability to anticipate problems.

B. Identify routes to return to financial health.

C. Improved resolvability.

D. Increased market share.

The correct answer is A.

The 'increased ability to anticipate problems' is the most relevant benefit for RUSSBANK in this

scenario. As RUSSBANK is new to the Ukrainian market, it is crucial for them to understand the

risks involved in their operations. Effective risk data aggregation allows risk managers to have a

comprehensive view of the risks, enabling them to anticipate potential problems. This holistic

understanding of risks is not limited to isolated incidents but extends to the overall risk

landscape. By anticipating problems, RUSSBANK can proactively implement measures to

mitigate these risks, thereby ensuring the success of their operations in Ukraine.

Choice B is incorrect. While identifying routes to return to financial health is an important

aspect of risk management, it is not the most crucial benefit for RUSSBANK's operation in a

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market with high bank failure rates due to low recovery rates. Effective risk data aggregation

would primarily help in anticipating problems before they occur, which is more critical in such a

volatile market.

Choice C is incorrect. Improved resolvability refers to the ability of a bank to be resolved

without severe systemic disruption or taxpayer loss, which although important, does not directly

address the issue of high bank failure rates due to low recovery rates that RUSSBANK faces in

Ukraine. Anticipating problems through effective risk data aggregation would be more

beneficial.

Choice D is incorrect. Increased market share might be an indirect result of effective risk

management but it's not the primary benefit that comes from enhancing risk data aggregation

and reporting as recommended by Basel Committee. The main advantage lies in being able to

anticipate potential issues and mitigate them proactively.

Q.260 Which of the following is not a key governance principle related to risk data aggregation
and risk reporting practices that were provided by the Basel Committee?

A. Data architecture and infrastructure

B. Conciseness

C. Distribution

D. Frequency

The correct answer is B.

Conciseness is not a key governance principle related to risk data aggregation and risk reporting

practices provided by the Basel Committee. While conciseness is generally a desirable quality in

reporting, it is not specifically identified as a key principle by the Basel Committee. The

principles outlined by the Basel Committee are intended to ensure that financial institutions have

robust risk management frameworks in place. These principles emphasize aspects such as

governance, data architecture and infrastructure, accuracy and integrity, completeness,

timeliness, adaptability, comprehensiveness, clarity and usefulness, frequency, distribution,

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review, remedial actions and supervisory measures, and home/host cooperation. Each of these

principles plays a crucial role in ensuring that risk data is accurately aggregated and reported,

thereby enabling effective risk management.

Choice A is incorrect. Data architecture and infrastructure is indeed recognized as a key

governance principle by the Basel Committee. It refers to the systems and processes that are

used to collect, store, manage, and report risk data. These systems should be robust enough to

handle large volumes of data and flexible enough to adapt to changing regulatory requirements.

Choice C is incorrect. Distribution is also recognized as a key governance principle by the

Basel Committee. This principle emphasizes that risk reports should be distributed in a timely

manner to all relevant parties within an organization, including senior management and the

board of directors.

Choice D is incorrect. Frequency too is acknowledged as a key governance principle by the

Basel Committee. The frequency of risk reporting should be determined based on the nature of

an institution's risks, its size, complexity, scope of operations etc., but it must at least meet

minimum regulatory requirements.

Q.261 Muhammad Zubair, head of compliance at Miliyon Investment Bank, quoted a key
governance principle related to risk data aggregation provided by the Basel Committee, which
states that "a bank should be able to generate accurate and reliable risk data to meet normal and
stress/crisis reporting accuracy requirements. Furthermore, data should be aggregated on a
largely automated basis so as to minimize the probability of errors." Which of the following
principles is Zubair referring to?

A. Governance

B. Completeness

C. Accuracy & Integrity

D. Timeliness

The correct answer is C.

According to the Basel Committee's 3rd Principle, "Accuracy & Integrity," a bank should be able

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to generate accurate and reliable risk data to meet normal and stress/crisis reporting accuracy

requirements. Data should be aggregated on a largely automated basis so as to minimize the

probability of errors.

Option A is incorrect: According to the principle of governance, a bank’s risk data

aggregation capabilities and risk reporting practices should be subject to strong governance

arrangements consistent with other principles and guidance established by the Basel Committee.

This principle suggests that risk data aggregation should be a central part of risk management,

and senior management should make sure the risk management framework incorporates data

aggregation before approving it for implementation.

Option B is incorrect: according to the principle of completeness, a bank should be able to

capture and aggregate all material risk data across the banking group. Data should be available

by business line, legal entity, asset type, industry, region and other groupings, as relevant for the

risk in question, that permit identifying and reporting risk exposures, concentrations and

emerging risks.

Option D is incorrect: The principle of timeliness states that a bank should be able to generate

aggregate and up-to-date risk data in a timely manner while also meeting the principles relating

to accuracy and integrity, completeness and adaptability. The precise timing will depend upon

the nature and potential volatility of the risk being measured as well as its criticality to the

overall risk profile of the bank. The precise timing will also depend on the bank-specific

frequency requirements for risk management reporting, under both normal and stress/crisis

situations, set based on the characteristics and overall risk profile of the bank.

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Q.262 Vijay Kumar, Sonnet Bank's Chief Risk Officer, writes in the management discussion and
analysis (MD&A) section of the bank's annual report that Sonnet Bank, at all times, devotes its
human and financial resources to the improvement of risk data aggregation as it considers data
aggregation and reporting a part of the bank's planning processes. He also writes that the bank
has established multiple data models that are used as robust automated reconciliation measures.
Kumar's comments are aligned with one of the key principles of risk data aggregation. Identify
that principle.

A. Adaptability

B. Comprehensiveness

C. Distribution

D. Data Architecture and Infrastructure

The correct answer is D.

The comments made by Vijay Kumar, the Chief Risk Officer of Sonnet Bank, align with the second
principle of risk data aggregation, which is 'Data Architecture and Infrastructure'. This principle
necessitates that a bank should dedicate its human and financial resources to improving risk
data aggregation, especially during stressful times. It also mandates that risk data aggregation
and reporting should be incorporated into the bank's planning processes and be subject to
business impact analysis. Furthermore, banks are required to establish integrated data
classifications and architecture across the banking group. In the context of Sonnet Bank,
Kumar's statements about the bank's commitment to enhancing risk data aggregation,
considering data aggregation and reporting as integral parts of the bank's planning processes,
and the establishment of various data models for robust automated reconciliation measures, all
indicate adherence to the 'Data Architecture and Infrastructure' principle.

Choice A is incorrect. Adaptability refers to the ability of a bank's risk data aggregation

capabilities to change in response to varying business needs, which is not specifically mentioned

in Kumar's statements.

Choice B is incorrect. Comprehensiveness pertains to the inclusion of all material risk data

into the scope of aggregation, but Kumar does not explicitly mention this aspect in his

statements.

Choice C is incorrect. Distribution refers to the dissemination of risk management reports at

all relevant levels within a bank, which again, isn't directly addressed by Kumar's comments.

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Q.264 Which of the following key principles of risk data aggregation requires banks to document
both the automated and the manual workarounds, and also requires banks to define why and
when human interventions are critical for data accuracy?

A. Timeliness

B. Adaptability

C. Accuracy and integrity

D. Clarity and usefulness

The correct answer is C.

This principle is one of the key principles of risk data aggregation. It emphasizes the importance
of maintaining the accuracy and integrity of risk data. This principle requires banks to document
both automated and manual workarounds. This is important because it allows for a clear
understanding of the processes involved in data aggregation. Furthermore, this principle also
requires banks to define the circumstances and reasons for which human interventions are
critical for data accuracy. This is crucial because it ensures that the data is not only accurate but
also reliable. It also ensures that there is a clear understanding of the role of human intervention
in maintaining data accuracy. This principle is fundamental in ensuring that banks have a robust
and reliable risk data aggregation process.

Choice A is incorrect. Timeliness refers to the need for risk data to be reported in a timely

manner, allowing for prompt decision-making. It does not specifically require banks to maintain

records of both automated and manual workarounds or explain the circumstances and reasons

for human interventions.

Choice B is incorrect. Adaptability pertains to the ability of risk data systems to adapt quickly

and efficiently to changing business needs, regulatory changes, or market conditions. While this

may involve some level of human intervention, it does not necessitate maintaining records of

such interventions or explaining their necessity.

Choice D is incorrect. Clarity and usefulness refer to the requirement that risk data should be

clear, understandable, and useful for decision-making purposes. This principle does not

specifically mandate banks to elucidate the circumstances and reasons for which human

interventions are deemed crucial for ensuring data accuracy.

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Q.265 The principle of comprehensive requires banks to create reports:
I. That contains position and risk exposure information for credit risk, liquidity risk, market risk,
and operational risk
II. That should satisfy senior management in terms of coverage, analysis, and comparability with
other banks
III. That should provide a historical review of the bank's risk appetite and past stress tests.

Which of the following statements is/are aligned with the principle of comprehensiveness?

A. Statement I

B. Statements II & III

C. Statements I & III

D. All statements are aligned with the principle of comprehensiveness

The correct answer is A.

Statements II and III are not aligned with the definition of the principle of comprehensiveness.
The principle of comprehensive requires banks to create reports:
1. That contains position and risk exposure information for credit risk, liquidity risk, market risk,
and operational risk
2. That should satisfy bank supervisors, not the senior management in terms of coverage,
analysis, and comparability with other banks
3. That should provide a forward-looking, not the historical, review of the bank's risk appetite
and past stress tests

Q.5322 A bank's CRO is assessing the bank's risk data management methods. The CRO observes
that the Basel Committee has proposed numerous principles to encourage strong and effective
risk data aggregation capabilities when describing various dimensions of a bank's data. Which of
the following is a recommendation of Principle 1 on Governance of the Basel committee?

A. Banks should make risk data aggregation and reporting practices a crucial part of the
bank's planning processes.

B. Banks should establish integrated data classifications and architecture across the
banking group.

C. Banks should appoint individuals tasked with various data management

responsibilities.

D. Banks’ risk data aggregation capabilities and risk reporting practices should be
unaffected by their group structure.

The correct answer is D.

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According to Principle 1 on Governance of the Basel Committee, the risk data aggregation

capabilities and risk reporting practices of banks should be unaffected by their group structure.

This principle emphasizes that these capabilities and practices should be fully documented,

validated, and independently reviewed by individuals who are knowledgeable in IT, data, and risk

reporting functions. Furthermore, senior management should make significant efforts to

integrate risk data aggregation into the risk management function. This principle also stipulates

that risk data aggregation should be considered in any new initiatives, including acquisitions and

divestitures, IT change initiatives, and new product development.

Choice A is incorrect. While risk data aggregation and reporting practices are important, the

Basel Committee's Principle 1 on Governance does not specifically state that these should be a

crucial part of the bank's planning processes. This principle primarily focuses on the governance

structure and responsibilities related to risk data management.

Choice B is incorrect. The establishment of integrated data classifications and architecture

across the banking group is not a specific recommendation under Principle 1 on Governance by

the Basel Committee. This aspect pertains more to technical infrastructure rather than

governance.

Choice C is incorrect. Although appointing individuals tasked with various data management

responsibilities can be part of good governance, it is not explicitly stated in Principle 1 by the

Basel Committee. The principle emphasizes more on overall governance framework rather than

individual roles.

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Q.5323 According to Basel Committee, A bank should be able to generate aggregate risk data to
meet a broad range of on-demand, ad hoc risk management reporting requests, including
requests during stress or crises, requests due to changing internal needs, and requests to meet
supervisory queries. Which of the following Basel Committee Principles does the above
statement refer to?

A. Principle 1 on Governance

B. Principle 6 on Adaptability

C. Principle 4 on Completeness

D. Principle 11 on Distribution

The correct answer is B.

Principle 6, as outlined by the Basel Committee, emphasizes the need for banks to have

adaptable risk data aggregation capabilities and risk reporting practices. This adaptability is

crucial in order for banks to meet changing needs, including during periods of stress or crisis.

The principle also highlights the importance of being able to respond effectively to supervisory

queries. This adaptability ensures that banks can effectively manage their risk data, regardless

of the circumstances they find themselves in. This principle is directly related to the statement in

the question, which emphasizes the need for banks to be able to generate comprehensive risk

data to meet a variety of on-demand, ad hoc risk management reporting requests.

Choice A is incorrect. Principle 1 on Governance refers to the need for a strong governance

framework to oversee the risk data aggregation capabilities and risk reporting practices of

banks. It does not specifically address the ability of banks to generate comprehensive risk data

for ad hoc requests.

Choice C is incorrect. Principle 4 on Completeness emphasizes that a bank should be able to

capture and aggregate all material risk data across the banking group. While this principle does

touch upon comprehensive risk data, it doesn't specifically focus on generating such data for ad

hoc requests.

Choice D is incorrect. Principle 11 on Distribution pertains to timely distribution of accurate

and reliable risk management reports within a bank's organization, but it doesn't directly relate

to generating comprehensive risk data for various ad hoc requests.

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 Reading 8: Enterprise Risk Management and Future Trends

Q.67 Martin & Co., a multinational firm that specializes in the manufacturing of high-quality tech
products, has been experiencing high volatility in its business operations. The board of directors
has noticed fluctuating profits, a high level of operational risks, inconsistent financial
performance, and potential regulatory concerns. The board has hired David, a risk management
consultant, to analyze the current situation and recommend strategies to mitigate these risks
and improve the company's performance. David, after thorough evaluation, suggests the firm
adopt an Enterprise Risk Management (ERM) initiative. He believes it would help them manage
and understand the risks better while ensuring the firm's growth and sustainability. However,
some members of the board are skeptical about the ERM adoption and ask David to clarify the
motivations for a firm like theirs to adopt an ERM initiative. Based on David's understanding of
Martin & Co., which of the following is the most compelling reason for the firm to adopt an ERM
initiative?

A. To ensure that the firm maintains the minimum risk levels needed to satisfy regulatory
requirements.

B. To provide a strategic, integrated approach to managing all risks facing the firm.

C. To focus on managing financial risks only, to stabilize the firm's financial performance.

D. To mitigate operational risks only, as these are the most direct threats to the firm's
manufacturing operations.

The correct answer is B.

An ERM initiative is not just about meeting regulatory requirements or focusing on a particular

type of risk such as financial or operational risks. Instead, it provides a holistic, integrated

framework for managing all the risks a firm faces. ERM helps to align risk appetite and strategy,

enhance risk response decisions, reduce operational surprises and losses, and identify and

manage multiple and cross-enterprise risks. It improves the deployment of capital by providing

the rigorous framework needed for informed decision-making. Therefore, it's most compelling for

a firm facing high volatility and multiple types of risks, like Martin & Co., to adopt ERM.

A is incorrect. While ERM does help in maintaining risk levels to satisfy regulatory

requirements, this is not its primary purpose. It is a broader initiative designed to manage all

types of risks, including strategic, operational, financial, and hazard risks. Focusing on

regulatory requirements alone wouldn't address the firm's broader risk challenges.

C is incorrect. Managing financial risks is an important aspect of risk management, but ERM is

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a comprehensive approach that covers all types of risks. Focusing solely on financial risks may

overlook other potential risks that can have a significant impact on a firm's overall performance.

D is incorrect. While operational risks are critical, especially for a manufacturing firm like

Martin & Co., focusing only on these risks through ERM would be a narrow approach. ERM's

primary motivation is to provide a comprehensive, integrated approach to managing all types of

risks. Mitigating operational risks alone may not fully leverage the benefits of ERM.

Things to Remember

Enterprise Risk Management (ERM) is a strategic, integrated approach to managing all

risks a firm faces. It is not just about meeting regulatory requirements or focusing on

one particular type of risk.

ERM helps align risk appetite and strategy, enhancing risk response decisions and

reducing operational surprises and losses. It provides a comprehensive view of risk,

helping manage multiple and cross-enterprise risks.

The implementation of an ERM framework facilitates informed decision-making,

improving the deployment of capital by providing rigorous risk assessments.

The adoption of ERM can be particularly compelling for firms facing high volatility and

multiple types of risks, as it provides a holistic risk management solution.

Q.68 Which of the following arguments best explains why some companies prefer siloed risk
management to ERM?

A. The silo approach simplifies the risk management process as each business unit works
on a small 'slice' of the total risk exposure.

B. The silo approach promotes specialization, thus helps to develop a rich variety of risk
management expertise within the organization.

C. The silo approach enables organizations to extensively analyze each risk without
overlooking important aspects.

D. Managing risks in silos is more efficient and takes a shorter time compared to ERM.

The correct answer is B.

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The silo approach to risk management allows individual business units within an organization to

specialize in managing their specific risks. This specialization can lead to the development of a

diverse range of risk management expertise within the organization. Each business unit can

become highly skilled in managing its unique risks, leading to more effective and efficient risk

management strategies. This approach can also foster a culture of ownership and accountability

for risk management within each business unit. Furthermore, the silo approach can enable more

thorough and detailed risk analysis, as each business unit can focus on its specific risk landscape

without being distracted by the broader organizational risks. This can lead to the identification

and mitigation of risks that might be overlooked in a more generalized, organization-wide risk

management approach.

Choice A is incorrect. While the silo approach may simplify the risk management process for

individual business units, it does not necessarily simplify the overall risk management process

for the organization. In fact, it can complicate matters as risks are not viewed holistically and

interdependencies between risks in different business units may be overlooked.

Choice C is incorrect. The silo approach does allow organizations to analyze each risk in detail

within its own context, but this doesn't mean that important aspects won't be overlooked. Risks

often have impacts across multiple areas of an organization and these cross-impacts might be

missed when using a siloed approach.

Choice D is incorrect. Managing risks in silos might seem more efficient because each unit

handles its own risks, but this isn't necessarily true on an organizational level. ERM allows for a

comprehensive view of all risks and their interrelationships which can lead to more effective

mitigation strategies and potentially save time in the long run.

Things to Remember

The siloed approach to risk management can lead to a lack of communication and

coordination among different business units, potentially resulting in overlooked risks or

duplicated efforts.

Enterprise Risk Management (ERM) provides a holistic view of the organization's risk

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 profile, allowing for better strategic decision-making. However, it may be more complex

and time-consuming to implement compared to the siloed approach.

Both approaches have their pros and cons. The choice between them should depend on

factors such as the nature of the organization's operations, its size, its risk tolerance

level, and available resources.

Risk management is not a one-time activity but an ongoing process that involves

identifying potential risks, assessing their impact on the organization's objectives,

developing strategies to manage these risks effectively and monitoring progress

regularly.

Q.69 Which of the following best defines Enterprise Risk Management (ERM)?

A. The process of managing all the different categories of risks facing the organization.

B. The process of dividing risks into different categories for analysis by the various
autonomous units within an organization.

C. Application of risk management across an enterprise in a holistic, consistent, and

structured way.

D. Application of risk management across an autonomous business unit/department in a

structured, consistent way.

The correct answer is C.

Enterprise Risk Management (ERM) is indeed the application of risk management across an

enterprise in a holistic, consistent, and structured way. ERM is an integrated approach to

managing risk that involves identifying, assessing, and preparing for any dangers, uncertainties,

and risks that an organization might face. It is not limited to a single department or business unit

but spans across the entire organization. The aim of ERM is to provide a comprehensive view of

all the risks faced by the organization and their interrelationships. This allows for better

decision-making as it provides a more accurate picture of the organization's risk profile. ERM

integrates risk measurement and management into business processes, which in turn can be

integrated into strategic business decisions. This approach ensures that risk management is not

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an isolated activity but is embedded in the organization's culture and operations.

Choice A is incorrect. While ERM does involve managing different categories of risks, it is not

just about managing them but also about applying risk management principles in a holistic,

consistent and structured way across the entire enterprise. Therefore, this choice does not fully

capture the essence of ERM.

Choice B is incorrect. This option describes a fragmented approach to risk management where

risks are divided and managed by various autonomous units within an organization. This

contradicts the concept of ERM which advocates for a comprehensive and integrated approach

to managing all risks at an enterprise level.

Choice D is incorrect. The application of risk management principles in a structured and

consistent way across an autonomous business unit or department does not constitute ERM.

ERM involves applying these principles across the entire organization rather than just one

department or business unit.

Things to Remember

Enterprise Risk Management (ERM) is a holistic approach to risk management that

involves identifying, assessing, and preparing for any dangers or uncertainties an

organization might face.

ERM is not just about managing risks but also leveraging opportunities. It aims at

creating a balance between risk-taking and opportunity-seeking behaviors within the

organization.

The goal of ERM is to ensure that the risks taken by an organization are in line with its

strategic objectives and risk appetite. This requires continuous monitoring and

updating of the risk profile as per changes in internal or external environment.

Risk categories under ERM typically include operational risks, financial risks, strategic

risks, compliance/legal/regulatory risks etc. These categories should not be managed in

silos but rather integrated into one comprehensive framework.

ERM promotes better decision-making through improved understanding of business

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 complexity and interdependencies among different types of risks. It helps organizations

anticipate what may go wrong (risks) as well as what must go right (opportunities).

Q.70 Valley Bank, under scrutiny for risk management gaps leading to losses, plans to strengthen
its Enterprise Risk Management (ERM) program. The board, recognizing the need for robust risk
management, appoints a new Chief Risk Officer (CRO), Sam. Sam proposes a comprehensive
ERM strategy encompassing five key dimensions: Targets, Structure, Identification and Metrics,
ERM Strategies, and Culture. Some board members, concerned about complexity and resources,
question the plan's necessity, tasking Sam to convince them. Which of the following arguments
best supports the need for a comprehensive approach to the ERM program?

A. It simplifies the regulatory compliance process and reduces the likelihood of

regulatory penalties.

B. It allows for the ERM program to be entirely led by the CRO, reducing the need for
involvement from other business areas.

C. It enables a strategic, integrated approach to managing risk at all levels of the

organization, which is key to avoiding, mitigating, or transferring risks efficiently.

D. It reduces the need for external audits as the ERM program itself can provide
sufficient assurance on risk management practices.

The correct answer is C.

All five dimensions are necessary for an effective ERM program as they allow for a holistic

approach to risk management, aligning the risk management strategy with the firm's risk

appetite and strategic goals. The different dimensions, from setting correct risk targets to

defining the roles of key risk officers to identifying and measuring risks, help create a

comprehensive structure that considers all facets of risk. The ERM strategies help in deciding

whether risk will be avoided, mitigated, or transferred at the enterprise level, while a strong risk

culture can foster risk-conscious decision-making throughout the organization.

A is incorrect. While a comprehensive ERM program can aid in regulatory compliance, this is

not the primary reason for its implementation. It is a broader initiative designed to manage all

types of risks and ensure the firm's strategic goals align with its risk appetite.

B is incorrect. A successful ERM program requires involvement from all business areas, not

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just the CRO. The aim is to integrate risk management into the strategic planning and decision-

making processes across the entire organization, and not limit it to the purview of the CRO or

risk management department.

D is incorrect. Although an effective ERM program can provide an internal check on risk

management practices, it does not eliminate the need for external audits. External audits are an

integral part of the risk management process, providing independent assurance on the

effectiveness of the ERM program and compliance with regulatory requirements.

Q.81 In the recent past, a certain bank has had a poor relationship with its regulator. The CEO
asks the CRO to suggest some of the actions the company could take in a bid to improve this
relationship in the future. Which of the following presents a possible recommendation?

A. Allocating additional funding to the compliance department to enhance monitoring

capabilities.

B. Developing a robust internal supervisory policy.

C. Implementing an internal public relations campaign to highlight the bank's

commitment to regulatory compliance.

D. Scheduling frequent meetings with the regulator to discuss the bank's progress and
initiatives.

The correct answer is B.

Improving regulatory relations requires demonstrating commitment to compliance and risk

management. By developing robust internal supervisory policies, the bank shows proactive

management of regulatory risks. This addresses potential regulatory concerns directly, which is

more likely to improve their perception of the bank. In addition, coordinating submissions with

other banks can help to demonstrate the willingness to adhere to guidelines and timelines.

A is incorrect. While more funding for the compliance department might seem beneficial, it's

not necessarily the solution to improving relations with the regulator. The key is how effectively

these resources are used in enhancing compliance, not merely the act of increasing budget.

Without a comprehensive plan for risk management, increased funding might not lead to

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improved regulatory relations.

C is incorrect. Public relations campaigns can improve the image of the bank among its

stakeholders, but they might not have a significant impact on the bank's relationship with its

regulator. The regulator is more interested in the bank's adherence to regulatory standards,

rather than its image or reputation.

D is incorrect. While open communication with the regulator can be helpful, this is not a

solution in itself. The regulator is primarily interested in seeing tangible improvements in the

bank's risk management and compliance procedures. Without the demonstration of such

improvements, merely discussing the bank's progress might not effectively improve relations.

Things to Remember

Improving regulatory relationships demands a firm demonstration of commitment to

compliance and risk management, rather than merely increasing the compliance

department's budget.

Developing robust internal supervisory policies can show proactive management of

regulatory risks. This can address regulatory concerns directly and improve the

regulator's perception of the firm.

Coordinating submissions with other banks and adhering to guidelines and timelines

can further demonstrate a commitment to regulatory compliance.

Regulators are primarily interested in tangible improvements in a firm's risk

management and compliance procedures. Mere discussions or image improvement

campaigns are not sufficient in themselves.

Q.3840 Which of the following statements is correct as far as Enterprise Risk Management is
concerned?

A. Independent operations of ERM dimensions motivate the success of the ERM

framework in a firm

B. ERM advocates viewing of risk across business lines by looking at the diversification

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 and the concentration of the risk

C. The ERM looks at the level of each risk type in the firm and assesses them
independently

D. All of the above

The correct answer is B.

Enterprise Risk Management (ERM) is a comprehensive and integrated framework for managing

risk across an organization. It advocates for a holistic view of risk across business lines,

considering both the diversification and concentration of risk. This approach allows for a more

accurate and complete understanding of the organization's overall risk profile. It enables the

organization to identify and manage potential risks and opportunities, thereby enhancing its

ability to achieve strategic objectives. The ERM framework encourages organizations to consider

all types of risk, including strategic, operational, financial, and hazard risks, and to manage

these risks in a coordinated and integrated manner. By viewing risk across business lines,

organizations can identify and manage interdependencies and correlations among risks, which

can lead to a more effective and efficient risk management process.

Choice A is incorrect. ERM does not operate on independent dimensions. Instead, it integrates

all risk dimensions to provide a comprehensive view of the firm's risk profile. The success of the

ERM framework in a firm is not motivated by independent operations but by its ability to manage

and mitigate risks in an integrated manner.

Choice C is incorrect. This statement contradicts the holistic approach of ERM which

advocates for viewing and managing all types of risks as interrelated rather than assessing them

independently.

Choice D is incorrect. As explained above, choices A and C do not accurately reflect the

principles and practices of ERM, therefore this option cannot be correct.

Q.5324 Vista Technologies, a global software company, is struggling with establishing a strong
risk culture within the organization. The company's new Chief Risk Officer (CRO), Lisa, faces
several hurdles as she tries to navigate this issue. One of the challenges that Lisa mentions to

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the executive board is the 'curse of data.' Which of the following scenarios best exemplifies Lisa's
concern?

A. The excessive data generated by various business lines may lead to confusion and
difficulty in identifying genuine risk indicators.

B. There maybe a lack of data due to insufficient technological infrastructure, making it

challenging to identify risk trends.

C. Data privacy laws may prevent the company from fully utilizing the available data for
risk assessment.

D. The inconsistency in the data formats received from different business lines may bring
about delays in risk assessment.

The correct answer is A.

In today's digital age, organizations often have access to vast amounts of data generated by their

various business lines. This data can include everything from financial metrics, customer

behaviour, operational performance to external data such as market trends, economic indicators,

and regulatory updates. While this data can potentially provide invaluable insights for risk

management, it can also become overwhelming and counterproductive - a situation referred to

as the 'curse of data'.

B, C, and D are incorrect as per the explanation for A above.

Things to Remember

The 'curse of data' implies that having too much data can actually hamper risk identification and

management. The key challenges here include:

Volume: The sheer volume of data can be overwhelming. It can be time-consuming and

resource-intensive to sift through massive data sets to identify the most relevant

information for risk management.

Quality: Not all data is useful or accurate. Some data may be outdated, incorrect, or

irrelevant, which can lead to inaccurate risk assessments if not properly filtered out.

Complexity: The data may be complex and difficult to interpret, especially if it comes

from multiple different sources or in different formats.

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 Distraction: The abundance of data can distract from key risk indicators. It can lead to

information overload where critical risk indicators get lost in the noise of less

important data.

Q.5328 Atlas Bank's newly appointed risk analyst, Martin, has been discussing the benefits and
limitations of scenario analysis as a part of the bank's ERM framework during a strategy
meeting. He presents various facets of scenario analysis to the board members. Which of the
following statements made by Martin about scenario analysis is most likely correct?

A. It is fairly easy to determine the probability of events.

B. The number of appropriate situations that can be developed is unlimited.

C. Imaginative future scenarios may be dismissed as inappropriate.

D. Scenario analysis does not depend on historical data.

The correct answer is C.

In scenario analysis, teams try to imagine different futures to help organizations prepare for a

range of possibilities. However, in this process, certain proposed scenarios that seem too far-

fetched, imaginative, or divergent from the norm may be dismissed as improbable or

inappropriate. This is especially true for scenarios that may be considered as "black swan"

events - events that are extremely rare but have severe consequences. Because these events are

so rare and so difficult to predict, they may be ignored in the scenario planning process, often

due to cognitive biases like the availability heuristic or normalcy bias.

Statement A is incorrect. In reality, determining the probability of events in scenario analysis

can be quite challenging. Assigning probabilities to different scenarios often relies on subjective

judgments, expert opinions, or assumptions, which can introduce biases and uncertainties. The

difficulty in determining the probability of events accurately is a disadvantage, as it can lead to

less reliable or less useful results.

Statement B is incorrect. While it's true that there is no strict limit to the number of scenarios

that can be developed, creating an excessive number of scenarios can lead to analysis paralysis,

where decision-makers are overwhelmed by too muchinformation and unable to make effective

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decisions.

Statement D is incorrect. While it's true that scenario analysis can be used to explore potential

future events that deviate from historical trends, it often still relies on historical data to some

extent to inform the development of scenarios or to provide a baseline for comparison.

Things to Remember

Scenario analysis involves imagining different futures to prepare for a range of

possibilities. However, scenarios that appear far-fetched or overly imaginative may be

dismissed as improbable or inappropriate, even when they could have significant

implications (like "black swan" events).

Determining the probability of events in scenario analysis can be quite challenging.

Assignments of probabilities often rely on subjective judgements, which can introduce

biases and uncertainties.

While there is no strict limit to the number of scenarios that can be developed, creating

excessive scenarios can lead to "analysis paralysis", overwhelming decision-makers and

hindering effective decisions.

Though scenario analysis explores potential future events that deviate from historical

trends, it often relies on historical data to some extent for developing scenarios or

providing a baseline for comparison.

Q.5409 Which of the following observations correctly describes the fundamental differences
between Enterprise Risk Management (ERM) and a traditional silo-based risk management
program?

A. ERM approach reduces the overall risks to the enterprise by focusing primarily on
operational risks while a silo-based approach often overlooks operational risks due to its
focus on individual business units.

B. ERM approach identifies, monitors, and manages all types of risks in an integrated
manner, while a silo-based approach manages risks in isolation.

C. ERM approach tends to increase risk exposure due to its broad focus, while a silo-
based approach decreases risk exposure through focused, individualized risk

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 management.

D. ERM approach and silo-based approach are essentially the same, with the only
difference being that the ERM approach is used by larger organizations while the silo-
based approach is used by smaller organizations.

The correct answer is B.

Enterprise Risk Management (ERM) is a comprehensive and integrated approach for managing

all types of risks across an organization. It promotes better communication among various risk

management functions and helps in identifying the interdependencies among different risks. On

the other hand, a traditional silo-based risk management program manages each risk in isolation

without acknowledging the potential correlation among different risks. This approach tends to

lead to inefficiencies and gaps in risk coverage.

A is incorrect because the ERM approach does not primarily focus on operational risks. ERM

provides a holistic approach to managing all types of risks, including operational, financial,

strategic, and hazard risks, among others. The silo-based approach, on the other hand, could

overlook certain risks due to its focus on individual business units, but it does not specifically

overlook operational risks.

C is incorrect because the ERM approach does not tend to increase risk exposure. On the

contrary, its broad and integrated focus allows for a more comprehensive view of risk exposure

and, thus, better risk management. The silo-based approach, while providing focused risk

management, does not necessarily decrease risk exposure as it might miss interdependent risks

due to its isolated view.

D is incorrect because the size of the organization does not determine the use of ERM or a silo-

based approach. ERM and silo-based approaches are fundamentally different in their

perspectives on risk management. ERM is a more integrated and comprehensive approach, while

a silo-based approach manages risks in isolation, regardless of the size of the organization.

Things to Remember

Enterprise Risk Management (ERM) is a holistic, comprehensive, and integrated

approach to risk management, addressing all types of risks across an organization.

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 ERM is marked by effective communication between various risk management

functions, which facilitates the identification of interdependencies among risks.

The silo-based risk management approach manages each risk in isolation,

potentially leading to inefficiencies and coverage gaps due to a lack of consideration

for risk interdependencies.

The size of an organization does not dictate whether ERM or a silo-based approach

is employed. Both approaches can be used by organizations of any size.

The primary distinction between the ERM and silo-based approaches lies in their

perspectives on risk management: ERM advocates for a collective view, while the silo-

based approach advocates for an isolated view.

Q.5410 Atlas Capital Bank, a major financial institution with assets over $60 billion, is preparing
for its annual Comprehensive Capital Analysis and Reviews (CCAR). As part of its preparations,
the bank's risk management department has been tasked with integrating scenario analysis into
the bank's stress testing and capital planning programs. This integration is aimed at ensuring
the bank can withstand severe economic downturns and satisfy regulatory requirements. The
bank's Chief Risk Officer (CRO), Jennifer, has stressed the importance of employing diverse and
realistic scenarios in the stress testing program. She believes that this would provide a more
comprehensive view of the bank's potential vulnerabilities. Which of the following statements
made by Jennifer during a planning meeting is most likely correct?.

A. CCAR requires static forecasting of balance sheets and income statements.

B. Stress tests only need to be performed on the most profitable business lines.

C. The adverse scenario in the bank's stress tests should assume a global recession.

D. If stress tests reveal the bank might fail to meet minimum capital standards, there's a
need to increase the risk appetite.

The correct answer is C.

According to the information provided by the Federal Reserve, the "severely adverse" scenario

for stress testing should assume a global recession. This would test the bank's resilience under

extreme stress. Hence, Jennifer's statement about assuming a global recession in the adverse

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scenario aligns with the guidelines for severe stress testing.

A is incorrect. CCAR actually requires dynamic forecasting of balance sheets and income

statements, which means the bank must forecast revenues, loan loss provisions, rules for making

new loans, and regulatory ratios as they evolve over time.

B is incorrect. Stress tests should be performed across all business lines, not just the most

profitable ones. This is because stress testing aims to assess the potential impact of adverse

scenarios on the entire bank's financial health, not just the segments that currently bring in the

most revenue.

D is incorrect. If stress tests indicate that a bank fails to meet minimum capital standards, it

would actually need to lower its risk appetite, not increase it. This is because a failure to meet

minimum capital standards signifies that the bank is carrying too much risk relative to its

capital, so the bank would need to reduce its risk levels to bring them in line with its capital

base.

Things to Remember

For severe stress testing under CCAR, the "severely adverse" scenario should assume a

global recession. This allows institutions to test their resilience under extreme stress.

CCAR requires dynamic, not static, forecasting of balance sheets and income

statements. This involves forecasting revenues, loan loss provisions, rules for making

new loans, and regulatory ratios over time.

Stress tests should be performed across all business lines, not just the most profitable

ones. The objective is to assess the potential impact of adverse scenarios on the entire

bank's financial health.

If stress tests reveal that a bank might fail to meet minimum capital standards, it

indicates a need to reduce the bank's risk appetite, not increase it. This is because

failing to meet minimum capital standards suggests the bank is carrying too much risk

relative to its capital base.

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 Reading 9: Learning From Financial Disasters

Q.112 In the lead-up to the 2007/2009 financial crisis, Lehman Brothers had positioned itself as
the leading institution in the mortgage-backed securities market. Which of the following best
explains why the firm failed so spectacularly despite boasting huge amounts of capital?

A. The firm was highly leveraged, reducing its ability to absorb losses

B. A large number of the firm’s mortgage-backed securities were built upon sub-prime
mortgage assets

C. The firm was considered too big to fail

D. A lack of confidence among investors which in turn led to a lack of funding

The correct answer is A.

Lehman Brothers' failure was primarily due to its high leverage, which significantly reduced its

ability to absorb losses. Leverage refers to the use of borrowed funds to finance the purchase of

assets, with the expectation that the income or capital gain from the new asset will exceed the

cost of borrowing. In the case of Lehman Brothers, the firm had taken on an excessive amount of

short-term debt to finance long-term assets, a strategy that exposed it to serious liquidity

problems. When the housing bubble burst, the value of these long-term assets plummeted,

leading to substantial losses. However, the firm's high leverage meant that it had a limited

capacity to absorb these losses. As a result, it was unable to meet its debt obligations, leading to

its eventual bankruptcy.

Choice B is incorrect. While it's true that a significant portion of Lehman Brothers' mortgage-

backed securities were built upon sub-prime mortgage assets, this was not the primary reason

for the firm's downfall. Many financial institutions had similar exposure to sub-prime mortgages

but did not fail as Lehman Brothers did. The key difference was the level of leverage used by

Lehman Brothers, which amplified losses and reduced its ability to absorb them.

Choice C is incorrect. The concept of "too big to fail" refers to the idea that certain financial

institutions are so large and interconnected that their failure would be disastrous for the broader

economy, thus necessitating government intervention or bailout. However, in Lehman Brothers'

case, despite being a large institution, it was allowed to fail without any government intervention

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or bailout.

Choice D is incorrect. Although lack of confidence among investors leading to a lack of funding

can contribute to a firm's downfall, it wasn't the primary reason in case of Lehman Brothers'. It

was rather an outcome triggered by their high leverage and exposure to subprime mortgages

which led investors losing confidence in them.

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Q.113 The Barings incident came up mainly due to:

A. The actions of a single trading official

B. The lack of adequate control systems and the failure of management to exercise even
the basic oversight roles

C. Collusion between back-office staff and a junior level manager

D. The massive earthquake that hit Japan in 1995, triggering unprecedented losses in the
stock market

The correct answer is B.

The Barings Bank collapse was primarily due to the lack of adequate control systems and the

failure of management to exercise even the basic oversight roles. The bank allowed Nick Leeson,

a junior trader, to take on the dual role of head of trading and settlement operations. This was a

clear violation of the segregation of duties principle, which is a basic tenet of internal control

systems. This allowed Leeson to hide his trading losses and misrepresent the financial position of

his trading activities. Furthermore, the management failed to heed the warnings of auditors and

did not question the unusually high profits reported by Leeson. This lack of oversight and control

ultimately led to the collapse of the bank when Leeson's hidden losses were eventually revealed.

Choice A is incorrect. While the actions of a single trading official, Nick Leeson, did contribute

to the collapse of Barings Bank, it was not the main cause. His actions were only able to bring

about such disastrous consequences due to the lack of adequate control systems and failure of

management oversight.

Choice C is incorrect. There is no evidence or record suggesting that there was collusion

between back-office staff and a junior level manager leading to the collapse of Barings Bank.

This choice seems more like an assumption rather than a fact based on historical events.

Choice D is incorrect. The massive earthquake that hit Japan in 1995 did trigger

unprecedented losses in the stock market but it was not directly related to or responsible for the

collapse of Barings Bank. The bank's downfall was primarily due to internal factors such as poor

risk management and lack of oversight rather than external events.

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Q.114 The trouble among Savings and Loans Associations (S&Ls) in the United States can be
traced down to an increase in interest rates and inflation, which collectively served to reduce the
profit margin initially enjoyed by the heavily regulated S&Ls. The regulator responded by
relaxing some of the stringent rules. For example, the limit on deposit insurance coverage was
raised from $40,000 to $100,000 to make it easier for troubled or insolvent institutions to attract
deposits to lend with. Which of the following problems did this particular change create?

A. S&Ls engaged in even riskier lending activities

B. Taxpayers were forced to pay for the increase

C. There was a huge bailout after a large number of S&Ls failed

D. All of the above

The correct answer is D.

The increase in deposit insurance coverage from $40,000 to $100,000 led to several problems.

Firstly, it created a moral hazard as S&Ls started engaging in riskier lending activities. The

higher insurance coverage made it easier for these institutions to attract deposits, which they

then lent out. However, the riskier nature of these loans increased the probability of loss.

Secondly, when a large number of S&Ls failed, it led to one of the most expensive banking

system bailouts in history, costing around USD 160 billion. This bailout was funded by taxpayers,

thereby placing a significant financial burden on them.

Choice A is incorrect. While it's true that S&Ls engaged in riskier lending activities, this was

not a direct result of the increase in deposit insurance coverage. Rather, it was a consequence of

the overall deregulation and loosening of restrictions on S&Ls' activities. The increased limit on

deposit insurance may have indirectly contributed to this by providing a safety net for risky

behavior, but it was not the primary cause.

Choice B is incorrect. Although taxpayers did ultimately bear some of the cost of the S&L

crisis through government bailouts, this was not directly caused by the increase in deposit

insurance coverage. The increased limit may have made bailouts more costly when they did

occur, but it did not force taxpayers to pay for them.

Choice C is incorrect. While there indeed was a huge bailout after many S&Ls failed, this

cannot be solely attributed to the increase in deposit insurance coverage from $40,000 to

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$100,000. The failure and subsequent bailout were due to a combination of factors including

poor management decisions and economic conditions such as rising interest rates and inflation.

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Q.115 Which of the following served as the main source of funding for Lehman Brothers in the
lead-up to the 2007/2009 financial crisis?

A. Bond market

B. Repo market

C. Stock sale

D. Reserves

The correct answer is B.

Lehman Brothers, like many other financial institutions, relied heavily on the repo market for

funding. A repo, or repurchase agreement, is a form of short-term borrowing for dealers in

government securities. In a typical repo transaction, a dealer sells government securities to

investors, usually on an overnight basis, and buys them back the following day at a slightly

higher price. The difference in price is the dealer's overnight interest cost. Lehman Brothers was

heavily reliant on these short-term funding sources, borrowing billions of dollars each day in the

overnight wholesale funding markets to operate. This reliance on short-term funding was a

significant factor in Lehman's collapse when the liquidity of these markets dried up during the

financial crisis.

Choice A is incorrect. While Lehman Brothers did use the bond market as a source of funding,

it was not their primary source during the period leading up to the financial crisis. The bond

market can be a more expensive and less flexible form of financing compared to other sources.

Choice C is incorrect. Stock sales were not the primary source of funding for Lehman Brothers

during this period. Selling stock is a way to raise equity capital, but it also dilutes existing

shareholders' ownership in the company, which can be undesirable from a management

perspective.

Choice D is incorrect. Reserves are typically used as a buffer against unexpected losses and

are not generally considered as a primary source of funding for ongoing operations in financial

institutions like Lehman Brothers.

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Q.117 The following statements are true regarding Long-Term Capital Management (LTCM),
except:

A. LTCM is categorized as a financial disaster caused by large market moves but not
misleading reporting.

B. The incident highlighted the importance of stress testing to look at the effects of a
competitor holding similar assets unexpectedly exiting the market.

C. LTCM was founded with the aim of tapping short-term positions instead of focusing on
the long term.

D. LTCM models assumed that historical relationships were useful predictors of future
relationships, albeit in the absence of external economic shocks.

The correct answer is C.

LTCM was, in fact, focused on long-term investment strategies. The fund's investors were locked

into investments for extended periods of time to avoid illiquidity. The partners at LTCM were so

confident in the success of their venture that they committed a significant portion of their net

worth to the fund. This confidence was bolstered by the impressive results LTCM recorded in its

initial years. Therefore, the assertion that LTCM was aimed at short-term positions is incorrect.

Choice A is incorrect. LTCM's collapse was indeed a financial disaster triggered by large

market moves, particularly in the bond market. It was not due to misleading reporting. The firm

had taken on excessive risk with high leverage, and when the markets moved against their

positions, they were unable to meet their obligations.

Choice B is incorrect. The LTCM case did highlight the importance of stress testing for

extreme scenarios such as a major competitor unexpectedly exiting the market. This event could

lead to sudden changes in asset prices and liquidity conditions that could adversely affect a

firm's positions.

Choice D is incorrect. LTCM did rely heavily on models that assumed historical relationships

would continue into the future, even in the absence of external economic shocks. This

assumption proved to be one of their major downfalls when unexpected events occurred that

disrupted these historical relationships.

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Q.119 Consider the following statements:
I. LTCM models assumed that low frequency/high severity events were correlated over a period
of time
II. LTCM models accounted for the spikes in correlations among asset class prices during
economic shocks
Select the true statement(s):

A. I

B. II

C. Both I and II

D. None

The correct answer is D.

Neither of the statements accurately reflect the assumptions made by LTCM's models. The

models used by LTCM relied heavily on historical correlations to measure risk. This approach

failed to account for the possibility of a spike in correlations among asset class prices during

economic shocks. An example of such a shock was when Russia defaulted on its debt, causing a

global economic downturn. Furthermore, the models did not consider the possibility of low

frequency/high severity events being correlated over time. This led to an underestimation of risk

in the tails of the distribution. Therefore, both statements are incorrect.

Choice A is incorrect. The models used by LTCM did not assume that low frequency/high

severity events were correlated over a period of time. In fact, one of the key criticisms of LTCM's

approach was that it underestimated the likelihood and potential impact of these "tail risk"

events.

Choice B is incorrect. Similarly, LTCM's models did not account for spikes in correlations

among asset class prices during economic shocks. This was another major flaw in their approach,

as it led them to underestimate the risk of simultaneous losses across different asset classes.

Choice C is incorrect. As explained above, neither statement I nor II accurately reflects the

assumptions made by LTCM's models.

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Q.120 Which of the following risks was realized in the Metallgesellschaft case study?

A. Credit risk.

B. Interest rate risk.

C. Funding liquidity risk.

D. Operational risk.

The correct answer is C.

Funding liquidity risk refers to the risk that a company will not be able to meet its current and

future cash flow and collateral needs, both expected and unexpected, without affecting its daily

operations or financial condition. In the Metallgesellschaft case, the company offered its

customers the opportunity to buy oil and gasoline at a premium above the average price of

futures contracts expiring over the next 12 months. However, when the price of oil dropped

sharply from about \$21 to \$14 per barrel, the company suffered losses of approximately \$900

million. These losses were realized immediately as the futures contracts were marked to market.

The gains from customers, which could have offset the losses, could not be realized until several

years later. This situation led to a shortage of short-term cash outflows, thereby creating a

funding liquidity risk. Therefore, the Metallgesellschaft case is a classic example of funding

liquidity risk, where the company was unable to meet its short-term cash flow needs due to a

sudden drop in oil prices.

Choice A is incorrect. Credit risk refers to the potential that a borrower or counterparty will

fail to meet its obligations in accordance with agreed terms. In the Metallgesellschaft case, the

company's losses were not due to any default by its customers or counterparties, but rather due

to a sharp drop in oil prices.

Choice B is incorrect. Interest rate risk pertains to the potential for investment losses due to a

change in interest rates. In this scenario, Metallgesellschaft's losses were not related to changes

in interest rates but were caused by significant price fluctuations of heating oil and gasoline.

Choice D is incorrect. Operational risk involves loss resulting from inadequate or failed

internal processes, people and systems, or from external events. The company's strategy was not

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flawed because of operational failures; instead it suffered from an unexpected drop in oil prices

which led them into funding liquidity issues.

Q.121 Metallgesellschaft Refining and Marketing (MGRM), a U.S. subsidiary of the German oil
company Metallgesellschaft, lost over $1.5 billion as a result of a poor dynamic hedging strategy.
What triggered the loss? The company:

A. Adopted an outdated and largely ineffective hedging strategy called a “stack-and-roll

hedge”.

B. Bought too many long terms futures contracts.

C. Failed to predict the significant rise in oil prices in 1993.

D. Suffered a significant decline in oil prices resulting in huge unrealized losses and
subsequent margin calls.

The correct answer is D.

MGRM suffered a significant decline in oil prices, which led to massive unrealized losses and

subsequent margin calls. The company used short-term futures to hedge its position due to a

lack of alternatives, as the long-term futures contracts available were highly illiquid. MGRM's

open interest in unleaded gasoline contracts was 55 million barrels in the fall of 1993, compared

to an average trading volume of 15-30 million barrels per day. The company encountered

problems in the timing of cash flows required to maintain the hedge. Over the entire life of the

hedge, these cash flows would have canceled out. However, MGRM's problem was a lack of

necessary funds needed to maintain its position. The fundamental issue manifested in the form of

inadequate funds to mark positions to market and meet margin requirements. This situation was

exacerbated by the significant decline in oil prices, which led to huge unrealized losses and

subsequent margin calls, ultimately resulting in a loss of over $1.5 billion.

Choice A is incorrect because although MGRM did adopt a dynamic hedging strategy, it was

not outdated or largely ineffective. The strategy involved using short-term futures to hedge due

to a lack of alternatives, as the long-term futures contracts available were highly illiquid. The

problem was not with the strategy itself, but with the company's inability to predict the

significant decline in oil prices and its lack of necessary funds to maintain its position and meet

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margin requirements.

Choice B is incorrect because MGRM did not buy too many long-term futures contracts. In

fact, the company used short-term futures to hedge due to a lack of alternatives, as the long-term

futures contracts available were highly illiquid.

Choice C is incorrect because MGRM did not fail to predict a significant rise in oil prices in

1993. In fact, the company suffered a significant decline in oil prices, which led to massive

unrealized losses and subsequent margin calls.

Things to Remember

The MGRM case is a classic example of the risks associated with dynamic hedging strategies.

While these strategies can be effective in managing risk, they require careful management and a

thorough understanding of the underlying market dynamics. In the case of MGRM, the

company's inability to predict the significant decline in oil prices and its lack of necessary funds

to maintain its position and meet margin requirements led to massive losses. This case highlights

the importance of not only having a sound hedging strategy but also ensuring that the company

has the necessary resources to implement and maintain the strategy effectively. It also

underscores the importance of understanding and managing the cash flow requirements

associated with such strategies, as well as the potential risks associated with significant market

fluctuations.

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Q.122 In the modern business world, it's not uncommon to find organizations recording phone
conversations between clients and staff. Which of the following best explains why firms must
exercise caution when engaging in such an exercise as highlighted by the Bankers Trust
incident?

A. Taping conversations can have a negative impact on the ability of staff to freely and
candidly engage with clients.

B. The recorded conversations can be used against the organizations as evidence during
lawsuits.

C. The exercise may not yield significant results and may actually deal a heavy blow to
staff/management trust.

D. Taping conversations could consume considerable time and energy, which could
otherwise be channeled into more productive business.

The correct answer is B.

The Bankers Trust incident serves as a cautionary tale for organizations that record

conversations between their staff and clients. In this case, Procter and Gamble and Gibson

Greetings sued Bankers Trust for failing to customize derivative trades to suit their individual

needs. The plaintiffs used recorded phone conversations of Bankers Trust employees as evidence

in their lawsuits. Some of these recordings contained employees boasting about how they had

deceived clients with complex and incomprehensible structures. This case underscores the

potential legal risks associated with recording conversations, as these recordings can be used

against the organization in legal proceedings. Therefore, organizations must exercise caution

when recording conversations to avoid potential legal repercussions.

A, C, and D are incorrect as they all present scenarios unrelated to the Bankers Trust incident.

Q.123 In the history of financial disasters, there have been instances where companies have used
questionable accounting practices to misrepresent their financial health to investors. These
practices often involved disguising the size of borrowings, thereby creating a false impression of
financial stability. Among the following cases, which one is known for such practices?

A. Barings Bank

B. Continental Illinois

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 C. Enron

D. Orange County

The correct answer is C.

Enron Corporation is infamous for its accounting scandal that led to its downfall. The company

took on large loans but disguised them as oil futures contracts. This allowed Enron to avoid

accounting for these borrowings on its financial statements, thereby presenting a misleading

picture of its financial health to investors and lenders. The company's financial statements

showed it to be in a much better financial position than it actually was. When the truth came to

light, it led to one of the biggest corporate bankruptcies in U.S. history and a reevaluation of

corporate accounting practices.

Choice A is incorrect because Barings Bank's downfall was not due to questionable

accounting practices. Instead, it was associated with poor management oversight of the

settlement process. The bank's collapse was primarily due to unauthorized and speculative

trading activities by one of its employees, Nick Leeson, who was based in Singapore. Leeson's

activities led to losses amounting to more than the bank's available trading capital, leading to the

bank's insolvency in 1995.

Choice B is incorrect because Continental Illinois's financial disaster was not a result of

questionable accounting practices. The bank's problems were primarily associated with funding

liquidity risk. In the early 1980s, Continental Illinois had a high concentration of commercial real

estate loans and was heavily reliant on wholesale funding. When concerns about the bank's loan

portfolio arose, it led to a run on the bank by other financial institutions, leading to its eventual

failure in 1984. This case is often cited as an example of the risks associated with relying too

heavily on wholesale funding.

Choice D is incorrect because the financial disaster in Orange County was not due to

questionable accounting practices. Instead, it was a case of misuse of complex financial products

characterized by large amounts of leverage. The county's treasurer, Robert Citron, invested

heavily in derivatives, believing that interest rates would remain low. However, when rates rose,

the county suffered significant losses and was forced to file for bankruptcy in 1994. This case

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illustrates the risks associated with financial engineering and complex derivatives.

Things to Remember

Each of these financial disasters highlights different risks and issues in the financial sector.

Enron's case underscores the importance of transparency and integrity in accounting practices.

Barings Bank's collapse highlights the need for effective management oversight and risk

controls. The Continental Illinois case illustrates the risks associated with funding liquidity risk

and over-reliance on wholesale funding. Lastly, Orange County's bankruptcy demonstrates the

potential dangers of using complex financial products without fully understanding the associated

risks.

Q.124 In the Metallgesellschaft case study, which factor played the most significant role in the
events that unfolded?

A. German accounting rules of the time.

B. Outright fraud.

C. Flawed computer-based software.

D. Timing differences in the cash flows of its long and short positions.

The correct answer is D.

The Metallgesellschaft case study is a classic example of a financial disaster caused by a timing

mismatch between futures contract losses and forward contract cash flows. Metallgesellschaft, a

German industrial conglomerate, had entered into long-term contracts to deliver oil products at

fixed prices. To hedge against the risk of oil price fluctuations, the company took short positions

in oil futures. However, the cash flows from these two positions did not match in terms of timing.

The futures contracts required margin payments whenever the market price of oil increased,

leading to immediate cash outflows. On the other hand, the cash inflows from the long-term

contracts were spread out over several years. This timing mismatch created a liquidity crisis for

Metallgesellschaft when oil prices rose significantly. The company's positions were so large that

it could not close them without incurring substantial costs. This situation ultimately led to a

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financial disaster for Metallgesellschaft.

Choice A is incorrect because while the German accounting rules of the time may have

influenced Metallgesellschaft's financial reporting, they were not the primary cause of the

company's financial disaster. The company's problems stemmed from a timing mismatch between

the cash flows of its long and short positions, not from the accounting rules.

Choice B is incorrect because there is no evidence to suggest that outright fraud was a factor

in the Metallgesellschaft case.

Choice C is incorrect because flawed computer-based software was not a major factor in the

Metallgesellschaft case. The company's financial disaster was primarily caused by a timing

mismatch between the cash flows of its long and short positions, not by problems with its

software.

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Q.126 Enron, once a leading energy company, faced a catastrophic downfall that led to its
bankruptcy. This failure was attributed to various factors, primarily related to risk management.
Among the following types of risks, which one was the most significant contributor to Enron's
collapse?

A. Governance risk

B. Liquidity risk

C. Foreign currency risk

D. Credit risk

The correct answer is A.

Enron's failure was primarily due to governance risk.

Governance risk refers to the potential for losses due to a company's management decisions,

policies, and procedures. In Enron's case, the company's executives made decisions that were in

their personal interest, often at the expense of the company. This led to a culture of greed and

corruption, which ultimately resulted in the company's downfall. The executives' lack of

accountability and transparency, coupled with their unethical practices, created a high

governance risk that eventually led to Enron's collapse. Therefore, governance risk was the most

significant factor contributing to Enron's failure.

Choice B is incorrect. Enron did face liquidity issues, particularly towards the end when it was

unable to pay its debts. However, these issues were a consequence of the larger governance

issues that plagued the company.

Choice C is incorrect. While Enron was a multinational corporation with operations in various

countries, there is no evidence to suggest that foreign currency risk was a significant factor in its

downfall.

Choice D is incorrect. While Enron did have significant debts, credit risk was not the primary

cause of its downfall. The company's failure was primarily due to governance issues, not its

inability to repay its debts.

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Q.127 In financial crises, certain patterns and behaviors often precede the onset of a disaster.
These behaviors can be seen in the attitudes of investors, market trends, and the overall
economic climate. Among the following options, which one best describes the typical
characteristics observed in the initial phases of a financial catastrophe?

A. Unfettered optimism and an overwhelmingly bullish sentiment regarding the

trajectory of future asset prices, often culminating in speculative bubbles.

B. A significant and sudden influx of novice investors, often driven by fear of missing out
on a rapidly rising market, thus inflating asset prices beyond their intrinsic values.

C. A systemic failure in a sector such as the housing mortgage market, precipitated by an

unsustainable build-up of high-risk loans and amplified by a lack of diversification in
investment portfolios.

D. A persistent pattern of stagnating or barely fluctuating share prices, potentially

indicating an imminent market correction or bear market phase.

The correct answer is A.

Excessive optimism about future asset prices is a common characteristic of the early stages of a

financial disaster. This optimism is often fueled by a belief that asset prices will continue to rise

indefinitely, leading to a rush of buyers into the market. This behavior can create an asset

bubble, where the prices of assets like shares, mortgages, and other products inflate beyond

their intrinsic value. When this bubble eventually bursts, it can lead to a financial disaster.

Historically, this pattern has been observed in several financial crises. For instance, during the

lead-up to the 2008 financial crisis, there was excessive optimism about the housing market, with

many believing that house prices would continue to rise. This led to a surge in risky lending and

the creation of a housing bubble. When the bubble burst, it triggered a financial disaster that

had global repercussions.

Similarly, in the case of the collapse of Lehman Brothers, the firm's entry into the mortgage-

backed securities market coincided with a period of rapid growth in the industry, fueled by the

housing price bubble. For a few years, Lehman Brothers experienced fast growth, but when the

bubble burst, it led to their downfall.

Choice B is incorrect. While this scenario may contribute to financial instability, it is not the

primary characteristic of the initial phases of a financial catastrophe. It's typically a result of

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excessive optimism.

Choice C is incorrect because it refers more to a specific event during a financial crisis (like

the 2008 subprime mortgage crisis) rather than a general characteristic of the initial phases of

financial catastrophes. Not all financial crises have such sector-specific triggers.

Choice D is incorrect. Stagnating or barely fluctuating share prices may indicate a lack of

market activity or investor interest, but they're not necessarily indicative of an impending

financial catastrophe. Often, they're seen in mature markets or during economic downturns, not

specifically in the initial phases of a crisis.

Q.131 Which of the following dynamic hedging strategies was used by Metallgesellschaft
Refining and Marketing (MGRM)?

A. Stack-and-roll

B. Delta hedging

C. Stop-loss strategy

D. Dynamic delta-hedging

The correct answer is A.

The stack-and-roll strategy is characterized by the purchase of futures contracts for a nearby

delivery date and then rolling the position forward by purchasing a fewer number of contracts on

that date. The process continues for future delivery dates until the exposure at each maturity

date is hedged. This is exactly the strategy that was used by Metallgesellschaft Refining and

Marketing (MGRM). The aim of this strategy is to hedge against price fluctuations in the market

by maintaining a position in futures contracts. This strategy is particularly useful in volatile

markets where prices can change rapidly and unpredictably.

B, C, and D are incorrect as they represent strategies not adopted by MGRM. Here's a brief

description of each:

Delta hedging is a strategy that aims to reduce the risk associated with price movements of an

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underlying asset, such as a stock, by offsetting long and short positions. For example, if a trader

has a long position on a stock, they can hedge against potential losses by taking a short position

on the same stock.

In a stop-loss strategy, a trader sets a pre-determined point at which they will sell a stock to

avoid further losses. This strategy is used to limit potential losses on a position. However, this

strategy is not a dynamic hedging strategy and was not used by MGRM.

Dynamic delta-hedging is a strategy that adjusts the number of shares shorted as the price of the

underlying asset changes, in order to maintain a delta-neutral position. It is dynamic because the

number of shares shorted is continuously adjusted to maintain the delta-neutral position.

Things to Remember

MGRM essentially took long positions in short-dated futures contracts on oil to hedge against

possible increases in oil prices in the future. The "stack and roll" strategy involved rolling over

these contracts every month, essentially selling the near-term contract before it expired and

buying the next month's contract. This approach works well if prices increase or remain stable.

However, the oil market faced a significant downturn in the early 1990s. As oil prices fell, MGRM

was forced to meet large margin calls as its hedging position lost value, while its long-term

supply contracts remained unaffected as they were at fixed prices. With this, MGRM was

effectively in a situation where it was selling high and buying low, leading to significant losses.

The situation was further exacerbated when Metallgesellschaft's lenders, nervous about the

losses, demanded additional collateral and eventually forced a liquidation of the futures position,

turning paper losses into real ones. This chain of events eventually led to a liquidity crisis and

the near-collapse of the entire Metallgesellschaft conglomerate.

Q.132 In the history of financial markets, there have been numerous scandals that have had a
profound impact on the global economy. These scandals often involve a variety of risks, including
funding liquidity risk, which is the risk that a company will not be able to meet its short-term
financial needs. This type of risk was a significant factor in one of the following financial
scandals:

A. Orange County

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 B. Savings and Loans Crisis

C. SWIFT

D. Metallgesellschaft Refining and Marketing

The correct answer is D.

The Metallgesellschaft Refining and Marketing (MGRM) scandal is a prime example of a financial

disaster caused by funding liquidity risk. MGRM, a subsidiary of Metallgesellschaft AG, a large

German industrial conglomerate, entered into long-term fixed price contracts with its customers

to supply heating oil, gasoline, and diesel fuel. To hedge its exposure to volatile oil prices, MGRM

implemented a stack-and-roll futures strategy. However, when the oil prices fell significantly,

MGRM faced margin calls on its futures contracts that it could not meet, leading to a liquidity

crisis. The losses incurred by MGRM were fundamentally from cash flow timing differences

associated with the positions making up its hedge. This case highlights the importance of

understanding and managing funding liquidity risk in financial markets.

Choice A is incorrect because the Orange County bankruptcy was a case of financial

mismanagement and lack of risk management oversight. The treasurer of Orange County, Robert

Citron, invested heavily in risky derivatives, betting that interest rates would remain low. When

interest rates rose, the county suffered significant losses and was unable to meet its financial

obligations, leading to bankruptcy.

Choice B is incorrect because the Savings and Loan crisis in the United States during the

1980s and 1990s was not primarily a case of funding liquidity risk. Instead, it was a case of poor

regulatory oversight, risky and fraudulent lending practices, and a sharp decline in real estate

values.

Choice C is incorrect because the SWIFT (Society for Worldwide Interbank Financial

Telecommunication) case is all about cyber risk, not funding liquidity risk. This incident

highlighted the importance of cybersecurity in the financial sector.

Things to Remember

Funding liquidity risk is a crucial aspect of risk management in financial institutions. It refers to

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the risk that a firm will not be able to meet its current and future cash flow and collateral needs,

both expected and unexpected, without affecting its daily operations or financial condition. This

risk can arise from various sources, including market disruptions, changes in credit quality, and

mismatches between assets and liabilities. Effective management of funding liquidity risk

involves maintaining an adequate level of liquid assets, diversifying funding sources, and

regularly monitoring and managing liquidity risk exposures and funding needs within various

time horizons.

Q.134 Which of the following involves the purchase of a hedging instrument that very closely
matches the position to be hedged and is typically held for as long as the underlying position is
kept?

A. Dynamic hedge strategy

B. Static hedge strategy

C. Stack-and-roll hedge strategy

D. Delta-hedge strategy

The correct answer is B.

A static hedge strategy is a type of hedging strategy that does not require constant rebalancing

as the price and other characteristics (such as volatility) of the securities it hedges change. This

strategy typically involves the purchase of a hedging instrument that very closely matches the

position to be hedged. The hedging instrument is held for as long as the underlying position is

kept. This strategy is particularly useful in situations where the characteristics of the underlying

position are not expected to change significantly over time, thereby reducing the need for

constant monitoring and adjustment of the hedge. The static hedge strategy is a cost-effective

and efficient way to mitigate risk, as it minimizes transaction costs associated with frequent

rebalancing of the hedge.

Choice A is incorrect because a dynamic hedge strategy involves frequent rebalancing of the

hedge position as market conditions change. This strategy is typically used when the

characteristics of the underlying position are expected to change significantly over time.

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Choice C is incorrect because a stack-and-roll hedge strategy involves purchasing futures

contracts for a nearby delivery date and, on that date, rolling the position forward by purchasing

a fewer number of contracts for future delivery dates. This process continues until the exposure

at each maturity date is hedged. The stack-and-roll hedge strategy is typically used in situations

where the underlying position has a long duration and the futures contracts available for

hedging have shorter durations.

Choice D is incorrect because a delta-hedge strategy involves the reduction of the directional

risks associated with the movements in the price of the underlying assets. This strategy is

typically used in options trading, where the delta of an option represents the rate of change of

the option price with respect to changes in the price of the underlying asset.

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Q.4318 The trader known as the London Whale lost at least $6.2 billion for JPMorgan Chase &
Co. in 2012. In the first three months of that year, the number of days reporting losses exceeded
the number of days reporting profits. In an attempt to conceal these losses, the CIO came up
with a new valuation system. The CIO had hitherto (up to that point) valued credit derivatives by:

A. Marking them at or near the midpoint price in the daily range of prices.

B. Marking them above the midpoint price in the daily range of prices.

C. Marking them below the midpoint price in the daily range of prices.

D. Marking them at prices that were at significant variance to the midpoints of dealer
quotes in the market.

The correct answer is A.

The CIO had been valuing credit derivatives by marking them at or near the midpoint price in

the daily range of prices. This method is also known as marking to market. The midpoint price is

the average of the highest and lowest prices that a security reaches within a day, which is

considered to be the most representative of fair value. By using this method, the CIO was able to

provide a more accurate and fair valuation of the credit derivatives. This method is commonly

used in the financial markets to ensure that the valuation of securities is reflective of the current

market conditions.

Choice B is incorrect. The CIO was not marking the credit derivatives above the midpoint price

in the daily range of prices. This would have resulted in overvaluation of these derivatives, which

is not consistent with standard financial risk management practices.

Choice C is incorrect. The CIO was also not marking them below the midpoint price in the

daily range of prices. This would have led to undervaluation of these derivatives, which again

contradicts standard financial risk management practices.

Choice D is incorrect. The CIO did not mark them at prices that were at significant variance to

the midpoints of dealer quotes in the market until they devised a new valuation system to

obscure losses. Prior to this, they had been marking them at or near the midpoint price in the

daily range of prices as per standard practice.

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Q.4319 After consistently breaching risk limits, CIO traders at JPMorgan Chase & Co. proposed a
total overhaul of the VaR model in use at the time, claiming that the model was too conservative.
A new VaR model was eventually developed. Which of the following statements is most likely
correct?

A. The new model was developed and by CIO traders in collaboration with the office of
the Comptroller of Currency.

B. The new model resulted in risk numbers that were 50% higher than prior numbers.

C. The new model successfully corrected the mathematical flaws present in the first
model, which had produced highly overstated risk estimates.

D. The new model was eventually revoked and the prior one reinstated.

The correct answer is D.

The new VaR model developed by the CIO traders at JPMorgan Chase & Co. was eventually

revoked and the prior one reinstated. This decision was made after the bank's Model Risk and

Development Office identified several mathematical and operational flaws in the new model.

These flaws included coding errors in the calculation of hazard rates and correlation estimates,

the use of unrealistically low volatility for illiquid securities, and the use of a Uniform Rate option

instead of the Gaussian Copula model required under Basel 2.5. The new model had also resulted

in risk numbers that were 50% lower than the previous numbers, which had encouraged more

speculative trading and high-risk strategies. The revocation of the new model and the

reinstatement of the old one was a significant step taken by the bank to address these issues and

mitigate the risks associated with the flawed model.

Choice A is incorrect. The new model was not developed by CIO traders in collaboration with

the office of the Comptroller of Currency. In fact, it was developed internally within JPMorgan

Chase & Co., without any external collaboration.

Choice B is incorrect. The new model did not result in risk numbers that were 50% higher than

prior numbers. On the contrary, it significantly reduced the reported risk numbers, which was

one of the reasons for its eventual revocation and reinstatement of the prior model.

Choice C is incorrect. The new model did not successfully correct mathematical flaws present

in the first model that produced highly overstated risk estimates. Instead, it understated risks

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due to flawed assumptions and methodologies used in its development.

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Q.4320 In 2012, J.P. Morgan Chase lost more than $6.2 billion dollars from an exposure to a
massive credit derivatives portfolio in its London office. How did a lack of adequate management
oversight manifest?

A. Senior managers at the bank would receive daily risk reports from traders but never
read them.

B. The bank had no risk committee to monitor the activities of CIO traders.

C. Senior management ignored the breaching of risk limits.

D. Senior management did not hold even a single meeting to evaluate the goings-on at
the CIO.

The correct answer is C.

The case of J.P. Morgan Chase in 2012, often referred to as the 'London Whale' case, revealed a

culture of inadequate regulatory oversight. The risk limits were consistently breached, risk

metrics were disregarded, and risk models were manipulated. Despite these glaring issues, the

management did not take any substantial steps to rectify these anomalies. This lack of action on

the part of the management is a clear manifestation of ignoring the breaching of risk limits. The

Chief Investment Office (CIO), which was not a client-facing unit of the bank, was not subject to

the same level of regulatory scrutiny as other portfolios. This further contributed to the lack of

adequate management oversight.

Choice A is incorrect. While it's true that senior managers receiving daily risk reports but not

reading them would demonstrate a lack of oversight, this was not the specific issue in the J.P.

Morgan Chase case. The problem was not about ignoring daily risk reports, but rather about

ignoring breaches of risk limits.

Choice B is incorrect. The absence of a risk committee to monitor the activities of CIO traders

could indeed indicate insufficient management oversight, however, this was not the primary

issue in this particular case at J.P. Morgan Chase.

Choice D is incorrect. Although holding meetings to evaluate ongoing activities at CIO would

be an important part of management oversight, it wasn't specifically mentioned as a factor

contributing to the loss suffered by J.P. Morgan Chase in 2012.

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Q.4321 What was the main purpose of the Chief Investment Office, CIO, at J.P. Morgan Chase
Bank in the run-up to the London Whale scandal?

A. To monitor the operations of traders .

B. To invest excess deposits.

C. To look into ways in which the bank could reduce its regulatory capital requirements.

D. To raise funds for investment by floating long-term high-yield bonds.

The correct answer is B.

The Chief Investment Office (CIO) at J.P. Morgan Chase Bank was primarily established to invest

the bank's excess deposits. In the banking sector, excess deposits refer to the surplus cash that a

bank has after meeting its reserve requirements and providing for its lending activities. These

excess deposits can be invested in various ways to generate additional income for the bank. In

the case of J.P. Morgan Chase Bank, the CIO was specifically set up to manage these investments.

This strategy allowed the bank to maximize the returns on its surplus cash, thereby enhancing its

overall profitability. The role of the CIO became particularly significant in the run-up to the

London Whale scandal, as the office was responsible for making large-scale investments that

ultimately led to significant losses for the bank.

Choice A is incorrect. While monitoring the operations of traders is an important function

within a bank, it was not the primary role of the CIO at J.P. Morgan Chase Bank during this

period. The CIO's main responsibility was to manage excess deposits and invest them in a way

that would generate returns for the bank.

Choice C is incorrect. Although banks often look for ways to reduce their regulatory capital

requirements, this was not the primary function of the CIO at J.P. Morgan Chase Bank during this

time period. The main task of the CIO was to manage and invest excess deposits.

Choice D is incorrect. Raising funds for investment by floating long-term high-yield bonds

could be one of many strategies employed by a bank's investment office, but it wasn't specifically

what defined the role of J.P.Morgan's Chief Investment Office during that time frame.

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Q.4322 At the height of the 2007/2009 financial crisis, J.P. Morgan Chase Bank constructed a
synthetic credit portfolio (SCP) motivated by the need to protect itself against adverse credit
scenarios such as widening credit spreads. The bank’s synthetic credit portfolio (SCP) was
comprised of:

A. Call options on stocks featured in the S&P 500 index.

B. Credit default swaps featured in standardized credit default swap indices.

C. Short and long oil futures positions.

D. Mortgage-backed securities .

The correct answer is B.

J.P. Morgan Chase Bank's synthetic credit portfolio (SCP) was essentially a collection of credit

default swaps that were part of standardized credit default swap indices. The bank assumed both

buyer and seller positions in these swaps. As a protection buyer (holding a short risk position),

the bank would pay premiums and, in return, receive a guarantee of compensation in the event

of a default. Conversely, as a protection seller (holding a long risk position), the bank would

receive premiums and, in return, promise to compensate the buyer if a default occurred. This

strategy allowed the bank to hedge against adverse credit scenarios, such as widening credit

spreads, which were a significant concern during the 2007/2009 financial crisis.

Choice A is incorrect. Call options on stocks featured in the S&P 500 index are not

components of a synthetic credit portfolio (SCP). An SCP typically consists of financial

instruments that mimic the performance of actual credit, such as credit default swaps, rather

than equity derivatives like call options.

Choice C is incorrect. Short and long oil futures positions are not part of a synthetic credit

portfolio (SCP). These are commodity derivatives and do not have any direct relation to credit

risk or spreads. They would be more relevant in a commodities trading strategy rather than a

defensive strategy against unfavorable credit situations.

Choice D is incorrect. Mortgage-backed securities (MBS) could potentially be part of an SCP if

they were being used to synthetically replicate the performance of specific credits or sectors

within the broader market. However, MBS themselves are actual securities backed by

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mortgages, not synthetic representations of other credits or sectors.

Q.4323 The infamous collapse of the oldest merchant bank in England, Barings Bank, in 1995
after 233 years of existence, can be traced down to one key reason:

A. A bank run

B. The Kobe earthquake in Japan, which rattled financial markets in Asia and hence,
severely affected the bank’s activities.

C. Largely unchecked speculative trades.

D. A total overhaul of the board of directors which resulted in the loss of investor
confidence.

The correct answer is C.

The collapse of Barings Bank was primarily due to largely unchecked speculative trades. The

bank's downfall can be traced back to the actions of one employee, Nick Leeson, who was the

general manager and head trader at Barings. Leeson had a reputation for hard work and an

unrivaled understanding of the market, which he had developed during his successful career

elsewhere. After joining Barings, Leeson initially earned massive profits for the bank through

several unauthorized trades in 1992. However, his speculative trading eventually led to losses of

over $1 billion in company capital. Leeson hid these losses from his superiors, which further

exacerbated the situation. When the losses were eventually discovered, they were so substantial

that they led to the bank's collapse. This case highlights the dangers of unchecked speculative

trading and the importance of proper risk management and oversight in financial institutions.

Choice A is incorrect. While a bank run can indeed lead to the collapse of a financial

institution, it was not the primary cause in the case of Barings Bank. The bank's downfall was

primarily due to internal factors rather than external panic among depositors.

Choice B is incorrect. Although the Kobe earthquake did have an impact on financial markets

in Asia, it was not directly responsible for Barings Bank's failure. The bank's collapse was largely

due to speculative trades that were not properly monitored or controlled.

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Choice D is incorrect. A change in the board of directors can affect investor confidence and

potentially lead to instability within an organization, but this was not a key factor leading to

Barings Bank's downfall. The main issue at hand was unchecked speculative trading which led to

significant losses for the bank.

Q.4324 Which of the following is the main reason that led to the scale of losses suffered by the
Orange County portfolio in 1994?

A. Excessive use of leverage.

B. Overreliance on equity.

C. An unexpected increase in interest rates by the Federal Reserve.

D. Stringent collateral demands by providers of emergency capital.

The correct answer is A.

The primary reason for the scale of losses suffered by the Orange County portfolio in 1994 was

the excessive use of leverage. Robert Citron, the treasurer of Orange County, decided to borrow

heavily in the repo market. Repos, or repurchase agreements, allow investors to finance a

significant portion of their investments with borrowed money, which is known as leverage.

However, the use of leverage can have a multiplicative effect on the profit or loss on any position.

This means that even a small change in market prices can have a significant impact on the

investor. When the Federal Reserve announced an increase in interest rates, the fund could no

longer borrow in the repo market at favorable terms and was eventually forced to declare

bankruptcy. The excessive use of leverage amplified the impact of the interest rate increase,

leading to substantial losses for the portfolio.

Choice B is incorrect. Overreliance on equity was not the primary reason for the magnitude of

losses experienced by Orange County in 1994. The county's investment portfolio was heavily

invested in derivative securities, not equities. Therefore, this option does not accurately reflect

the main cause of the financial crisis.

Choice C is incorrect. While an unexpected increase in interest rates by the Federal Reserve

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did contribute to Orange County's financial crisis, it was not primarily responsible for the

magnitude of losses experienced by the county's investment portfolio. The main issue was that

Orange County had excessively used leverage to invest in derivative securities which were

sensitive to interest rate changes.

Choice D is incorrect. Stringent collateral demands by providers of emergency capital were a

consequence, rather than a cause, of Orange County's financial crisis in 1994. These demands

came into play after significant losses had already been incurred due to excessive use of leverage

and subsequent market volatility.

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Q.4325 The Orange County case illustrates how complex financial products characterized by
large amounts of leverage can create significant losses. The fund heavily invested in:

A. Mortgage-backed securities.

B. Equities.

C. Inverse floating-rate notes.

D. Credit default swaps.

The correct answer is C.

The Orange County investment fund, under the direction of Robert Citron, heavily invested in

inverse floating-rate notes. These are complex financial instruments whose coupon payments

decrease when interest rates rise. This is in contrast to conventional floating-rate notes, where

the coupon payments increase when interest rates rise. The fund's strategy was based on the

expectation that interest rates would remain low or decrease. However, when interest rates rose

unexpectedly, the value of the inverse floaters fell dramatically, leading to significant losses for

the fund.

Choice A is incorrect. While mortgage-backed securities are indeed complex financial

instruments, they were not the primary investment made by Orange County's investment fund

under Robert Citron. The fund primarily invested in inverse floating-rate notes.

Choice B is incorrect. Equities, although a common type of financial instrument, were not the

main focus of Orange County's investment strategy under Robert Citron. The fund was heavily

invested in inverse floating-rate notes which are more complex and carry higher risk.

Choice D is incorrect. Credit default swaps are a type of derivative used to hedge against the

risk of a debtor defaulting on their loans. However, these were not the specific type of financial

instrument that Orange County's investment fund heavily invested in during Robert Citron's

tenure as treasurer.

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Q.4326 The Orange County case illustrates how complex financial products characterized by
large amounts of leverage can create significant losses. Mr. Robert Citron, the fund’s treasurer,
heavily invested in inverse floating-rate notes expecting:

A. Interest rates to rise.

B. Interest rates to fall.

C. A recession in the near future.

D. The corporation tax rate to rise.

The correct answer is B.

Robert Citron, the treasurer of the fund, invested heavily in inverse floating-rate notes. These are

a type of debt instrument where the interest paid to the investor decreases when interest rates

increase. Conversely, when interest rates decrease, the interest paid to the investor increases.

This is the opposite of what happens with conventional floating-rate notes, where the interest

paid increases with rising interest rates. Therefore, by investing in inverse floating-rate notes,

Mr. Citron was essentially betting on interest rates to fall or remain low. If his prediction had

been correct, the value of the inverse floating-rate notes would have increased, leading to

significant profits for the fund. However, if interest rates were to rise, the value of these notes

would decrease, leading to potential losses. This is exactly what happened in the Orange County

case, leading to significant losses for the fund and eventually its bankruptcy.

Choice A is incorrect. Inverse floating-rate notes increase in value when interest rates fall, not

rise. Therefore, Mr. Citron's investment in these instruments indicates an expectation of falling

interest rates.

Choice C is incorrect. The expectation of a recession would likely lead to a different

investment strategy altogether, as recessions typically result in lower interest rates rather than

higher ones.

Choice D is incorrect. The corporation tax rate has no direct impact on the value of inverse

floating-rate notes and thus would not be a primary consideration for Mr. Citron's investment

decision.

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Q.4327 The financial scandals at Bankers Trust and Orange County have one thing in common:

A. They involved the use of complex financial instruments with an eye on high returns.

B. Both collapsed as a result of a crippling run.

C. Both were eventually acquired and dismantled.

D. Both invested heavily in mortgage-backed securities.

The correct answer is A.

Both the financial scandals at Bankers Trust and Orange County involved the use of complex

financial instruments with an aim to achieve high returns. Bankers Trust used complex

derivatives trades to promise Procter & Gamble (P&G) and Gibson Greetings a high probability

of a small reduction in funding costs in exchange for a low-probability, large loss. These

derivatives were intentionally complex to prevent P&G and Gibson Greetings from understanding

their risks and overall implications. Similarly, Orange County's treasurer, Robert Citron, used

complex structured products, specifically inverse floating-rate notes, to generate higher than

average returns. These notes' coupon payments would decrease when interest rates rose,

effectively betting on interest rates falling or staying low. However, when the Federal Reserve

increased interest rates, the value of Citron's portfolio decreased significantly, leading to

substantial losses.

Choice B is incorrect. While it's true that both Bankers Trust and Orange County faced

significant financial difficulties, they did not collapse as a result of a crippling run. A bank run

occurs when a large number of customers withdraw their deposits simultaneously due to fears

that the institution might become insolvent. However, in these cases, the financial scandals were

primarily related to risky investment strategies and misuse of complex financial instruments

rather than mass withdrawals by customers.

Choice C is incorrect. Although Bankers Trust was eventually acquired by Deutsche Bank,

Orange County was not dismantled or acquired by another entity after its bankruptcy. Instead, it

implemented measures to recover from its financial crisis and continues to operate today.

Choice D is incorrect. The statement that both institutions invested heavily in mortgage-

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backed securities is inaccurate. The scandals at Bankers Trust and Orange County involved

misuse of complex derivatives rather than investments in mortgage-backed securities

specifically.

Q.4328 Which of the following lessons is most relevant to the Orange County case?

A. Every firm needs to have more than a basic understanding of the risks that are
inherent in its business models.

B. Reporting and monitoring of positions and risks (i.e., back-office operations) must be
separated from trading (i.e., front-office operations).

C. Risk managers have a responsibility to analyze reported business profits and

determine if they seem logical in light of the positions held.

D. Outsized or strangely consistent profits should be independently investigated and

rigorously monitored in order to verify that they are real, generated in accordance with
the firm’s policies and procedures.

The correct answer is A.

The main lesson learned from the Orange County case has much to do with the need for firms to
have a deep/detailed basic understanding of the inherent risks in their business models. Robert
Citron, Orange County’s treasurer, used complex structured products in an attempt to generate a
higher than average return. Citron later admitted he understood neither the position he took nor
the risk exposure of the fund with respect to these products.
Choices B, C, and D are all lessons under the Barings case study that revolves around Nick
Leeson, a trader.

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Q.4329 The Volkswagen scandal of 2015 highlighted the need for companies to:

A. Invest in social media to ensure a fast spread of positive information.

B. Uphold ethical conduct and demonstrate their commitment to environmental, social,

and governance-related best practices.

C. To hire qualified professionals capable of detecting anomalies before it’s too late.

D. To nurture and protect their brand name by investing in research and development.

The correct answer is B.

The Volkswagen scandal of 2015 was a significant event that highlighted the importance of

ethical conduct and commitment to environmental, social, and governance-related best practices

for companies. Volkswagen, a renowned automobile manufacturer, was found to have cheated on

emissions tests, causing severe damage to its brand reputation. The company's share price fell

by over a third, and it faced potential fines and penalties amounting to billions of dollars. This

scandal underscored the need for companies to uphold ethical conduct and demonstrate their

commitment to environmental, social, and governance-related best practices. By doing so,

companies can avoid such scandals, maintain their reputation, and ensure their long-term

success.

Choice A is incorrect. While investing in social media can help spread positive information

about a company, it does not address the root cause of ethical issues or misconduct that may lead

to scandals like the Volkswagen case. It's more of a reactive approach rather than proactive.

Choice C is incorrect. Hiring qualified professionals capable of detecting anomalies is

important, but it doesn't necessarily ensure ethical conduct or commitment to environmental,

social, and governance-related best practices. It's possible for anomalies to go undetected or be

ignored if there isn't a strong culture of ethics and responsibility within the company.

Choice D is incorrect. Nurturing and protecting their brand name by investing in research and

development can contribute to a company's reputation, but it doesn't directly address ethical

conduct or commitment to ESG practices. In fact, without these commitments, any investment in

R&D could potentially be wasted if unethical behavior leads to reputational damage.

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Q.5329 During a company’s annual general meeting, a shareholder asks the Chief Risk Officer to
elaborate on what she meant by funding liquidity risk. Which of the following definitions given by
the Chief Risk Officer is correct?

A. It is the possibility that a bank could find itself unable to settle obligations as soon as
they are due.

B. It is the danger that a change in rates will cause the value of assets to decline and that
of liabilities to increase.

C. It is the aim to ensure that banks have liquidity and funding strategies that will survive
system-wide stress scenarios.

D. It is the risk of loss resulting from the use of insufficiently accurate models to make
decisions when valuing financial securities.

The correct answer is A.

Funding liquidity risk is indeed the possibility that a bank or any financial institution could find

itself unable to settle obligations as soon as they are due. This risk arises when a company is

unable to meet its short-term financial obligations due to insufficient cash, cash equivalents, or

limited access to funding sources. This inability to settle obligations on time can have severe

consequences, including reputational damage, loss of confidence from customers and investors,

increased borrowing costs, and, in extreme cases, insolvency or bankruptcy. Therefore,

managing funding liquidity risk is crucial for the survival and success of any financial institution.

Choice B is incorrect. This choice describes interest rate risk, not funding liquidity risk.

Interest rate risk refers to the potential for investment losses due to a change in interest rates,

not the inability to meet obligations as they come due.

Choice C is incorrect. While this statement does relate to liquidity management strategies, it

does not define funding liquidity risk. Funding liquidity risk specifically refers to the possibility

that a bank could find itself unable to settle obligations as soon as they are due.

Choice D is incorrect. This choice describes model risk, which pertains to potential

inaccuracies and misapplications of models used in financial valuation and risk assessment,

rather than funding liquidity risk.

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Q.5330 The hacking of the Society for Worldwide Interbank Financial Telecommunication, also
known as SWIFT that led to the loss of approximately $81 million from the Central Bank of
Bangladesh highlighted the exposure of individuals and institutions to cyber risk. Which of the
following is an appropriate definition of cyber risk?

A. The potential for adverse consequences arising from unauthorized access, use,
disclosure, disruption, modification, or destruction of information systems, digital assets,
or data.

B. The potential for negative impacts on an individual or organization's reputation due to

factors such as data breaches, privacy violations, or unethical practices.

C. The potential for losses or damages stemming from insufficient or malfunctioning

internal controls, technology failures, or human errors in the context of an organization's
operations.

D. The potential for adverse outcomes arising from inaccuracies, limitations, or

misapplications of financial or statistical models employed by an organization in decision-
making or risk management.

The correct answer is A.

Cyber risk is accurately defined as the potential for adverse consequences arising from

unauthorized access, use, disclosure, disruption, modification, or destruction of information

systems, digital assets, or data. This definition encompasses a wide range of threats, including

data breaches, hacking, phishing attacks, malware, ransomware, and other forms of

cyberattacks. These threats can compromise the confidentiality, integrity, or availability of digital

resources, leading to significant financial and reputational damage for individuals and

organizations. The hacking of SWIFT and the subsequent loss from the Central Bank of

Bangladesh is a prime example of cyber risk.

Choice B is incorrect. While reputation risk can be a consequence of cyber risk, it is not the

definition of cyber risk itself. Reputation risk refers to potential negative impacts on an

organization's reputation due to various factors, which may include but are not limited to cyber

incidents.

Choice C is incorrect. This choice describes operational risk, which includes losses from

inadequate or failed internal processes, people and systems or from external events. Although

cyber threats can lead to operational failures, they represent only one aspect of operational risk

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and do not define the entirety of cyber risk.

Choice D is incorrect. This choice refers to model risk - the potential for adverse outcomes

arising from inaccuracies or misapplications in financial models used by an organization for

decision-making or managing risks. While a poorly designed cybersecurity model could increase

an organization's vulnerability to cyber threats, this does not encompass the full scope of what

constitutes as 'cyber risk'.

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Q.5332 During the Global Financial Crisis of 2008, different types of institutions played different
roles in the financial services industry. Which of the following roles was played by mortgage
brokers during the financial crisis?

A. Bringing together mortgage borrowers and lenders, without using their own funds.

B. Originating mortgage-backed securities.

C. Securitizing mortgages by creating structured investment vehicles.

D. Providing credit ratings for various financial instruments.

The correct answer is A.

During the Global Financial Crisis of 2008, mortgage brokers acted as intermediaries between

borrowers and lenders. They did not use their own funds but facilitated the mortgage application

process. Their role was to help borrowers find suitable mortgage loans from various lenders.

They earned fees or commissions for their services. This role was crucial in the financial services

industry as it helped to connect borrowers with potential lenders, thereby facilitating the flow of

funds in the economy. However, it's important to note that while they played a significant role in

the mortgage application process, they did not bear the credit risk associated with the loans.

That risk was borne by the lenders who provided the funds for the loans.

Choice B is incorrect. Mortgage brokers do not originate mortgage-backed securities. This role

is typically performed by investment banks or other financial institutions that pool together

mortgages and sell them as securities to investors.

Choice C is incorrect. The process of securitizing mortgages by creating structured investment

vehicles (SIVs) was not a function performed by mortgage brokers during the Global Financial

Crisis of 2008. This was primarily done by large financial institutions, which used SIVs to offload

risk from their balance sheets.

Choice D is incorrect. Providing credit ratings for various financial instruments, including

mortgage-backed securities, was the role of credit rating agencies and not mortgage brokers

during the crisis.

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 Reading 10: Anatomy of the Great Financial Crisis of 2007-2009

Q.135 In the early 2000s, mortgage lenders introduced a new strategy to attract more customers
by offering adjustable mortgage rates with initial 'teaser rates'. This strategy involved a lower
interest rate for the first few years, followed by a significantly higher rate in the subsequent
years. What was the immediate impact of this strategy on the mortgage market?

A. Tighter lending standards, making it more difficult for potential homeowners to secure
a mortgage.

B. The number of mortgage applications started to increase.

C. The price of houses started to rise.

D. A rapid increase in mortgage defaults.

The correct answer is B.

Mortgage lenders in the United States started to relax lending standards in about 2000. Part of
the new strategies involved restructuring repayment terms to allow borrowers to pay a small
rate of interest for the first 2-3 years followed by substantially higher rates in the later years.
The immediate effect was an upturn in demand for homes as families previously unqualified
could now afford to repay borrowed funds. The lenders deemed the move as a low-risk strategy
because home prices were continually increasing, meaning that potential borrower default was
adequately mitigated by an increasing collateral value.

Choice A is incorrect because the introduction of adjustable mortgage rates with initial 'teaser

rates' actually represented a relaxation, not a tightening, of lending standards. This strategy

aimed at making mortgages more accessible to a broader range of potential homeowners by

offering lower initial costs, which in turn, increased the number of mortgage applications.

Choice C is incorrect because while the introduction of adjustable mortgage rates with 'teaser

rates' did lead to an increase in demand for homes, it did not immediately cause house prices to

rise. The increase in demand for homes was primarily due to the lower initial rates making

mortgages more affordable for many families who were previously unqualified.

Choice D is incorrect because, while the adjustable mortgage rates with initial 'teaser rates'

did eventually contribute to a higher number of mortgage defaults, this was not the immediate

effect. Initially, the lower rates made mortgages more accessible and attractive, leading to an

increase in applications. The rise in defaults happened later when the 'teaser rates' ended, and

the higher rates were applied, which many homeowners were unable to afford.

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Q.137 Which of the following options best describes the conditions under which a non-recourse
mortgage operates?

A. The borrower is given flexible repayment terms, including variable interest rates and a
grace period.

B. If the borrower defaults, the lender can take possession of the assets used as collateral
as well as other assets of the borrower.

C. If the borrower defaults, the lender can only take possession of the assets used as
collateral and not any other assets of the borrower.

D. The borrower can only sell the assets used as collateral with express authority from
the lender.

The correct answer is C.

A non-recourse mortgage is a type of loan where the lender's ability to claim repayment in the

event of a default is limited to the collateral pledged for the loan. In other words, if the borrower

defaults on a non-recourse mortgage, the lender can only take possession of the assets used as

collateral and not any other assets of the borrower. This is a key feature of non-recourse loans

and distinguishes them from recourse loans, where the lender can go after the borrower's other

assets if the collateral is insufficient to cover the outstanding loan balance. Non-recourse loans

are less risky for borrowers, but more risky for lenders, as they may not be able to recover the

full amount of the loan if the value of the collateral falls. As such, non-recourse loans often come

with higher interest rates or more stringent lending criteria to compensate for this increased

risk.

Choice A is incorrect. A non-recourse mortgage limits the lender in terms of the assets they

can possess in case the borrower defaults on the loan, the lender has few chances of reducing

the risks associated with the loan, and therefore they tend to charge fixed-interest rates.

Choice B is incorrect because it describes a recourse mortgage, not a non-recourse mortgage.

In a recourse mortgage, if the borrower defaults, the lender can take possession of the assets

used as collateral as well as other assets of the borrower.

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Choice D is incorrect because it is not a defining characteristic of non-recourse mortgages.

Both recourse and non-recourse loans can include clauses that restrict the borrower's ability to

sell the collateral without the lender's permission.

Q.140 An asset-backed security is usually divided into three tranches: the senior tranche,
mezzanine tranche, and equity tranche. Which of the following correctly categorizes the three
tranches in terms of risk, from the riskiest to the least risky?

A. Senior tranche; Equity tranche; Mezzanine tranche

B. Mezzanine tranche; Equity tranche; Senior tranche

C. Mezzanine tranche; Senior tranche; Equity tranche

D. Equity tranche; Mezzanine tranche; Senior tranche

The correct answer is D.

Asset-backed securities are divided into tranches to distribute risk. The equity tranche is the

riskiest as it is the first to absorb losses. This tranche is often referred to as the 'first loss' piece

as it takes the first hit when there are defaults on the underlying assets. The mezzanine tranche

is less risky than the equity tranche but riskier than the senior tranche. It absorbs losses only

after the equity tranche has been completely wiped out. The senior tranche is the least risky as it

is the last to absorb losses. It is protected by both the equity and mezzanine tranches which

absorb losses first. Therefore, from the riskiest to the least risky, the order is: Equity tranche,

Mezzanine tranche, Senior tranche.

Q.141 Which of the following best explains how credit rating agencies contributed to the
financial crisis of 2007/2008?

A. Credit rating agencies colluded to give major financial institutions “undue” health.

B. Rating agencies did not sound the alarm bells early enough after detecting the
deteriorating financial stability of the economy's major players.

C. Rating agencies underestimated the risks inherent in asset-backed securities and

CDOs.

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 D. Rating agencies overestimated the risks borne by asset-backed securities and CDOs,
leading to low demand for those financial instruments.

The correct answer is C.

Credit rating agencies played a significant role in the financial crisis of 2007/2008 by

underestimating the risks associated with asset-backed securities (ABSs) and collateralized debt

obligations (CDOs). These financial instruments were complex and relatively new to the market,

and the agencies lacked the necessary experience and expertise to accurately assess their risk

levels. ABSs and CDOs were primarily composed of subprime mortgages, which are loans given

to borrowers with poor credit histories. The rating agencies, however, rated these securities as

highly safe investments, leading investors to believe that they were low-risk. When the housing

market collapsed, the value of these securities plummeted, causing significant losses for

investors. This underestimation of risk by the rating agencies was a major factor that contributed

to the severity of the financial crisis.

Choice A is incorrect because while there were criticisms of the relationships between credit

rating agencies and the institutions they rated, there is no substantial evidence to suggest that

there was collusion to give major financial institutions 'undue' health. The primary issue was not

collusion but rather a failure to accurately assess and communicate the risks associated with

certain financial instruments, particularly asset-backed securities and collateralized debt

obligations.

Choice B is incorrect because the issue was not that rating agencies failed to sound the alarm

early enough after detecting the deteriorating financial stability of the economy's major players.

In fact, many rating agencies did not recognize the severity of the risks associated with asset-

backed securities and collateralized debt obligations until it was too late.

Choice D is incorrect because rating agencies actually underestimated the risks, which led to

high demand for these securities. When the true risk level of these securities became apparent,

their value plummeted, leading to significant losses for investors.

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Q.143 In the 2008 financial crisis, agency costs were a significant factor that contributed to the
unfolding of events. Which of the following scenarios best represents an instance of agency cost
during the 2008 financial crisis?

A. Prospective homeowners lying about their income and mortgage security.

B. A lack of government regulation of the property market in the period leading to the
crisis.

C. Rating agencies were paid for their ratings and would overlook potential financial
pitfalls so as to impress their clients.

D. Failure by Congress and the Senate to crack down on relaxed lending even after a few
leaders brought the matter to the floors of the two houses.

The correct answer is C.

Agency costs are incurred when there is a conflict of interest between two parties, often due to

misaligned incentives. In the context of the 2008 financial crisis, rating agencies were paid by

their clients to rate financial instruments. These agencies had a vested interest in providing

favorable ratings to keep their clients happy and secure future business. This led to a situation

where they overlooked potential financial risks, thereby underestimating the inherent risks in

Asset-Backed Securities (ABSs) and Collateralized Debt Obligations (CDOs). By maximizing the

number of AAA-rated tranches, the agencies misled investors into purchasing overvalued and

overrated instruments. This is a clear example of agency cost, where the rating agencies pursued

their selfish interests at the expense of the investors.

Choice A is incorrect because the homeowners were not acting as agents for another party,

and their actions were driven by personal gain rather than a conflict of interest.

Choice B is incorrect because the government's failure to regulate the property market does

not represent a conflict of interest between two parties, but rather a failure of oversight and

regulation.

Choice D is incorrect. The actions of Congress and the Senate represent a failure of oversight

and regulation, not a conflict of interest between two parties.

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Q.145 A financial institution has recently bundled subprime mortgages into three distinct
tranches: the senior, mezzanine, and equity tranches. In terms of risk and return, how would you
characterize the senior tranche in comparison to the other two tranches?

A. Lower return than the equity tranche but higher return than the mezzanine tranche.

B. Higher return than the equity tranche but lower return than the mezzanine tranche.

C. Lower risk than both the equity and mezzanine tranches.

D. Lower risk than the mezzanine tranche but higher risk than the equity tranche.

The correct answer is C.

The senior tranche of an asset-backed security, such as a mortgage-backed security, is designed

to have the lowest risk among all tranches. This is because the senior tranche has the highest

priority in the payment structure, meaning that it is the first to receive payments from the

underlying assets. This priority payment structure significantly reduces the risk of loss for the

senior tranche, making it less risky than both the equity and mezzanine tranches. However, this

lower risk also means that the senior tranche typically offers lower returns compared to the

other tranches. This is because in finance, there is a direct relationship between risk and return -

the higher the risk, the higher the potential return, and vice versa. Therefore, the senior tranche,

with its lower risk, also has lower returns compared to the equity and mezzanine tranches.

Choice A is incorrect because it incorrectly states that the senior tranche has a higher return

than the mezzanine tranche. In reality, the senior tranche, due to its lower risk, offers lower

returns than both the mezzanine and equity tranches. The mezzanine tranche, being riskier than

the senior tranche but less risky than the equity tranche, offers returns that are higher than the

senior tranche but lower than the equity tranche.

Choice B is incorrect because it incorrectly states that the senior tranche has a higher return

than the equity tranche. The equity tranche is the riskiest of the three tranches and therefore

offers the highest potential return. The senior tranche, on the other hand, is the least risky and

therefore offers the lowest return. This is in line with the fundamental principle in finance that

higher risk is associated with higher potential return.

Choice D is incorrect because it incorrectly states that the senior tranche has a higher risk

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than the equity tranche. The equity tranche is the riskiest of the three tranches, as it is the last

to receive payments from the underlying assets and is therefore the most exposed to potential

losses. The senior tranche, on the other hand, is the least risky as it is the first to receive

payments, thereby significantly reducing its exposure to potential losses.

Things to Remember

In an asset-backed security, the tranches are structured in a way that the senior

tranche has the lowest risk and therefore the lowest return. This is due to the priority

payment structure, where the senior tranche is the first to receive payments from the

underlying assets.

The mezzanine tranche is riskier than the senior tranche but less risky than the equity

tranche. Therefore, it offers returns that are higher than the senior tranche but lower

than the equity tranche.

The equity tranche is the riskiest of the three tranches and therefore offers the highest

potential return. This is because it is the last to receive payments from the underlying

assets and is therefore the most exposed to potential losses.

The relationship between risk and return is a fundamental principle in finance. The

higher the risk, the higher the potential return, and vice versa.

Q.146 In the lending market, different categories of borrowers are identified based on their
financial standing, credit history, and ability to repay loans. One such category is referred to as
'Ninja borrowers'. Which of the following best describes the characteristics of Ninja borrowers?

A. Borrowers who have not been subjected to vetting or any other attempt aimed at
ascertaining their credentials.

B. Borrowers who have a near-zero credit history.

C. Borrowers with assets insufficient to secure the mortgages awarded.

D. Borrowers with no income, no job, and no assets.

The correct answer is D.

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Ninja borrowers are individuals who have no income, no job, and no assets. The term 'Ninja' is

an acronym derived from the first letters of the words 'No Income, No Job, No Assets'. These

borrowers are considered high-risk because they lack a stable source of income and assets that

could be used as collateral for the loan. During the 2007/2008 financial crisis, the number of

Ninja borrowers increased significantly as lending standards were relaxed. This allowed

individuals who would typically be barred from borrowing due to their high-risk status to secure

loans. However, these loans were often defaulted on after the first few months of the repayment

schedule, contributing to the financial crisis.

Choice A is incorrect. While it's true that Ninja borrowers may not have been subjected to

rigorous vetting, this is not the defining characteristic of such borrowers. The term 'Ninja' stands

for 'No income, No job, and No assets', which means these borrowers lack a stable source of

income, employment and significant assets.

Choice B is incorrect. Having a near-zero credit history does not necessarily qualify one as a

Ninja borrower. Although it's possible for Ninja borrowers to have minimal or no credit history,

the key distinguishing feature of these individuals is their lack of income, job and assets.

Choice C is incorrect. Insufficient assets to secure mortgages might be a characteristic of

some Ninja borrowers but it's not what primarily defines them. The main attributes are no

income, no job and no assets regardless of whether they are seeking mortgages or other types of

loans.

Things to Remember

Ninja borrowers are considered high-risk borrowers due to their lack of income, job,

and assets. This makes it difficult for them to secure loans from traditional lenders.

The term 'Ninja' is an acronym that stands for 'No Income, No Job or Assets'. It

originated from the subprime mortgage crisis in the United States.

Loans given to Ninja borrowers are often referred to as 'Ninja Loans'. These types of

loans were common during the housing bubble in the early 2000s.

Ninja Loans are typically unsecured because they lack collateral. This increases the

risk for lenders as there is no asset to seize if a borrower defaults on their loan

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 payments.

Credit risk management involves assessing and managing risks associated with lending

money or extending credit. It includes identifying potential risks, measuring those

risks, and developing strategies to mitigate them.

Q.147 Capital M bank is involved in a process where it originates mortgages, securitizes them
into asset-backed securities, and then invests in these securities. This process involves a series of
financial and investment activities. Which of the following terms term best describes this
scenario in the context of financial markets and banking operations?

A. Regulatory arbitrage

B. Securitization

C. Irrational exuberance

D. Agency costs

The correct answer is A.

Regulatory arbitrage is a practice where firms capitalize on loopholes in regulatory systems in

order to circumvent unfavorable regulations. This is often done by structuring transactions in a

way that presents lower regulatory capital requirements. In the context of the question, Capital

M bank is involved in regulatory arbitrage. The bank originates mortgages and then securitizes

these mortgages to create asset-backed securities. It then invests in these securities. The

motivation behind such a strategy is largely accounting-driven. By doing so, the bank can

potentially achieve specific accounting advantages, although the specifics of these advantages

are beyond the scope of this discussion. Regulatory arbitrage can be risky as it can lead to a lack

of transparency and increased systemic risk.

Choice B is incorrect. The bank is not just securitizing the mortgages, but also investing in the

securities it creates. Therefore, the term 'securitization' does not fully capture the scenario

described in the question.

Choice C is incorrect. In the context of the question, there is no indication that the bank's

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actions are driven by irrational exuberance.

Choice D is incorrect. There is no evidence to suggest that the bank's strategy of originating,

securitizing, and investing in mortgages is resulting in agency costs.

Things to Remember

Securitization is a financial process that involves pooling various types of contractual

debt and selling their related cash flows to third-party investors as securities. It allows

banks to remove assets from their balance sheets and obtain fresh capital.

Irrational exuberance refers to a situation where the optimism of investors about the

market or an asset exceeds its fundamental value. It is often associated with asset price

bubbles.

Agency costs arise from the conflict of interest between stakeholders in an

organization, such as between shareholders and management. These costs can result

from actions taken by agents that may not align with the best interests of the

principals.

Q.150 One of the factors associated with the Credit Crisis of 2007 is the relaxed lending
standards of lenders. Lenders began to attract new entrants in the housing market by offering
adjustable-rate mortgages (ARMs) and teaser rates. Teaser rates are defined as:

A. The mortgage rates that are mentioned on the mortgage's promotional material.

B. The very low rates that are offered for the first few years before the rates increased
significantly in later years.

C. The fixed mortgage rate that is calculated as LIBOR plus specific basis points.

D. The fixed rate at which a defaulting borrower can restructure the mortgage.

The correct answer is B.

A teaser rate is a promotional interest rate offered by mortgage lenders for a specified initial

period, typically the first few years of the mortgage term. This rate is significantly lower than the

standard mortgage rate, making the mortgage appear more attractive to potential borrowers.

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The purpose of a teaser rate is to entice borrowers into a mortgage by offering a low initial rate,

which then increases significantly after the initial period. This practice was prevalent in the

years leading up to the Credit Crisis of 2007. Lenders offered these low initial rates to attract

new entrants into the housing market. However, when these rates increased after the initial

period, many borrowers were unable to meet their mortgage obligations, leading to a surge in

defaults and contributing to the Credit Crisis.

Choice A is incorrect. While promotional materials may mention the teaser rates, this

definition is not comprehensive enough. Teaser rates are specifically low introductory rates that

increase significantly after a certain period, which is not captured in this choice.

Choice C is incorrect. This choice describes a type of adjustable-rate mortgage where the

interest rate is tied to a benchmark rate (like LIBOR) plus some fixed points. However, it does

not accurately define 'teaser rates' which are initially low and then increase significantly after an

introductory period.

Choice D is incorrect. This option refers to the restructuring of mortgages for defaulting

borrowers, which has no relation to 'teaser rates'. Teaser rates are used as an initial offering to

attract new borrowers and do not pertain to default or restructuring scenarios.

Things to Remember

'Teaser rates' are typically offered by lenders to attract new borrowers. These rates are

usually lower than the standard interest rate and last for a limited period, often the

first few years of the mortgage.

After the teaser rate period ends, the interest rate on an adjustable-rate mortgage

(ARM) will adjust periodically based on market conditions. This could lead to

significantly higher payments for the borrower.

The Credit Crisis of 2007 was largely triggered by such lending practices where

borrowers were initially attracted by low teaser rates but were unable to meet their

payment obligations when rates increased.

Understanding how different types of mortgages work, including ARMs and those with

teaser rates, is crucial in risk management. It helps in assessing potential risks

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 associated with these lending products.

The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which

major global banks lend to one another in the international interbank market for short-

term loans. It's not directly related to 'teaser rates', but it's often used as a reference

point for adjustable-rate mortgages.

Q.151 In mortgage lending in certain states within the United States, there exists a feature that
permits the lender to only seize the borrower's home, which is financed through a mortgage, in
the event of a default, but not any of the borrower's other assets. Which of the following options
best describes this feature?

A. Teaser rate

B. NINJA borrowing

C. Nonrecourse mortgage

D. Securitization

The correct answer is C.

In several states of the United States, a nonrecourse mortgage is a type of loan where the lender

can only seize the borrower's home, which is financed through the mortgage, in the event of a

default. The lender cannot go after the borrower's other assets. This essentially provides the

borrower with an American-style put option on their home. If the housing prices fall, the

borrower can sell their home to the lender for the principal outstanding on the mortgage. This

feature of nonrecourse mortgages provides a level of protection for borrowers, as it limits the

lender's recourse to the collateralized property only.

Choice A is incorrect. A Teaser Rate is an initial low interest rate on a loan or mortgage that's

temporarily lower than the eventual standard rate. It does not relate to the seizure of assets in

case of default.

Choice B is incorrect. NINJA borrowing refers to a type of lending where the borrower does

not need to provide proof of income, job, or assets (No Income, No Job or Assets). This term

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doesn't describe the feature where only the borrower's home can be seized in case of default.

Choice D is incorrect. Securitization involves pooling various types of contractual debt such as

residential mortgages and selling their related cash flows to third-party investors as securities. It

doesn't refer specifically to any feature that allows lenders to seize only certain assets in case of

default.

Things to Remember

A Teaser Rate is an initial interest rate charged on a mortgage that is artificially low.

It increases after a certain period, usually 2-3 years.

NINJA borrowing stands for No Income, No Job or Assets. It's a type of risky lending

practice where the borrower does not have to disclose income, job status, or assets to

get the loan.

A Nonrecourse mortgage is a type of home loan where the lender can only seize the

property in case of default and cannot go after other assets owned by the borrower.

This feature protects borrowers from losing more than their homes in case they default

on their loans.

Securitization is a financial process that involves pooling various types of contractual

debt such as residential mortgages, commercial mortgages, auto loans, or credit card

debt obligations and selling them as bonds, pass-through securities, or Collateralized

Mortgage Obligation (CMO), to various investors.

Some states like California and Arizona are known as non-recourse states because

lenders can only seize properties tied to the mortgage but not any other assets in case

of default by borrowers.

The opposite of a nonrecourse mortgage is a recourse mortgage where lenders can go

after other assets owned by borrowers if sale proceeds from seized property do not

cover the outstanding loan balance.

Q.152 In a recent seminar for graduate trainees at a leading Chinese investment bank, the

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facilitator initiated a discussion on the concept of 'Securitization.' Several trainees offered their
interpretations of the term. Which of the following explanations provided by the trainees aligns
most accurately with the concept of securitization?

A. Trainee A: The process of securing a mortgage with a security or collateral which the
lender can use in the case of default.

B. Trainee B: The financial asset created from the cash flows of financial assets, including
mortgages, loans, auto loans, and bonds.

C. Trainee C: The process of pooling mortgage loans into a pool, dividing the pool into
smaller units, and selling them as financial assets to investors in order to transfer risk.

D. Trainee D: The process of setting up a bankruptcy-remote entity with the sole purpose
of acquiring asset-backed securities (ABSs).

The correct answer is C.

Securitization is the process of pooling various mortgage loans into a larger pool, dividing this

pool into smaller units, and then selling these units as financial assets to investors. This process

is primarily carried out by large banks and financial institutions with the primary objective of

transferring the risk associated with these loans to the market. By doing so, these institutions

are able to mitigate the potential losses that could arise from defaults on these loans.

Furthermore, the process of securitization allows these institutions to free up capital that can be

used for issuing more loans, thereby facilitating a continuous cycle of lending and securitization.

Choice A is incorrect. Securitization is not merely the process of securing a mortgage with a

security or collateral which the lender can use in case of default. This explanation confuses

securitization with the concept of collateralized loans, where an asset (like a house in case of a

mortgage) serves as security for repayment.

Choice B is incorrect. While it's true that securitized financial assets are created from cash

flows of underlying assets such as mortgages, loans, auto loans and bonds, this explanation

misses out on key aspects like pooling these assets and selling them to investors to transfer risk.

Choice D is incorrect. The creation of bankruptcy-remote entities (Special Purpose Vehicles or

SPVs) is indeed part of the securitization process but this explanation omits other crucial steps

such as pooling various types of contractual debt and selling their related cash flows to third

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party investors.

Things to Remember

Securitization is a financial process that involves pooling various types of contractual

debt such as residential mortgages, commercial mortgages, auto loans or credit card

debt obligations and selling their related cash flows to third party investors as

securities.

The entity that issues the securitized assets is known as the issuer. The issuer creates a

Special Purpose Vehicle (SPV) or Special Purpose Entity (SPE) for each securitization

deal.

The SPV which holds these assets serves as collateral in case of default. This process

ensures that the investors have a claim on all future cash flows generated by the

pooled assets.

Securitization helps in risk transfer from an originator to multiple investors. It also

provides liquidity to markets and reduces risk through diversification.

Asset-Backed Securities (ABS), Mortgage-Backed Securities (MBS), Collateralized Debt

Obligations (CDOs) are some examples of instruments created through securitization.

Q.153 In Asset-Backed Securities (ABSs), the originator of the mortgage creates these securities
from the cash flow of its mortgages and loans. These ABSs are then sold to Special Purpose
Vehicles (SPVs) that distribute the cash flows of the ABS to different tranches. Generally, each
security is divided into three tranches: the senior tranche, the mezzanine tranche, and the equity
tranche. Considering the risk and return characteristics of these tranches, which tranche is
expected to yield the highest returns and which tranche is likely to be assigned the highest
rating?

A. Senior tranches should receive the highest expected returns and highest ratings.

B. Equity tranches should receive the highest ratings, and senior tranches should have
the highest expected returns.

C. Senior tranches should receive the highest ratings, and equity tranches should have
the highest expected returns.

D. Equity tranches should receive the highest ratings, and mezzanine tranches should

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 have the highest expected returns.

The correct answer is C.

In the structure of Asset-Backed Securities (ABSs), the senior tranche is typically assigned the

highest rating, while the equity tranche is expected to yield the highest returns. This is due to

the risk-return trade-off inherent in these securities. The senior tranche is considered the least

risky among the three tranches. It is the first to receive cash flows from the underlying assets

and is therefore less exposed to default risk. As a result, it is typically assigned the highest credit

rating, often AAA. On the other hand, the equity tranche is the most risky. It is the last to receive

cash flows and bears the first losses if the underlying assets default. Therefore, it is often

unrated. However, to compensate for this higher risk, the equity tranche offers the highest

expected returns. This structure allows investors to choose the tranche that best suits their risk

tolerance and return expectations.

Choice A is incorrect. While it is true that senior tranches are assigned the highest ratings due

to their lower risk, they do not yield the highest returns. The higher returns are typically

associated with higher risk, which in this case would be the equity tranches.

Choice B is incorrect. Equity tranches do not receive the highest ratings; instead, they have

the highest expected returns due to their higher risk profile. Senior tranches, on the other hand,

receive high ratings because of their lower risk but do not offer high expected returns.

Choice D is incorrect. Equity tranches cannot receive both the highest ratings and provide

high expected returns as there's a trade-off between risk and return in financial securities.

Mezzanine tranches also don't yield the highest return; instead, they fall between senior and

equity tranche in terms of both risks and return.

Things to Remember

The senior tranche is the most secure part of an ABS, and it is typically assigned the

highest credit rating. This tranche has the first claim on the cash flows from the

underlying assets.

The mezzanine tranche carries a higher risk than the senior tranche but lower than

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equity tranches. It offers higher yields to compensate for this increased risk.

The equity or junior tranche carries the highest risk as it absorbs initial losses before

any other tranches. Therefore, it offers potentially high returns to compensate for this

high level of risk. It's usually unrated

Special Purpose Vehicles (SPVs) are legal entities created solely for holding these

securities and distributing cash flows to investors in different tranches. They play a

crucial role in securitization transactions by isolating financial risks.

Asset-Backed Securities (ABSs) are financial securities backed by a loan, lease, or

receivables against assets other than real estate and mortgage-backed securities. They

can be based on various types of loans like auto loans, credit card debt, etc.

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Q.288 A novice risk analyst is tasked with summarizing the key events that precipitated the
financial crisis of 2007 – 2009. As part of their task, they delve into the role of subprime
mortgages as a factor influencing the crisis. Which of the following statements correctly
characterizes the impact or role of these mortgages in the period leading up to the financial
crisis?

A. Rigid documentation requirements for prospective borrowers led to a liquidity crisis in

real estate due to a shortage of eligible borrowers.

B. The loan-to-value ratios for new subprime borrowers consistently declined in the years
prior to the crisis.

C. The majority of mortgage brokers received their compensation based on the

performance of the subprime mortgages they originated, and had to refund large
commissions as these loans started to default.

D. Many subprime mortgages experienced a sharp increase in interest rates after an

initial period of low rates, causing some borrowers to fall into default.

The correct answer is D.

In the years leading up to the financial crisis, subprime mortgages often utilized adjustable-rate
mortgage (ARM) structures. These mortgages typically offered borrowers a low introductory
interest rate for a limited period, known as the teaser rate. However, once this initial period
ended, the interest rates on these mortgages would reset to significantly higher levels. As a
result, many borrowers who initially qualified for the mortgage based on the lower teaser rate
found themselves unable to afford the higher payments when the rates reset. This led to a rise in
defaults among subprime borrowers, contributing to the overall crisis.

A is incorrect. Strict documentation requirements were not a leading cause of the financial

crisis. In fact, the opposite was true, as there were instances of lax documentation requirements

that allowed unqualified borrowers to obtain subprime mortgages.

B is incorrect. In the years preceding the crisis, loan-to-value ratios for subprime borrowers

actually tended to increase, meaning borrowers were taking on larger loans relative to the value

of their homes. This increased their risk of default when home prices began to decline.

C is incorrect. While mortgage brokers did receive commissions for originating subprime

mortgages, their compensation structure was typically not directly tied to the performance of the

loans. Instead, brokers often earned commissions upfront without being held financially

accountable for loan defaults. This misalignment of incentives contributed to the proliferation of

risky subprime lending.

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Q.291 In the period leading up to the 2007/2008 financial crisis, lenders had to devise strategies
to align their interests with those of investors in asset-backed securities. This was crucial to
ensure the sustainability of the financial markets and to prevent the occurrence of a crisis. One
of the strategies involved the lenders maintaining exposure to the performance of the loan pool.
Which of the following options best describes how lenders maintained their exposure?

A. Retaining a portion of the risk by holding onto the first-loss tranche of the securitized
assets.

B. Engaging in recourse lending, where they agreed to buy back non-performing loans.

C. Implementing interest rate swaps to maintain an indirect exposure to the underlying

assets.

D. Employing a "vertical slice" approach, where they maintained ownership of a

proportional share across all tranches, thus bearing a portion of any potential losses.

The correct answer is A.

In the lead-up to the 2007/2008 financial crisis, one strategy lenders used to maintain exposure

to the performance of the loan pool was by retaining the "first-loss" or equity tranche of the

securitized assets. This was the most junior tranche in a securitization, and was the first to

absorb losses from defaults on the underlying loans. By holding onto this tranche, lenders kept

"skin in the game" and aligned their interests with those of other investors. This was meant to

incentivize responsible lending since lenders would be directly impacted by the performance of

the loans.

B is incorrect. While it's true that some loan agreements might have included a provision

allowing for the buyback of non-performing loans, this isn't typically how lenders maintained

exposure to the loan pool in the context of asset-backed securities. In fact, having to buy back

non-performing loans might represent a failure of the securitization process, which is intended to

transfer risk away from the lender.

C is incorrect. Interest rate swaps are a type of financial derivative used to hedge interest rate

risk, not to maintain exposure to the performance of a loan pool. While interest rate swaps might

be used in the broader context of managing a securitized portfolio, they wouldn't directly align

the interests of lenders and investors in the way the question implies.

D is incorrect. While a "vertical slice" approach could indeed represent a way for lenders to

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maintain exposure to the performance of a securitized loan pool, this approach wasn't the

primary method used leading up to the 2007/2008 financial crisis. In a "vertical slice" approach,

the lender maintains an interest in each tranche of the securitized assets, from most senior to

most junior, hence bearing some of the risk if the loans default. However, the most common

practice was to retain the first-loss or equity tranche, which is considered the riskiest part of the

securitization and the first to absorb any losses.

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Q.293 Which of the following best describes the concept of misaligned incentives in the outcome
of the 2007/2008 financial crisis?

A. Mortgage originators concentrated on high-quality loans, while investment banks were

interested in creating low-risk asset-backed securities.

B. Credit rating agencies, despite being paid by issuers, consistently provided

conservative and accurate ratings for asset-backed securities.

C. Mortgage originators prioritized issuing a high volume of loans, while credit rating
agencies were incentivized to provide optimistic ratings for these loans to retain business
from the issuers.

D. Investors were solely reliant on their own comprehensive risk analysis, dismissing
ratings provided by credit rating agencies.

The correct answer is C.

Mortgage originators were incentivized to issue as many loans as possible, often overlooking

creditworthiness. Credit rating agencies, paid by the issuers of securities (the banks), had an

incentive to rate securities more optimistically to retain their business.

A is incorrect as it presents a more ideal scenario rather than the actual situation. Leading up

to the crisis, mortgage originators often overlooked loan quality in favor of volume, and

investment banks created asset-backed securities from these loans, which were often risky.

D is incorrect because it suggests an ideal role for credit rating agencies that was not evident

in the period leading to the crisis. In reality, there was a conflict of interest because credit rating

agencies were paid by the issuers of the securities they were rating, leading to over-optimistic

ratings.

B is incorrect because, during the period leading to the crisis, many investors were heavily

reliant on ratings provided by credit rating agencies and often did not perform extensive

independent risk assessments of the securities they were buying. The complexity of these

products also made such assessments difficult for many investors.

Q.294 In the midst of the housing boom in 2005, Ann, who had a less than stellar credit rating,
sought to ride the wave and purchase her own home. Despite her credit rating suggesting a

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higher-than-average probability of defaulting on loan repayments, the local bank decided to
approve her mortgage application. This was a common practice during this period, and it
ultimately contributed significantly to the 2008/2009 financial crisis. Which of the following
terms most accurately describes this type of lending practice?

A. Unsecured mortgage lending

B. Transactional lending.

C. Premium mortgage lending.

D. Subprime mortgage lending.

The correct answer is D.

Subprime mortgage lending refers to the practice of lending to borrowers who are considered a

higher credit risk, often due to a lower credit rating, as in Ann's case. During the housing boom

in the years leading up to the 2008/2009 financial crisis, there was a significant increase in

subprime lending, which eventually contributed to the severity of the crisis.

Option A is incorrect. "Unsecured mortgage lending" is not a recognized term in the context of

mortgage lending. Mortgages are by definition, secured loans, with the purchased property

serving as collateral.

Option B is incorrect. "Transactional lending" refers more broadly to any lending activity

where a lender provides a loan to a borrower for a specific purpose. It doesn't specifically refer

to the risk associated with the borrower.

Option C is incorrect. "Premium mortgage lending" suggests that the loans are offered to high-

quality or 'prime' borrowers, which is the opposite of Ann's situation.

Things to Remember

Subprime mortgage lending refers to the practice of offering loans to borrowers who

have low credit scores and a high risk of defaulting on their payments.

These loans often come with higher interest rates than prime loans to compensate for

the increased risk of default. Subprime loans frequently feature adjustable-rate

mortgages (ARMs), where the initial interest rate is typically low, but it can increase

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 significantly after a certain period.

The subprime lending market played a major role in the 2008 financial crisis. An

abundance of these risky loans, bundled into securities and sold off to investors, led to

widespread defaults.

Subprime borrowers may also face additional loan terms that can be financially
burdensome, such as high loan origination fees or prepayment penalties.

Q.413 Which of the following statements best explains how banks created collateralized debt
obligations in the build-up to the 2007-2008 financial meltdown?

A. Forming a diversified portfolio of cash-flow generating assets, pooling them together,

and then repackaging the asset pool into discrete tranches that could be sold to
investors.

B. Pooling together cash-generating assets, and then repackaging the asset pool into
discrete slices that could be sold to investors.

C. Forming a diversified portfolio of mortgage products, pooling them together, and then
repackaging the asset pool into discrete tranches that could be sold to investors.

D. Pooling together a well-diversified portfolio of mortgages, and then slicing the pool
into three tranches that could be sold to investors.

The correct answer is A.

The process of creating collateralized debt obligations (CDOs) involved forming a diversified

portfolio of cash-flow generating assets. These assets could include a variety of financial

instruments such as mortgages, corporate bonds, and different types of loans. The next step in

the process was to pool these assets together. This pooling created a large asset pool that could

then be divided or 'tranched' into discrete sections. Each tranche represented a different level of

risk and return, allowing investors to choose the tranche that best matched their risk tolerance

and investment objectives. The tranches were then sold to investors, effectively moving the risk

of the underlying assets off the bank's balance sheet and onto the investors who purchased the

tranches. This process played a significant role in the build-up to the 2007-2008 financial crisis

as the underlying quality of the assets in the CDOs was often poorly understood or

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misrepresented.

Choice B is incorrect. While this choice does mention the pooling and repackaging of cash-

generating assets, it fails to mention the crucial step of forming a diversified portfolio. This

diversification is key in spreading risk and making the CDOs more attractive to investors.

Choice C is incorrect. This choice incorrectly specifies that only mortgage products were used

in the creation of CDOs. In reality, a variety of cash-flow generating assets were used, not just

mortgages.

Choice D is incorrect. Similar to Choice C, this option incorrectly implies that only mortgages

were used in creating these financial instruments. Additionally, it inaccurately suggests that

there are always three tranches created from the asset pool which isn't necessarily true as the

number can vary based on several factors.

Things to Remember

The process of creating CDOs involves pooling together cash-flow generating assets,

which are then divided into different tranches based on their risk and return profiles.

These tranches are then sold to investors.

Tranching is a method used in finance to create different investment classes for the

securities of a company, based on the riskiness of their cash flows. The senior tranche

has the least risk because it has first claim on the cash flows from the underlying

assets.

CDOs can be composed of various types of debt including mortgages (residential or

commercial), corporate bonds, auto loans or credit card debt obligations.

The diversification in CDOs comes from having a wide variety of underlying assets.

However, during the financial crisis, many CDOs were heavily concentrated in high-risk

mortgage products which led to significant losses when housing prices fell.

Investors need to understand that higher yielding tranches also come with higher risks.

During economic downturns these tranches can suffer severe losses.

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Q.414 In 2005, a certain American investment firm decided to invest in an assortment of
collateralized debt obligations (CDOs). To protect itself, the firm also purchased a credit default
swap. This implied that:

A. The firm would pay a periodic fixed fee and in turn receive a contingent payment in
the event of credit default.

B. The firm was 100% protected against credit default, and therefore cash inflows from
the CDOs were guaranteed.

C. The firm would pay a fixed fee at the onset of the contract and in turn receive a
contingent payment in the event of credit default.

D. The firm would pay a periodic fixed fee and, in turn, receive a contingent payment at
the end of the CDO contract.

The correct answer is A.

The firm would pay a periodic fixed fee and in turn receive a contingent payment in the event of

credit default. This is the fundamental principle of a credit default swap (CDS). A CDS is a

financial derivative that allows an investor to 'swap' their credit risk with that of another

investor. In this case, the investment firm is paying a fixed fee to another party (usually a bank or

another financial institution), who agrees to compensate them if a certain credit event, such as a

default, occurs. This is akin to an insurance policy, where the firm pays a premium to protect

itself against a potential financial loss. The periodic fixed fee is the 'premium' that the firm pays

for this protection, and the contingent payment is the 'claim' that the firm would receive if the

credit event occurs. This strategy allows the firm to mitigate the credit risk associated with its

investment in CDOs.

Choice B is incorrect. While the firm did use a credit default swap as a risk mitigation strategy,

it does not imply that the firm was 100% protected against credit default. Credit default swaps

can help manage and mitigate risk, but they do not provide absolute protection against defaults.

Furthermore, cash inflows from CDOs are never guaranteed as they depend on the underlying

assets' performance.

Choice C is incorrect. In a typical credit default swap contract, the buyer does not pay a fixed

fee at the onset of the contract. Instead, they pay periodic premiums over the life of the contract

in return for a contingent payment in case of a credit event such as default.

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Choice D is incorrect. The statement is misleading because it suggests that contingent

payments are only received at the end of CDO contracts which isn't accurate. In reality,

contingent payments under credit default swaps are triggered by specific credit events like

defaults or downgrades and aren't necessarily tied to when CDO contracts end.

Things to Remember

A Credit Default Swap (CDS) is a financial derivative that allows an investor to 'swap'

their credit risk with that of another investor. It is essentially a form of insurance

against the default risk of a bond or loan.

In a CDS, the buyer makes periodic payments to the seller and in return receives a

payoff if an underlying financial instrument defaults.

Collateralized Debt Obligations (CDOs) are complex financial instruments that pool

together cash flow-generating assets and repackages this asset pool into discrete

tranches, which can then be sold to investors. The risk level associated with CDOs

varies greatly.

The use of both CDOs and CDS indicates that the firm was attempting to diversify its

portfolio while also hedging against potential credit risks. This shows an active

approach towards risk management.

However, it's important to note that while these strategies can mitigate some risks,

they do not provide 100% protection against credit default. The effectiveness of these

strategies depends on various factors such as market conditions and the specific terms

of the contracts involved.

Q.415 During the period preceding the financial crisis of 2007-2008, banks experienced an
increase in the maturity mismatch on their balance sheets. This situation, where the maturity of
a bank's assets does not align with that of its liabilities, led to a significant problem:

A. Exposure to massive cash withdrawals at short notice.

B. Exposure to credit default risk.

C. Exposure to funding liquidity risk.

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 D. Unprecedented legal confrontations with regulatory authorities.

The correct answer is C.

A maturity mismatch is a situation where the maturity of a bank's assets does not align with that

of its liabilities. This imbalance can be either positive or negative. In the period leading up to the

2007-2008 financial crisis, banks experienced an increase in maturity mismatches due to the use

of off-balance-sheet vehicles. These vehicles involved investing in long-term assets while

borrowing with short-term paper. This strategy exposed banks to funding liquidity risk. Funding

liquidity risk is the risk that a firm will not be able to meet efficiently both expected and

unexpected current and future cash flow and collateral needs without affecting either daily

operations or the financial condition of the firm. In other words, it is the risk that a firm may not

be able to settle its debts as they come due. This was the main problem that arose due to an

increase in the maturity mismatch on the balance sheet of banks during the period leading up to

the financial meltdown.

Choice A is incorrect. While massive cash withdrawals at short notice can indeed pose a

problem for banks, it was not the primary issue that emerged as a result of the increased

maturity mismatch in the banking sector during the period preceding the financial crisis of 2007-

2008. The main problem was related to funding liquidity risk, which refers to a bank's ability to

meet its liabilities as they come due.

Choice B is incorrect. Credit default risk refers to the risk that borrowers will default on their

loan repayments. Although this can be an issue for banks, it was not directly linked with the

increased maturity mismatch experienced by banks during this period.

Choice D is incorrect. Legal confrontations with regulatory authorities were not primarily

caused by maturity mismatches on bank balance sheets. These confrontations are more likely to

arise from non-compliance with regulatory standards and requirements rather than from issues

related to asset-liability management.

Things to Remember

Maturity mismatch refers to the situation where a bank's assets (loans) have a longer

maturity than its liabilities (deposits). This can lead to liquidity problems if depositors

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 demand their money back before the loans are repaid.

Funding liquidity risk is the risk that a firm will not be able to meet efficiently both

expected and unexpected current and future cash flow and collateral needs without

affecting either daily operations or the financial condition of the firm.

Credit default risk, also known as counterparty credit risk, is the possibility that one

party in a financial transaction will fail to fulfill their obligation, causing financial loss

for the other party. This is different from funding liquidity risk which arises due to

maturity mismatch.

Massive cash withdrawals at short notice can exacerbate funding liquidity risks caused

by maturity mismatches. However, this is more related to run-on-the-bank scenarios

rather than being directly linked with maturity mismatches.

Legal confrontations with regulatory authorities are usually consequences of non-

compliance with banking regulations rather than direct outcomes of increased maturity

mismatch in banks' balance sheets.

Q.416 Which of the following statements best explains why securitized products were especially
popular among money market and pension funds?

A. They allowed such institutions to hold assets that they were previously prevented from
holding by regulatory requirements.

B. They were more profitable compared to corporate bonds.

C. Securitization enabled the funds to hold assets without disclosing such information in
the balance sheet.

D. Securitized products were considered less risky compared to traditional cash-

generating assets such as corporate bonds.

The correct answer is A.

Securitization was particularly popular among money market and pension funds because it

enabled them to invest in financial vehicles that they would normally not hold due to regulatory

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constraints. For example, they might have been allowed to invest only in AAA-rated fixed-income

securities. Through securitization, they could now invest in the AAA-rated senior tranche of a

portfolio consisting of BBB-rated securities. This allowed these institutions to diversify their

portfolios and potentially achieve higher returns without violating regulatory requirements.

Choice B is incorrect. While securitized products can sometimes offer higher yields than

corporate bonds, this is not always the case. It can depend on a wide range of factors including

the credit quality of the underlying assets, the structure of the securitized product, the interest

rate environment, and market conditions. Therefore, stating that they are more profitable as a

rule is not accurate.

Choice C is incorrect. Securitization does not allow funds to hold assets without disclosing

such information in their balance sheet. In fact, regulatory requirements mandate that all

financial institutions disclose their holdings in a transparent manner. Therefore, this cannot be

the primary reason for these institutions' preference for securitized products.

Choice D is incorrect. Although securitized products can be structured to reduce risk through

diversification and tranching, they are not inherently less risky than traditional cash-generating

assets like corporate bonds. The perceived riskiness of an asset depends on various factors such

as credit quality and market volatility which may vary across different types of securities.

Things to Remember

Securitization is the process of transforming illiquid assets into securities. This process

allows financial institutions to remove risky assets from their balance sheets.

Securitized products are often favored by money market and pension funds due to their

ability to diversify risk and generate steady cash flows.

The primary reason for these institutions' preference for securitized products is not

necessarily profitability, but rather the ability to hold a diversified portfolio of assets

that can generate stable returns over time.

Regulatory requirements may prevent certain institutions from holding specific types of

assets. However, through securitization, these restrictions can be circumvented as the

underlying asset is transformed into a security that can be held by the institution.

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 While securitized products may appear less risky compared to traditional cash-

generating assets such as corporate bonds, it's important to note that they also carry

risks such as credit risk and liquidity risk. Therefore, understanding these risks is

crucial when investing in securitized products.

Q.417 During the period leading up to the 2007-2008 financial crisis, credit rating agencies were
frequently observed to provide overly positive ratings and forecasts for structured financial
assets. This practice was seen as problematic and indicative of a certain agency problem. What
was the specific agency problem that was at play in this scenario?

A. Structured financial assets initially had very low demand, and credit rating agencies
wanted to push that demand up.

B. Credit rating agencies were under considerable pressure from the federal government
to issue favorable ratings that would stir the economy and lead to growth.

C. Credit rating agencies depended heavily on sophisticated mathematical models, which

failed to accurately predict the risk of these structured financial assets.

D. Credit rating agencies would get paid by originators of structured financial assets for
their work, and also made more money than they would otherwise have made from rating
corporate bonds.

The correct answer is D.

The agency problem in question is one where the interests of the principal (the originator of the

structured financial assets) and the agent (the credit rating agency) are not aligned. In an ideal

scenario, a credit rating agency should provide an unbiased and accurate assessment of the

financial assets. However, in this case, the agencies were being paid by the originators for their

services. This created a conflict of interest, as the agencies had a financial incentive to issue

favorable ratings to increase their chances of being rehired by the originators. This is a classic

example of an agency problem, where the agent acts in their own best interest at the expense of

the principal. The fact that the agencies were making more money from rating structured

financial assets than they would have from rating corporate bonds further exacerbated this

problem.

Choice A is incorrect. While it's true that credit rating agencies may have an interest in

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promoting certain financial assets, this does not directly constitute an agency problem. An

agency problem arises when there is a conflict of interest between the agent (in this case, the

credit rating agency) and the principal (the investors relying on the ratings). The demand for

structured financial assets does not inherently create such a conflict.

Choice B is incorrect. This statement suggests that government pressure was a primary factor

influencing credit rating agencies' overly positive ratings. However, while government policies

can influence market conditions and indirectly affect ratings, they do not represent an inherent

agency problem within the structure of credit rating agencies themselves.

Choice C is incorrect. Although mathematical modeling could potentially lead to flawed

ratings, this would not qualify as an agency problem. In addition, there's little evidence to

suggest that credit rating agencies were deploying flawed models. They could asess the proper

rating correctly but chose to go with exaggerated ratings in an attempt to appease issuers and

continue making money.

Things to Remember

Credit rating agencies play a crucial role in the financial markets by providing an

independent evaluation and assessment of the creditworthiness of companies and their

financial instruments.

The agency problem arises when there is a conflict of interest between the needs or

interests of the principal (investors) and agent (credit rating agencies). In this case, it

refers to credit rating agencies potentially giving overly positive ratings due to their

own vested interests.

Structured financial assets are complex instruments that derive their value from

underlying assets. They were at the heart of the 2007-2008 financial crisis.

Understanding these assets requires a deep understanding of both the underlying asset

and how changes in market conditions might affect them.

It's important to understand that credit ratings are just one tool investors can use when

assessing whether to invest in a particular security. Investors should also conduct their

own due diligence and not rely solely on these ratings.

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Q.418 While the financial meltdown of 2007-2008 started in the US, it spread fast to other
countries leading to worldwide economic turmoil. Which of the following statements best
describes why the crisis spread so fast?

A. Banks in the US had been the main financiers of a multitude of smaller foreign banks,
and therefore when the financiers suffered liquidity problems, the smaller banks just
couldn’t obtain funding.

B. Global investors had overestimated the stability of emerging markets, which led to
widespread panic and sell-offs when the U.S. financial crisis began.

C. The US entered into a recession, and their demand for exports fell, and therefore
many countries experienced a major decline in exports, triggering a worldwide recession.

D. Foreign banks in Asia, Europe and other parts of the world had bought collateralized
US debt and therefore when defaults rose, these banks lost a lot of money and
consequently global lending, even among banks themselves, took a downward spiral.

The correct answer is D.

The global financial crisis of 2007-2008 was primarily caused by the collapse of the subprime

mortgage market in the United States. This collapse led to a significant increase in defaults on

mortgage loans, which had a direct impact on the value of collateralized debt obligations (CDOs)

held by banks around the world. These CDOs were essentially bundles of mortgage loans that

had been sold to investors, including many foreign banks. When the defaults on the underlying

mortgage loans increased, the value of these CDOs plummeted, leading to significant losses for

the banks that held them. This, in turn, led to a decrease in global lending, as banks became

more cautious in the face of these losses. This decrease in lending had a significant impact on

global economic activity, leading to a worldwide recession. This explanation is supported by the

fact that the crisis spread rapidly to other parts of the world, including Asia and Europe, where

many banks had purchased these collateralized US debt.

Choice A is incorrect. While it's true that many US banks were significant financiers of smaller

foreign banks, this was not the primary reason for the swift global spread of the financial crisis.

The crisis was not primarily a liquidity problem but rather a solvency issue related to defaults on

collateralized debt.

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Choice B is incorrect. The global spread of the crisis was not primarily due to overestimation

of the stability of emerging markets. While investor sentiment and behavior can contribute to

financial instability, the main driver of the global financial crisis was widespread exposure to the

U.S. housing market through complex financial instruments like mortgage-backed securities and

collateralized debt obligations.

Choice C is incorrect. The decline in US demand for exports did contribute to economic

downturns in many countries, but it was not the primary cause of the rapid global spread of the

financial crisis. The main driver was more directly related to financial market linkages and

exposure to toxic assets.

Things to Remember

The global financial crisis of 2007-2008 was primarily caused by the bursting of the

United States housing bubble, which led to high default rates on "subprime" and

adjustable rate mortgages (ARM).

Securitization is a process in which certain types of assets are pooled so that they can

be repackaged into interest-bearing securities. The risk associated with these assets is

then divided among many investors.

Liquidity problems occur when a firm or individual does not have enough liquid assets

(cash or assets that can be quickly converted into cash) to meet their short-term

obligations.

A recession is a significant decline in economic activity spread across the economy,

lasting more than a few months. It is visible in real GDP, real income, employment,

industrial production and wholesale-retail sales.

Collateralized debt obligations (CDOs) are financial tools that banks use to repackage

individual loans into a product sold to investors on the secondary market. These

packages consist of auto loans, credit card debt, mortgages or corporate debt.

Q.419 In finance, liquidity is a critical concept that pertains to the ease with which an asset can
be converted into cash without affecting its market price. Two key types of liquidity that are

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often discussed in this context are funding liquidity and market liquidity. These terms, while
related, refer to different aspects of financial liquidity:

A. Funding liquidity describes the ease with which expert investors can obtain funding
from financiers by using purchased assets as collateral, whereas market liquidity
describes the ease with which investors can raise money by selling their assets.

B. Funding liquidity refers to the total value of an investor's assets that can be quickly
converted into cash, while market liquidity refers to the overall ability of the market to
absorb the sale of large assets without significant price fluctuations.

C. Funding liquidity refers to the ability of an investor to raise funds for in-house
operations while market liquidity refers to the ability to raise funds for the specific
investment projects themselves.

D. Funding liquidity describes the ability of an investor to raise short-term debt while
market liquidity is the ability to raise long term capital.

The correct answer is A.

Funding liquidity and market liquidity are two distinct concepts in finance. Funding liquidity

refers to the ease with which investors can obtain funding from financiers by using purchased

assets as collateral. This essentially means how easily an investor can borrow money against

their assets. On the other hand, market liquidity refers to the ease with which investors can raise

money by selling their assets. This means how quickly and easily an asset can be sold without

significantly affecting its price.

B, C, and D are incorrect as per the explanation above.

Things to Remember

Funding liquidity and market liquidity are two different aspects of financial liquidity.

Understanding the difference between them is crucial for risk management and

investment decisions.

Funding liquidity refers to the ease with which a borrower can obtain funds. It is often

associated with the ability to meet obligations as they come due without incurring

unacceptable losses.

Market liquidity, on the other hand, refers to the ease with which an asset or security

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 can be bought or sold in a market without affecting its price. High market liquidity

means that transactions can be conducted quickly and with minimal impact on prices.

Liquidity risk arises from situations where a party interested in trading an asset cannot

do it because nobody in the market wants to trade for that asset. This can be assessed

by looking at trade volume patterns, bid-ask spreads, or price movements.

In times of financial stress, both funding and market liquidity can dry up, leading to a

'liquidity crunch'. This was evident during the 2008 global financial crisis when banks

were unwilling or unable to lend to each other due to fears over their own funding

positions.

Q.420 Which of the following statements best describes why interbank market interest rates rose
sharply relative to the Treasury bill rate during and in the aftermath of the 2007-2008 financial
crisis?

A. The Federal Reserve Bank increased the rate of interest at which it was willing to lend
to banks.

B. Losses incurred by banks combined with uncertainty on the part of structured

investment vehicles meant that there was less money available for lending to other
parties.

C. Interbank market interest rates were internationally linked while the Treasury bill rate
was largely local.

D. As demand for mortgages worsened, profit streams for banks took a hit, meaning that
there was less money for lending to other banks.

The correct answer is B.

As it became apparent that off-balance-sheet investment vehicles, conduits, and other structured

investments would most likely require the injection of more capital than initially anticipated,

each bank’s uncertainty about its own funding needs took a sharp increase. Furthermore, the

possibility of a bank turning to its “colleagues” for cash boosts after a minor shock became more

uncertain, in part because the other banks most likely had similar financial issues. As a result,

the interbank interest rate, LIBOR, took a sharper spike compared to the Treasury bill rate.

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Choice A is incorrect. While the Federal Reserve Bank does have the power to influence

interest rates, it was not the primary reason for the sharp rise in interbank market interest rates

relative to the Treasury bill rate during the financial crisis of 2007-2008. The Fed's actions are

typically aimed at stabilizing and controlling inflation, not directly influencing interbank lending

rates.

Choice C is incorrect. Although interbank market interest rates can be influenced by

international factors, this was not a significant factor during this period. The Treasury bill rate is

indeed largely local but its relationship with interbank market interest rates isn't primarily

determined by their geographical scope.

Choice D is incorrect. While it's true that banks' profit streams were affected as demand for

mortgages worsened, this did not directly lead to a sharp rise in interbank market interest rates

relative to the Treasury bill rate. This choice incorrectly assumes a direct causal relationship

between mortgage demand and interbank lending rates.

Things to Remember

The interbank market is a system where banks lend to and borrow from each other.

This system is crucial for the smooth functioning of the banking sector.

During a financial crisis, banks may become wary of lending to each other due to

increased risk of default. This can lead to an increase in interbank market interest

rates.

The Treasury bill rate is determined by the U.S. government and is considered risk-

free. It does not directly reflect the conditions in the banking sector or interbank

market.

Structured investment vehicles (SIVs) are entities set up by financial institutions that

invest in long-term assets financed by short-term debt. The failure of SIVs during the

2007-2008 financial crisis led to significant losses for banks.

The Federal Reserve Bank can influence interbank lending rates through its monetary

policy tools, such as setting the discount rate at which it lends money to commercial

banks.

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Q.422 The main vulnerability of the repo market in the time period leading up to the financial
crisis had much to do with the fact that:

A. The market was highly susceptible to fluctuations in foreign exchange rates, which
created additional risk for international institutional investors.

B. The market was large and unregulated, and many repo agreements were backed by
securitized mortgages as collateral.

C. The market was dominated by a small number of large financial institutions, creating a
lack of competition and skewed pricing dynamics.

D. Most repo agreements were tied to specific equity indices, creating a direct link
between the stock market's performance and the stability of the repo market.

The correct answer is B.

The repo market was indeed large and unregulated, and many repo agreements were backed by

securitized mortgages as collateral. Repo agreements are transactions where a large-scale

depositor or institutional investor puts money in a bank for a short term, usually overnight. The

bank agrees to some “overnight interest” on the deposited amount. The deposit is secured by an

asset of roughly the same value. Between 2000 and 2007, the repo market accounted for up to

30% of the U.S. GDP. Despite the large scale of such transactions, the market was largely

unregulated, making liabilities among dealers and brokers grow sharply. A popular view is that

the repo market collapsed when cash depositors became concerned about the quality of the

collateral backing repos and consequently withdrew their funding. This vulnerability was a

significant factor that contributed to the financial crisis.

Choice A is incorrect. The repo market is generally not directly affected by fluctuations in

foreign exchange rates. Repos are short-term borrowing agreements, typically collateralized with

government securities, not foreign currencies.

Choice C is incorrect. While it's true that large financial institutions play a significant role in

the repo market, the primary vulnerability was not a lack of competition or skewed pricing. The

key issue leading up to the financial crisis was the lack of regulation and the use of risky

collateral, like securitized mortgages.

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Choice D is incorrect. Repo agreements are typically collateralized by safer assets like

government securities, not equities. Therefore, the stability of the repo market is not directly

tied to the performance of specific equity indices.

Things to Remember

The repo market is a form of short-term borrowing for dealers in government

securities.

Repo agreements are essentially collateralized loans, where the borrower sells a

security to an investor with an agreement to repurchase it at a higher price at a later

date.

The primary vulnerability of the repo market during the financial crisis was that many

of these agreements were backed by securitized mortgages as collateral. When the

housing market collapsed, these securities lost their value, leading to significant losses

for investors.

Another vulnerability was that this market was largely unregulated. This lack of

oversight allowed risky practices to go unchecked and contributed to the instability of

the financial system during this period.

While liquidity can be an issue in some markets, it was not considered a primary

vulnerability in this case. The repo market is typically highly liquid due to its short-term

nature and large volume of transactions.

Q.423 In September 2008, Lehman Brothers Holdings Inc. famously filed for Chapter 11
bankruptcy protection. What was the immediate effect of the move?

A. Other large institutional investors also followed suit.

B. The Federal Reserve moved with speed to inject capital into the firm.

C. It triggered a crisis of confidence in mortgage-backed securities.

D. It led to a run on the reserve primary money market funds after one large fund “broke
the buck” .

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The correct answer is D.

The bankruptcy of Lehman Brothers Holdings Inc. led to a run on the reserve primary money

market funds after one large fund “broke the buck”. Lehman Brothers was a significant player in

the financial markets, with a substantial investment in mortgage-backed securities (MBSs). By

2007, the firm had amassed an MBS portfolio worth over $85 billion. However, in the first half of

2008, Lehman Brothers suffered massive losses due to a decline in the value of its commercial

real estate assets. This led to the firm filing for bankruptcy in September 2008 after reporting a

loss of $3.5 billion and a 42% plunge in its stock value.

Following the bankruptcy filing, there was a run on the reserve primary money market funds

when one large fund “broke the buck”. This term refers to a situation where the net asset value

of a money market fund falls below $1, indicating a loss of principal. This occurred when the

money market fund announced losses of $785 million in the commercial papers of Lehman

Brothers. The announcement led to a loss of investor confidence in money market funds,

triggering large-scale withdrawals from these funds. This was the immediate effect of Lehman

Brothers' bankruptcy declaration.

Choice A is incorrect. The bankruptcy of Lehman Brothers did not lead to other large

institutional investors declaring bankruptcy as well. While the event did cause a significant shock

in the financial markets, it did not directly result in a domino effect of bankruptcies among other

large institutions.

Choice B is incorrect. The Federal Reserve did not inject capital into Lehman Brothers after its

bankruptcy declaration. In fact, the Federal Reserve and other government authorities made a

conscious decision not to bail out Lehman Brothers, which was a significant departure from their

previous actions during the financial crisis.

Choice C is incorrect. Although the collapse of Lehman Brothers contributed to an overall loss

of confidence in financial markets, it was not specifically tied to a crisis of confidence in

mortgage-backed securities. The issues with mortgage-backed securities were already well

underway by the time Lehman declared bankruptcy.

Things to Remember

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 The bankruptcy of Lehman Brothers was a major event in the global financial crisis of

2008. It is important to understand the role that large financial institutions play in the

stability of global markets.

"Breaking the buck" refers to a situation where a money market fund's net asset value

(NAV) falls below $1 per share, which can trigger panic among investors and lead to a

run on funds. This happened with the Reserve Primary Fund following Lehman's

bankruptcy.

Mortgage-backed securities (MBS) are complex financial instruments that played a

significant role in the 2008 financial crisis. The collapse of Lehman Brothers led to

widespread doubt about their value and safety, triggering a crisis of confidence.

The Federal Reserve often steps in during times of financial instability to provide

liquidity and prevent further market disruption. However, it did not inject capital into

Lehman Brothers before its bankruptcy.

Lehman's bankruptcy did not immediately cause other large institutional investors to

declare bankruptcy, but it did contribute significantly to an environment of fear and

uncertainty within the global finance industry.

Q.424 The period leading up to the financial crisis of 2007-2009 was characterized by historically
low interest rates in the United States. This was a significant factor in the economic landscape of
the time. What was the primary reason for the low interest rates?

A. Low savings rates in the U.S.

B. High savings rates in the U.S.

C. Low demand for credit in the country

D. Accommodative monetary policy

The correct answer is D.

In the years leading up to the financial crisis, the U.S. government had been striving to reduce

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interest rates so as to increase lending rates and grow the economy. This is known as an

accommodative monetary policy. The goal of such a policy is to make money cheaper to borrow,

thereby encouraging spending and investment. This can stimulate economic growth, but it can

also lead to inflation and asset bubbles if not managed carefully. In the case of the 2007-2009

financial crisis, the low interest rates contributed to a housing bubble, as people were able to

borrow money cheaply to buy homes. When the bubble burst, it led to a severe economic

downturn.

Choice A is incorrect. Low savings rates in the U.S. would not necessarily lead to low interest

rates. In fact, it could potentially lead to higher interest rates as banks would need to incentivize

individuals to save more.

Choice B is incorrect. High savings rates in the U.S. could potentially lead to lower interest

rates due to an increased supply of loanable funds, but this was not the primary reason for low

interest rates during this period.

Choice C is incorrect. Low demand for credit in the country could theoretically result in lower

interest rates as lenders compete for borrowers, but during this period there was actually a high

demand for credit due to factors such as easy lending standards and a booming housing market.

Things to Remember

The Federal Reserve controls the short-term interest rate in the United States, which

can influence longer-term rates.

Monetary policy is used to control inflation and stabilize the economy. An

accommodative monetary policy, as mentioned in option (d), often involves lowering

interest rates to stimulate economic growth.

High savings rates can lead to lower interest rates as banks have more funds available

for lending. However, this was not the primary reason for low interest rates during this

period.

Low demand for credit could potentially lead to lower interest rates as lenders compete

for borrowers. However, during the period leading up to the financial crisis of 2007-

2009, there was actually a high demand for credit due to factors such as easy access to

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 loans and a booming housing market.

Q.426 In the face of competition from money market funds and junk bonds towards the end of
the 20th century, the traditional banking model became less profitable and partly contributed to
the emergence of the shadow banking system. This system consisted of a set of institutions
which:

A. Were not only illegal but also engaged in money laundering.

B. Were allowed to invest only in short-term financial assets such as T-bills.

C. Were non-depository, and not subject to banking regulations.

D. Were non-depository, and subject to more stringent regulations compared to banks.

The correct answer is C.

The shadow banking system is a network of non-depository financial institutions – investment

banks, structured investment vehicles, conduits, hedge funds, and other non-bank financial

entities that serve as intermediaries to channel savings into investments. Due to the fact that

they do not take deposits, they escape a myriad of limits and laws imposed on traditional banks.

Before the crisis, shadow institutions used to borrow via short-term, liquid markets and then

used the funds to invest in longer-term illiquid assets. When the housing bubble burst, lenders

and investors started to avoid taking on the credit risk, and short-term borrowing dried up

almost overnight, making these institutions unable to raise money for their own operations.

Compounding their woes was the inability to get funds from their collapsing investments in

securitized assets, which were now considered “toxic” in investment terms.

A is incorrect because the shadow banking system, while operating outside of traditional

banking regulations, is not exclusively made up of institutions engaged in illegal activities or

money laundering. While the lack of regulation can make these institutions more susceptible to

such practices, it is incorrect and oversimplified to categorize the entire shadow banking system

in this way.

B is incorrect because while some institutions in the shadow banking system, like money

market funds, may invest in short-term financial assets such as Treasury bills (T-bills), it is not a

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defining characteristic. The shadow banking system is broad and diverse, with different entities

focused on various types of assets and investments.

D is incorrect because, unlike traditional banks, the institutions in the shadow banking system

typically do not operate under the oversight of central banks. Although these institutions may

have certain operational flexibilities, they are not directly regulated by central banks, which is

one of the reasons they fall under the umbrella of 'shadow banking'.

Q.428 The financial crisis that began in 2007 had a significant impact on global markets. The
month of August 2007 is often referred to as the first 'panic' month, marking the onset of the
crisis. This period was characterized by a specific event that signaled the beginning of the crisis.
Which of the following events best describes the event that characterized this "panic" month?

A. An unprecedented spike in firms declaring bankruptcy.

B. The sudden implosion of the market for asset-backed commercial papers.

C. A historic scale of federal bail-outs dispensed to prominent U.S. institutions.

D. A sudden, sharp contraction in the foreign exchange market.

The correct answer is B.

The collapse of the market for asset-backed commercial papers was the defining event of August

2007, marking the onset of the financial crisis. Prior to the crisis, large institutions frequently

funded long-term investments through commercial papers, which are short-term loans, often

unsecured. Many investors in securitized assets obtained their funding in this manner, using

mortgages and other receivables as collateral. When a commercial paper matured, the

borrowing institution would typically refinance it with another one, often by mobilizing repeat

lenders. Conceptually, an asset-backed commercial paper program would experience a 'run' if

lenders were unwilling to refinance it upon maturity. Starting from August 7, 2008, the

frequency of such runs dramatically increased, and many programs found themselves unable to

refinance.

Choice A is incorrect. While numerous firms did declare bankruptcy during the financial crisis,

the high frequency of bankruptcy declarations did not specifically characterize the onset in

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August 2007. The significant rise in bankruptcy filings followed the initial liquidity crisis and

continued throughout the crisis period.

Choice C is incorrect. While there were indeed record federal bail-outs during the financial

crisis, these were responses to the crisis that took place after the initial 'panic' month of August

2007. Major bail-outs such as that of AIG or the creation of the Troubled Asset Relief Program

(TARP) took place in late 2008.

Choice D is incorrect. The financial crisis was not marked by a contraction in the foreign

exchange market, especially not in August 2007. The financial crisis primarily impacted the

credit market and had more of an indirect impact on the foreign exchange market.

Things to Remember

The financial crisis of 2007-2008, also known as the Global Financial Crisis (GFC), was

a severe worldwide economic crisis. It was the most serious financial crisis since the

Great Depression (1929).

Asset-backed commercial paper (ABCP) is a form of commercial paper that is

collateralized by other financial assets. ABCP is typically a short-term instrument that

matures between 1 and 270 days from issuance and is typically issued by a bank or

other financial institution.

The collapse of the market for asset-backed commercial papers was one of the key

events that marked the onset of this crisis. This led to significant liquidity issues in

various markets.

Bankruptcy refers to a legal process involving a person or business that is unable to

repay their outstanding debts. The bankruptcy process begins with a petition filed by

the debtor, which is most common, or on behalf of creditors, which is less common.

Federal bailouts are measures taken by government bodies to provide financial

assistance or take over companies in danger of bankruptcy due to an economic

downturn or bad management decisions.

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Q.432 During periods of economic downturn, governments often weigh the option of bailing out
financial institutions to prevent a complete collapse of the economy. Nonetheless, this approach
is not without its pitfalls. What is the principal challenge associated with the bailout of
institutions during economic crises?

A. It necessitates a significant write-off of toxic assets.

B. It amplifies the issue of adverse selection in financial markets.

C. It may instigate widespread public dissent or potentially disastrous protests.

D. It exacerbates the problem of moral hazard within financial institutions.

The correct answer is D.

The primary issue with bailing out institutions during economic crises is that it increases the

problem of moral hazard. Moral hazard refers to a situation where an entity is more likely to take

risks because the costs that could result will not be borne by the entity taking the risk. In the

context of financial institutions, if they are aware that they will be bailed out in times of crisis,

they may engage in riskier behavior, knowing that they will not bear the full brunt of the

negative consequences of their actions. This can lead to a cycle of risky behavior and bailouts,

which can have detrimental effects on the economy. The government's decision to bail out

certain institutions during the 2007-2009 financial crisis, such as AIG, Freddie Mac, and Fannie

Mae, may have inadvertently encouraged this kind of behavior.

Choice A is incorrect. While a significant write-off of assets can indeed be a consequence of a

financial crisis, it is not specifically a problem associated with the bailout of institutions. The

write-off of assets often occurs before a bailout as a way to clear bad debt off the balance sheets.

Choice B is incorrect. Adverse selection refers to a situation where one party in a transaction

has more information than the other party, leading to an imbalance in the transaction. Although

adverse selection can be an issue in financial markets, it's not directly related or increased by

government bailouts during economic crises.

Choice C is incorrect. Public discontent or demonstrations can indeed occur as a result of

government bailouts; however, these are secondary issues and are more related to public

perception and social factors rather than being inherent drawbacks of bailout itself.

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Things to Remember

The term 'bailout' refers to financial support or rescue to a failing business or economy,

typically by government bodies. It is often seen as a last resort measure during

economic crises.

Moral hazard is a situation in which one party gets involved in risky situations knowing

that it is protected against the risk and the other party will incur the cost. In context of

bailouts, it refers to the risk that providing financial assistance to distressed

institutions may encourage irresponsible behavior in future.

Adverse selection refers to a situation where sellers have information that buyers do

not have, or vice versa, about some aspect of product quality. In terms of bailout, it

could mean financially weak institutions being more likely to seek aid thus increasing

overall risk.

Public discontent and demonstrations can occur if citizens perceive bailouts as unfair

use of taxpayer money or favoring certain institutions over others.

Asset write-off occurs when an asset's value becomes zero due to non-recovery. This

can be a consequence of bailout if assets are overvalued during rescue operations.

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Q.433 Which one of the following characteristics is common in financial crises witnessed since
the Great Depression?

A. They have invariably led to the implementation of a gold standard.

B. They are characterized by scarcity or even absence of liquidity in financial markets.

C. They are invariably accompanied by a global rise in commodity prices.

D. They inevitably lead to a dissolution of the financial market's infrastructure.

The correct answer is B.

Financial crises are often characterized by a lack of liquidity in markets. Liquidity refers to the

ease with which an asset, or security, can be converted into ready cash without affecting its

market price. In a financial crisis, firms and financial institutions may face difficulties in

financing or refinancing their operations due to a sudden and severe shortage of liquidity in the

market. This can lead to a vicious cycle of asset sell-offs, falling asset prices, and further liquidity

shortages, exacerbating the crisis. The Global Financial Crisis of 2007-2008 is a prime example

of a liquidity crisis, where the sudden collapse of liquidity in the subprime mortgage market led

to a broader financial meltdown.

A is incorrect.While some financial crises have sparked discussions about monetary policy and

the nature of money itself, they have not invariably led to the implementation of a gold standard.

For example, the 2007-2008 financial crisis led to quantitative easing and other unconventional

monetary policies rather than a return to the gold standard.

C is incorrect. Financial crises do not invariably lead to a global rise in commodity prices. In

fact, crises can lead to a decrease in commodity prices due to reduced demand, especially if the

crisis leads to a slowdown in economic activity.

D is incorrect. Financial crises do not inevitably lead to a dissolution of the financial market's

infrastructure. Although crises often expose weaknesses in financial markets and lead to changes

and reforms, they do not typically result in the complete dissolution of existing financial market

structures.

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Q.435 The second panic period of the 2007-2009 financial crisis was triggered by:

A. A total collapse of the commercial paper market.

B. A big number of bankruptcy filings among financial conglomerates.

C. The declaration of bankruptcy by Lehman Brothers.

D. The collapse of the shadow banking system.

The correct answer is C.

The second panic period of the 2007-2009 financial crisis was indeed triggered by the

declaration of bankruptcy by Lehman Brothers. This event occurred in September 2008. Lehman

Brothers was the largest underwriter of securitized assets at the time. When news of their

bankruptcy filing broke, investors quickly lost confidence in financial institutions. This loss of

confidence triggered what is known as 'runs', where many investors attempted to salvage their

money by withdrawing it from these institutions. This mass withdrawal of funds further

exacerbated the financial crisis, leading to the second panic period.

Choice A is incorrect. The total collapse of the commercial paper market was a characteristic

of the first panic period, not the second. This event had already occurred and thus could not have

triggered the second panic period.

Choice B is incorrect. While there were indeed numerous bankruptcy filings among financial

conglomerates during this time, these were more a result of the crisis rather than a trigger for it.

Furthermore, these bankruptcies occurred throughout both panic periods and therefore cannot

be specifically linked to triggering the second one.

Choice D is incorrect. The collapse of shadow banking system was an outcome that spanned

across both periods but it wasn't a specific trigger for either one of them. It's more accurate to

say that it was an effect rather than cause of these panics.

Things to Remember

The 2007-2009 financial crisis was a global banking crisis that led to the Great

Recession. It was triggered by a complex interplay of valuation and liquidity problems

in the United States banking system.

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The first panic period was characterized by the collapse of short-term funding markets,

particularly commercial papers. Commercial paper is an unsecured, short-term debt

instrument issued by corporations, typically for financing accounts receivable and

inventories.

The second panic period was triggered by different events which were more severe

than the first one. This includes major bankruptcy filings among financial

conglomerates and other significant events in the financial sector.

Lehman Brothers' declaration of bankruptcy on September 15, 2008 marked a

significant turning point in the crisis. It resulted in a large drop in market confidence

and led to significant disruptions in financial markets.

The shadow banking system also played a crucial role during this crisis. Shadow banks

are non-bank financial intermediaries that provide services similar to traditional

commercial banks but outside normal banking regulations.

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 Reading 11: GARP Code of Conduct

Q.266 Jack Oboyo, FRM, is a manager at Somalia's largest investment bank, managing a portfolio
that focuses on stocks from Somalia's logistics and transportation sector. Oboyo has some close
contacts at the securities exchange commission of Somalia, providing him with non-public sales
and profit-related data of firms that file their reports with the commission before being
distributed to the general public. Oboyo uses this information to advise his employer on potential
investment-grade stocks. It is common and legal in Somalia to obtain material non-public
information or insider information related to public limited companies. Jack Oboyo's practice:

A. Has not violated the GARP's Code of conduct.

B. Has violated the Code related to confidentiality.

C. Has violated the Code related to professional integrity and ethical conduct.

D. Has violated the Code related to conflict of interest.

The correct answer is C.

According to the code of professional integrity and ethical conduct, GARP members should
endeavor to be mindful of cultural differences regarding ethical behavior and customs, and to
avoid any actions that are, or may have the appearance of being unethical according to local
customs. If there appears to be a conflict or overlap of standards, the GARP member should
always seek to apply the higher standard.

Q.267 David Bremen, FRM, has recently joined one of Austria's largest jet engine manufacturers
as a Chief Risk Officer. Previously, Bremen had worked for 35 years in risk hedging and risk
management in the banking sector. Based on his vast experience, David recommends his team
hedge all of its foreign currency-denominated sales. He does not, however, state that this is just
his opinion. He believes that most foreign currencies are most volatile at the end of every
financial year. David's recommendation:

A. Has not violated the Code.

B. Has violated the Code because he has not clearly disclosed his expertise and
knowledge concerning risk assessment.

C. Has violated the Code because he failed to distinguish between fact and opinion in the
presentation of his recommendation.

D. Has violated the Code because he cannot delegate his team to perform hedging
transactions.

The correct answer is C.

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David Bremen has indeed violated the Code of Conduct because he failed to distinguish between

fact and opinion in the presentation of his recommendation. The Code of Conduct, which is a set

of ethical and professional guidelines that financial professionals are expected to adhere to,

mandates that members should clearly differentiate between facts and their personal opinions

when presenting recommendations. In this case, David Bremen made a recommendation to

hedge all foreign currency-denominated sales without explicitly stating that this was based on

his personal opinion and experience. This could potentially mislead his team into believing that

this recommendation is a universally accepted fact in the field of risk management, rather than a

strategy that is influenced by David's personal beliefs and experiences. Furthermore, the Code of

Conduct also requires members to perform reasonable due diligence before making any

recommendations. By basing his recommendation solely on his personal experience, without

providing any empirical evidence or conducting a thorough analysis of the current market

conditions, David Bremen has failed to meet this requirement. Therefore, his actions are in

violation of the Code of Conduct.

Choice A is incorrect. David has indeed violated the Code of Conduct, but not for the reasons

stated in this option. His violation lies in his failure to distinguish between fact and opinion, not

in his decision to hedge all foreign currency-denominated sales.

Choice B is incorrect. The Code of Conduct does not require David to disclose his expertise

and knowledge concerning risk assessment explicitly. His violation pertains to the presentation

of his recommendation as a fact rather than an opinion.

Choice D is incorrect. The Code does not prohibit delegation of tasks such as hedging

transactions. David's violation stems from his failure to differentiate between facts and opinions

when presenting recommendations, not from delegating tasks to his team.

Q.268 Muhammad Aslam, FRM, is a risk analyst at Financial Angels, a venture capitalist firm
that invests in tech and health science-related startups and small-medium enterprises (SMEs).
After careful risk assessments, the manager has approved Aslam to initiate the first round of
funding for seven startups. Aslam's wife co-founded one of the selected startups. Without
disclosing this information, Aslam proceeded with the manager's recommendation. Determine if
Muhammad Aslam's actions are in violation of a Code.

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 A. No, because the recommendation of investing in seven startups, including the startup
cofounded by Muhammad Aslam's wife, came from senior manager.

B. No, because the startup is founded by Muhammad Aslam's wife, not him. Therefore he
can invest without disclosing this information.

C. Yes, as the Code requires a member to disclose to their employer the matters that
could impair his independence and objectivity.

D. Yes, because Muhammad Aslam acted on the manager's recommendation without

performing self-analysis.

The correct answer is C.

Muhammad Aslam's actions are indeed in violation of the Code. The Code in question here is the

Global Association of Risk Professionals' (GARP) Code of Conduct, which stipulates that members

must disclose all matters that could potentially impair their independence and objectivity. In this

case, Aslam's wife's co-founding of one of the startups selected for funding could be seen as a

conflict of interest, which could impair Aslam's ability to objectively assess the risk and potential

of the startup. By failing to disclose this information to his employer, Aslam has violated this

Code. It is important to note that the Code is in place to ensure that all members act with the

highest level of integrity, and any violation of the Code could lead to disciplinary action.

Choice A is incorrect. Even though the recommendation came from a senior manager, it does

not absolve Muhammad Aslam of his responsibility to disclose any potential conflicts of interest.

The Code requires all members to disclose such matters regardless of who made the initial

recommendation.

Choice B is incorrect. The fact that the startup was founded by Muhammad Aslam's wife and

not him does not exempt him from disclosing this information. His wife's involvement in the

startup could potentially impair his independence and objectivity, which he is required to

maintain as per the Code.

Choice D is incorrect. While performing self-analysis before acting on recommendations is

good practice, it isn't necessarily a requirement under the Code in this context. The main issue

here lies with Muhammad Aslam's failure to disclose his wife's involvement in one of the

startups, which could potentially affect his objectivity and independence.

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Q.270 Which of the following GARP's Code of conduct requires a member to be diligent about not
overstating the accuracy or certainty of results or conclusions and clearly disclosing the limits of
their expertise and knowledge in areas of risk assessment?

A. Professional integrity and ethical conduct.

B. Fundamental responsibilities.

C. General accepted principles.

D. Conflict of interest.

The correct answer is B.

The section outlines the basic responsibilities that members of the GARP are expected to uphold

in their professional conduct. These responsibilities include compliance with all applicable laws,

rules, and regulations, including the Code itself. Members are also expected not to delegate or

outsource these responsibilities to others. Furthermore, this section specifically requires

members to be diligent about not overstating the accuracy or certainty of results or conclusions,

and to clearly disclose the limits of their expertise and knowledge in areas of risk assessment.

This requirement is crucial in maintaining the integrity and credibility of the risk management

profession, as it ensures that risk assessments are conducted with the highest level of accuracy

and transparency.

Choice A is incorrect. While professional integrity and ethical conduct are indeed important

aspects of the GARP's Code of Conduct, they do not specifically address the requirement to

exercise diligence in not overstating the accuracy or certainty of results or conclusions, nor do

they require members to disclose their limits of expertise and knowledge in areas of risk

assessment. This section primarily focuses on honesty, fairness, and respect for others.

Choice C is incorrect. The general accepted principles section does not specifically deal with

the requirement mentioned in the question either. It mainly outlines broad principles that all

members should adhere to such as maintaining a high standard of professional competence and

treating everyone fairly regardless of their race, religion, gender etc.

Choice D is incorrect. Conflict of interest refers to situations where a member's personal

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interests may interfere with their professional duties or judgement. It does not cover

requirements related to accuracy or disclosure about one's expertise and knowledge.

Q.271 Jack Simpson, FRM, and John Philip, FRM, are two risk analysts and team members at
Dark Well Insurance Company. Simpson recently found out that John Philip shares the company's
confidential risk-related data with his friend, Louis Keynes, an investment manager at Verizon
Investment Company that regularly trades Dark Well's stocks. Keynes also uses this information
for personal gains. Which of the following action is in line with GARP's Code of conduct?

A. Simpson should bar John Philip from using the FRM designation as he shares the
company's confidential information with outsiders.

B. Simpson should ignore John Philip's action, as Simpson is not personally involved in
sharing the company's confidential information.

C. Simpson should not take any action against John Philip because the company's
confidential information is being used by an outsider for personal gains only.

D. Simpson should immediately report John Philip's activities to their employer.

The correct answer is D.

The Global Association of Risk Professionals (GARP) has a strict Code of Conduct that its

members are expected to adhere to. This Code of Conduct includes a requirement that members

should not commit any act that compromises the integrity of GARP or the FRM designation. This

includes not knowingly participating or assisting in any violation of the Code or laws.

Furthermore, members are not allowed to make use of their employer or client's confidential

information for inappropriate purposes or personal use. In this scenario, John Philip is clearly

violating these rules by sharing confidential information with an outsider for personal gain. As a

fellow FRM and member of GARP, Jack Simpson has a responsibility to report this violation to

their employer. By doing so, he would be upholding the integrity of the FRM designation and the

GARP Code of Conduct. Ignoring the violation or trying to punish John Philip himself would not

be in line with the GARP Code of Conduct. Therefore, the correct action for Simpson to take is to

report John Philip's activities to their employer.

Choice A is incorrect. Simpson, despite being an FRM holder, does not have the authority to

bar John Philip from using the FRM designation. This power lies with the Global Association of

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Risk Professionals (GARP), which can revoke a member's designation if they are found to be in

violation of its Code of Conduct.

Choice B is incorrect. According to GARP's Code of Conduct, all members are obligated to

uphold professional integrity and report any unethical behavior they witness within their

organization. Ignoring such actions would be a breach of this code.

Choice C is incorrect. The fact that the company's confidential information is being used by an

outsider for personal gains only does not absolve John Philip from his misconduct. As per GARP’s

Code of Conduct, sharing confidential information without proper authorization itself constitutes

a violation irrespective of how it’s used.

Q.272 A formal investigation that confirms violation of the GARP Code of Conduct can bring
about serious consequences. Which of the following is a potential consequence of such a
violation?

A. Mandatory participation in ethical training.

B. A temporary suspension of the GARP member's right to work in the field of risk
management.

C. Withdrawal of the GARP member's right to use the FRM designation for any purpose.

D. A formal request to the GARP member's employer to withdraw certain benefits such as
bonuses and other fringe benefits.

The correct answer is C.

The Global Association of Risk Professionals (GARP) has a Code of Conduct that its members are

expected to adhere to. This Code of Conduct is a set of ethical guidelines that governs the

behavior of GARP members in their professional activities. Violation of this Code can lead to

serious consequences. One such consequence, as stated in the Code, is the withdrawal of the

GARP member's right to use the FRM (Financial Risk Manager) designation for any purpose.

This means that the member would no longer be able to refer to themselves as a FRM, which is a

significant professional designation in the field of risk management. This consequence is

intended to uphold the integrity of the FRM designation and to deter members from violating the

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Code of Conduct. It is a severe penalty that reflects the seriousness with which GARP views

violations of its Code of Conduct.

Choice A is incorrect. While ethical training could be a potential consequence, it is not

mandatory according to the GARP Code of Conduct. The code does not explicitly state that

members who violate the code must participate in ethical training.

Choice B is incorrect. The GARP does not have the authority to suspend a member's right to

work in the field of risk management. This decision would typically fall under the jurisdiction of

an employer or regulatory body, not a professional association like GARP.

Choice D is incorrect. The GARP cannot request an employer to withdraw certain benefits such

as bonuses and other fringe benefits from its member for violating its Code of Conduct. Such

actions are beyond the scope and power of this professional association.

Q.273 Kelvin White, FRM, works for a consultancy firm that specializes in pension fund
management in a certain city. Recently, one of his close friends who work for the city's planning
and development department approached him with an offer to work as an unpaid volunteer for
the department's pension fund. In turn, the department would grant White a free parking space
just outside his office. Which of the following is the most appropriate thing to do before
accepting the offer?

A. Do nothing as this is a volunteer job.

B. Request the department not to grant him any fringe benefit, including the free parking
space.

C. Seek advice regarding the offer from one of his colleagues at the consultancy firm.

D. Disclose the details of the volunteer position to his employer.

The correct answer is D.

Kelvin White should disclose the details of the volunteer position to his employer. This is in line

with the GARP Code of Conduct, which states that members should 'make full and fair disclosure

of all matters that could reasonably be expected to impair independence and objectivity or

interfere with respective duties to their employer, clients, and prospective clients.' Although the

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department may not be a current client of the firm, that could change in the future while White

is still an employee of the firm. By disclosing the details of the volunteer position to his employer,

White ensures that he is transparent about any potential conflicts of interest that may arise from

his involvement with the department's pension fund. This allows his employer to make an

informed decision about whether or not to allow White to accept the volunteer position.

Furthermore, it demonstrates White's commitment to upholding the ethical standards of his

profession, which include maintaining independence and objectivity in all professional activities.

Choice A is incorrect. Even though it's a volunteer job, White still has professional obligations

to his employer. He should disclose any potential conflicts of interest, including this offer.

Choice B is incorrect. While refusing fringe benefits could potentially mitigate some conflicts

of interest, it does not address the primary issue here which is the potential conflict between

White's duties to his employer and his new role as a volunteer for the city's planning and

development department.

Choice C is incorrect. Seeking advice from a colleague may be helpful but it does not replace

the need for formal disclosure to his employer about this opportunity. It's important that he

informs those who can make an informed decision about potential conflicts of interest.

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Q.274 A GARP member working in a certain country establishes that the GARP Code of Conduct,
the country's laws, and the local law applicable within the region where she conducts business
all specify different requirements. The member must abide by:

A. The GARP Code of Conduct.

B. The highest standard of local law, her country's laws, or the GARP Code of Conduct.

C. The GARP Code of Conduct or the local law, whichever is higher.

D. The country's law.

The correct answer is B.

The GARP Code of Conduct, as well as the local and national laws, all have their own unique

requirements. However, when these standards appear to be in conflict or overlap, the GARP

member should always seek to apply the highest standard. This means that the member should

adhere to the most stringent requirement among the GARP Code of Conduct, the local law, and

the country's law. This approach ensures that the member is always operating within the bounds

of the law and the professional code of conduct, thereby minimizing the risk of legal and

professional repercussions. It also demonstrates the member's commitment to maintaining high

ethical standards in her professional conduct, which is a key aspect of risk management.

Choice A is incorrect. While the GARP Code of Conduct is important, it may not always

represent the highest standard when compared to local or national laws. Therefore, simply

adhering to the GARP Code of Conduct without considering other regulations could lead to non-

compliance with stricter standards.

Choice C is incorrect. This option suggests that the member should adhere either to the GARP

Code of Conduct or local law, depending on which one is higher. However, this choice neglects

consideration for national laws which might have stricter stipulations than both local law and

GARP code.

Choice D is incorrect. Adhering only to the country's law would ignore potentially stricter

standards set by local laws or by professional codes such as the GARP Code of Conduct.

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Q.275 Jessica Pearson, FRM, works for an investment bank. At the end of a 2-year contractual
relationship between the bank and one of its clients, the client offers Jessica a car worth USD
43,200 in part because of her outstanding expertise and professionalism throughout the period
of the contract. How should Jessica proceed?

A. Accept the gift because the contract has lapsed.

B. Accept the gift but make sure that she informs her employer about it.

C. Reject the gift.

D. Reject the gift but request the client to redirect it to the bank itself.

The correct answer is C.

Jessica should reject the gift. The Global Association of Risk Professionals (GARP) Code of

Conduct clearly states that members should not offer, solicit, or accept any gift, compensation, or

consideration that could reasonably be expected to compromise their objectivity and

independence. This rule applies regardless of whether a contract has lapsed or not. The client

could potentially seek professional assistance in the future, and accepting the gift could create a

conflict of interest or the perception of one. Therefore, to maintain her professional integrity and

adhere to the GARP Code of Conduct, Jessica should politely decline the gift.

Choice A is incorrect. Even though the contract has lapsed, accepting such a high-value gift

can create a conflict of interest and may be perceived as a bribe or an attempt to influence

future business decisions. This would violate the professional ethics and standards of conduct

that Jessica, as an FRM, is expected to uphold.

Choice B is incorrect. Informing her employer about the gift does not eliminate potential

conflicts of interest or ethical concerns. The value of the gift is substantial enough to potentially

influence Jessica's decision-making in future dealings with this client, which could compromise

her professional integrity.

Choice D is incorrect. While redirecting the gift to her employer might seem like a solution, it

still doesn't address potential ethical issues. It could still be seen as an attempt by the client to

curry favor with Jessica's employer for future contracts or business deals.

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Q.276 Green Belt Market Fund directs its two subsidiaries to buy and sell emerging market
stocks simultaneously. In its monthly investment outlook literature, the company points to the
overall emerging market volume as indicative of the market's liquidity. The move prompts more
investors to participate in the emerging markets fund increasingly. Green Belt Market Fund most
likely:

A. Did not violate the GARP Code of Conduct.

B. Violated the GARP Code of Conduct regarding conflict of interest.

C. Did not violate the GARP Code of Conduct but may have breached stock brokerage
rules.

D. Violated the GARP Code of Conduct regarding professional integrity and ethical
conduct.

The correct answer is D.

The Green Belt Market Fund's actions indicate a violation of the GARP Code of Conduct

regarding professional integrity and ethical conduct. The company appears to be manipulating

the market's liquidity to attract investments in its own funds. The increased participation in the

emerging markets fund is not a result of market forces such as supply and demand, nor does it

reflect a genuine trading strategy intended to benefit investors. Instead, it seems to be a

concealed effort to increase the assets under the company's management. This conduct is not in

line with the principles of professional integrity and ethical conduct as stipulated in the GARP

Code of Conduct.

Choice A is incorrect. Green Belt Market Fund did violate the GARP Code of Conduct. The

company's strategy of using its subsidiaries to simultaneously buy and sell stocks in emerging

markets can be seen as a form of market manipulation, which is against the principles of

professional integrity and ethical conduct outlined in the GARP Code.

Choice B is incorrect. While it may seem that there could be a conflict of interest, this choice

does not accurately describe the violation committed by Green Belt Market Fund. The GARP

Code's provisions on conflicts of interest primarily deal with situations where an individual or

organization might benefit at the expense of a client or other party, which does not appear to be

the case here.

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Choice C is incorrect. Although it's possible that Green Belt Market Fund may have breached

stock brokerage rules with its trading strategy, this doesn't negate their violation of the GARP

Code regarding professional integrity and ethical conduct. Therefore, stating they didn't violate

the GARP code would be inaccurate.

Q.277 Theresa Conway, FRM, is a trade manager of an investment fund specializing in currency
trading. In a report sent to investors, Conway outlines her trading strategy which is hinged on
the appreciation of the United States dollar against other world currencies. She quantifies
expected returns if the dollar appreciates by less than 5%, 5% - 10%, and by more than 10%. She
also outlines possible scenarios if the dollar depreciates by similar margins. Also explicitly stated
therein is that these projections are her professional opinion. Has Conway violated the GARP
Code of Conduct with respect to communication?

A. Yes.

B. No, because she disclosed the basic details of her investment strategy.

C. No, because she explicitly distinguishes fact from opinion, while still giving a range of
scenarios if the dollar appreciates or depreciates - therefore capturing most (or all)
possible scenarios.

D. No, because it's her legal duty to communicate the details of her strategy to investors.

The correct answer is C.

Conway did not violate the GARP Code of Conduct with respect to communication. The GARP

Code of Conduct requires members to disclose factual data that is devoid of falsehoods. In

addition, personal judgment or opinion must be clearly distinguished from facts. Conway

adhered to these requirements in her communication with her investors. She provided factual

data about her trading strategy and the potential scenarios based on the appreciation or

depreciation of the United States dollar. She also clearly distinguished her professional opinion

from the facts by stating that the projections are her professional opinion. Therefore, she did not

violate the GARP Code of Conduct with respect to communication.

Choice A is incorrect. Theresa Conway did not violate any rules of the GARP Code of Conduct

regarding communication. She provided a clear explanation of her investment strategy and

distinguished fact from opinion, which is in line with the code's requirements.

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Choice B is incorrect. While it's true that Conway disclosed the basic details of her investment

strategy, this alone does not determine whether she violated any rules or not. The key point here

is that she also distinguished facts from opinions and provided a range of scenarios, which aligns

with the GARP Code of Conduct.

Choice D is incorrect. Although it may be part of Conway's legal duty to communicate her

strategy to investors, this does not necessarily mean she didn't violate any rules under the GARP

Code of Conduct regarding communication. However, in this case, she did comply with all

relevant guidelines by providing clear information and distinguishing between facts and

opinions.

Q.278 Richard Leakey, FRM, is an analyst with a large portfolio of stocks, including the stock of
Brighter World Limited (BWL). Leakey's uncle owns about 20,000 shares of BWL. He informs
Leakey that he has created a trust in his name and placed 5,000 BWL shares into the trust. The
wording of the trust prevents Leakey from selling the shares until his uncle dies, but may
nonetheless vote for the shares. Leakey is due to give an updated research analysis on BWL in a
fortnight. Leakey should most appropriately:

A. Disregard the situation and proceed to update the report as usual because he is not a
beneficiary of the shares as of now.

B. Notify his superiors that he's no longer in a position to issue recommendations on

BWL.

C. Request his uncle to amend the terms of the trust to allow him to sell the shares at any
time.

D. Disclose the situation to his employer and, if given the green light to prepare a report,
also disclose his new status as a beneficiary of BWL stocks.

The correct answer is D.

Richard Leakey should disclose the situation to his employer and, if given the permission to

prepare a report, also disclose his new status as a beneficiary of BWL stocks. This is because, as

a member of the Global Association of Risk Professionals (GARP), Leakey is obligated to disclose

any actual or potential conflict of interest to all affected parties. This disclosure should be

comprehensive and fair, especially if there is a possibility that it could compromise his

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independence or objectivity, or interfere with his employer's or clients' interests. In this case,

Leakey has a financial interest in BWL shares and also has voting rights. Therefore, he must

inform his employer about the potential conflict of interest and should only continue to monitor

BWL after his employer has given him the go-ahead.

Choice A is incorrect. Even though Leakey is not a beneficiary of the shares at present, he still

has voting rights and stands to benefit in the future. This could potentially influence his analysis

and recommendations, hence it's important to disclose this conflict of interest.

Choice B is incorrect. While notifying superiors about potential conflicts of interest is a good

practice, completely abstaining from issuing recommendations on BWL may not be necessary if

proper disclosures are made and approved by his employer.

Choice C is incorrect. Requesting his uncle to amend the terms of trust does not address the

issue at hand - potential conflict of interest due to Leakey's new status as a beneficiary of BWL

stocks. The most appropriate course would be disclosure rather than changing terms of trust.

Q.279 Paul Lambert, FRM, serves as a financial analyst for Lakeside Investments. He has been
tasked with preparing a purchase recommendation on Brighter World Limited. Which of the
following statements about disclosure of conflicts of interest would Lambert have to disclose
fully?

A. He co-owns 30,000 of Brighter World Limited with his brother.

B. He has a significant ownership in Brighter World Limited through a family trust.

C. Lakeside is an over-the-counter market maker for Brighter World Limited's stock.

D. All of the above.

The correct answer is D.

According to the GARP Code of Conduct, members are required to make full and fair disclosure

of all matters that could reasonably be expected to impair their objectivity and independence or

interfere with their respective duties to their employers, clients, and prospective clients. This

includes all the scenarios mentioned in the options.

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In option (a), Lambert co-owns 30,000 shares of Brighter World Limited with his brother. This

personal investment could potentially influence his analysis and recommendations, thereby

creating a conflict of interest.

In option (b), Lambert has a significant ownership in Brighter World Limited through a family

trust. Again, this personal stake could bias his analysis and recommendations, leading to a

conflict of interest.

In option (c), Lakeside Investments, Lambert's employer, is an over-the-counter market maker for

Brighter World Limited's stock. This means that Lakeside Investments could potentially influence

the price of Brighter World Limited's stock, which again could create a conflict of interest for

Lambert.

Therefore, in all these scenarios, Lambert would be required to make a full and comprehensive

disclosure of potential conflicts of interest, as per the GARP Code of Conduct.

Choice A is incorrect. While it's true that owning shares in Brighter World Limited with his

brother could potentially create a conflict of interest, this alone does not necessitate a full and

comprehensive disclosure according to the GARP Code of Conduct. The ownership must be

significant enough to influence Lambert's professional judgement or create an appearance of

impropriety.

Choice B is incorrect. Having a significant ownership in Brighter World Limited through a

family trust could indeed pose a potential conflict of interest for Lambert. However, the GARP

Code of Conduct requires disclosure only when such ownership is likely to impair his ability to

make unbiased and objective recommendations.

Choice C is incorrect. Lakeside being an over-the-counter market maker for Brighter World

Limited's stock might present potential conflicts, but it doesn't automatically require full and

comprehensive disclosure under the GARP Code of Conduct unless it can significantly affect

Lambert's impartiality in making investment recommendations.

Q.280 Which of the following is NOT a fundamental responsibility of GARP members as

stipulated in the Code of Conduct?

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 A. Members must purpose, and encourage others, to operate at the highest level of
professional skills.

B. Members have a personal ethical responsibility and must maintain the highest ethical
standards.

C. Members cannot delegate or outsource their ethical responsibility to others.

D. Members do not have to continue perfecting their expertise once they have passed
exams and obtained all the necessary certifications.

The correct answer is D.

The statement that 'Members do not have to continue perfecting their expertise once they have

passed exams and obtained all the necessary certifications' is incorrect and does not align with

the GARP Code of Conduct. The Code of Conduct emphasizes the importance of continuous

learning and professional development. It stipulates that members should always strive to

improve their expertise, even after they have passed their exams and obtained all necessary

certifications. This is because the field of risk management is dynamic and constantly evolving.

New risks emerge, and risk management techniques and practices are continually being

developed and refined. Therefore, to effectively manage risks and uphold the highest standards

of professional conduct, GARP members must stay abreast of these developments and continually

enhance their knowledge and skills. This commitment to lifelong learning and professional

development is a fundamental responsibility of GARP members, as stipulated in the Code of

Conduct.

Choice A is incorrect. This statement accurately represents one of the fundamental

responsibilities as per the GARP Code of Conduct. Members are indeed expected to operate at

the highest level of professional skills and encourage others to do so.

Choice B is incorrect. This statement also correctly reflects a fundamental responsibility

according to the GARP Code of Conduct. Members are required to maintain high ethical

standards and have a personal ethical responsibility.

Choice C is incorrect. As per the GARP Code of Conduct, members cannot delegate or

outsource their ethical responsibility to others, making this statement correct.

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Q.281 Chris Jefferson, FRM, is the manager of a hedge fund. Over the last 3 days, he has been
investing the hedge fund by purchasing significant quantities of ABC's stock while
simultaneously selling the three-month futures contract (i.e. initiating a short position in it).
Although his clients are aware of the fund's general investment strategy to generate earnings,
Jefferson did not inform them of the trades. One of the following statements is most likely
correct. Which one?

A. Jefferson violated the GARP Code of Conduct.

B. Jefferson did not violate the GARP Code of Conduct.

C. Manipulated the price of a publicly traded security hence violated the Code of
Conduct.

D. Violated the GARP Code of Conduct by failing to keep his clients in the loop regarding
the transactions before they occurred.

The correct answer is B.

Jefferson did not violate the GARP Code of Conduct. The GARP Code of Conduct is a set of

ethical guidelines that professionals in the field of risk management are expected to adhere to. It

emphasizes the importance of integrity, objectivity, competence, fairness, confidentiality,

professionalism, and diligence. In this case, Jefferson's actions do not appear to contravene any

of these principles. He was not attempting to manipulate the price of a security or mislead

market participants. Instead, he was employing a legitimate investment strategy, seeking to

exploit a potential arbitrage opportunity between the spot price of ABC's stock and its futures

price. This is a common practice in the world of hedge funds, where managers often use complex

strategies to generate returns. Furthermore, the clients of the hedge fund were aware of the

general investment strategy, even if they were not informed about the specific trades. Therefore,

there was no breach of confidentiality or lack of transparency. It's important to note that the

GARP Code of Conduct does not require risk managers to disclose every single trade or

investment decision to their clients. Instead, it emphasizes the importance of clear

communication and transparency about the overall investment strategy and risk management

practices. In this case, Jefferson appears to have met these requirements, hence he did not

violate the GARP Code of Conduct.

Choice A is incorrect. There is no evidence in the scenario provided that Jefferson violated the

GARP Code of Conduct. The GARP Code of Conduct does not require disclosure of every specific

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trade to clients, but rather a general investment strategy.

Choice C is incorrect. The question does not provide any information suggesting that Jefferson

manipulated the price of a publicly traded security. Simply buying large volumes and initiating a

short position in futures contracts do not constitute price manipulation.

Choice D is incorrect. As per the GARP Code of Conduct, it's not mandatory for risk managers

to inform their clients about each transaction before they occur. They are required to disclose

their general investment strategy which Jefferson has done in this case.

Q.282 Carol Bauer, FRM, serves as a portfolio manager for several wealthy clients with well-
diversified portfolios. Among her clients is Matthew Cook, for whom she manages a personal
portfolio of stocks and government bonds. Cook recently disclosed to Bauer that he is under
investigation for tax evasion related to his business, Cook Concrete. After a few days, Bauer
shares that information with a friend who works at a local bank that has plans to underwrite
Concrete's IPO. Carol Bauer has most likely:

A. Violated the GARP Code of Conduct with respect to confidentiality.

B. Not violated the GARP Code of Conduct with respect to confidentiality.

C. Not violated the GARP Code of Conduct because she revealed illegal activities on the
part of her client.

D. Violated the GARP Code of Conduct by failing to detect the tax evasion despite being
central to her client's business dealings.

The correct answer is A.

Carol Bauer has indeed violated the GARP Code of Conduct with respect to confidentiality. The

GARP Code of Conduct is a set of ethical guidelines that members of the Global Association of

Risk Professionals (GARP) are expected to adhere to. One of the key principles of this code is the

protection of confidential information. Members are required to take all reasonable precautions

to prevent both intentional and unintentional disclosure of confidential information. In this case,

Bauer was privy to confidential information about her client, Matthew Cook. When Cook

informed her about the investigation into his business for potential tax evasion, this information

became part of the confidential information that Bauer was obligated to protect. By sharing this

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information with a friend at a bank that was considering underwriting an IPO for Cook's

business, Bauer violated the confidentiality principle of the GARP Code of Conduct. She did not

have the right to disclose her client's situation to anyone without his explicit consent, regardless

of the circumstances. This violation could have serious consequences for Bauer, including

disciplinary action by GARP and potential legal repercussions.

Choice B is incorrect. Bauer did violate the GARP Code of Conduct with respect to

confidentiality. As a certified FRM, she is expected to maintain the confidentiality of her client's

information unless there is legal or professional obligation to disclose it. In this case, she

disclosed sensitive information about her client's business without any such obligation.

Choice C is incorrect. Even though Cook Concrete was under investigation for potential tax

evasion, Bauer was not justified in revealing this information without a legal or professional

obligation to do so. The GARP Code of Conduct requires FRMs to maintain confidentiality unless

disclosure is required by law or consented by the client.

Choice D is incorrect. While detecting and preventing illegal activities can be part of an FRM's

responsibilities, the GARP Code of Conduct does not specifically require them to detect tax

evasion in their clients' businesses. Therefore, Bauer did not violate the code by failing to detect

Cook Concrete's potential tax evasion.

Q.283 Donald Lee, FRM, is an exam proctor for the FRM part I exam. A few days before the
exam, Lee emails a copy of 5 questions to each of his two friends, Martin and Joseph, who are
part 1 candidates in the FRM program. Lee and his two friends had planned the distribution of
exam questions months in advance. Martin proceeds to prepare for the exam. However, Joseph
develops cold feet and declines to load the questions and use them to his advantage. Which of
the following statements is most likely correct?

A. Donald Lee violated the GARP Code of Conduct, but Martin and Joseph did not.

B. All the three violated the GARP Code of Conduct.

C. Donald Lee and Martin violated the code, but Joseph did not.

D. Martin and Joseph violated the code, but Donald Lee did not.

The correct answer is B.

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All three individuals, Donald Lee, Martin, and Joseph, have violated the GARP Code of Conduct.

The GARP Code of Conduct is a set of ethical guidelines that all members and candidates of the

FRM program are expected to adhere to. It is designed to uphold the integrity of the GARP and

the validity of the examinations that lead to the award of the FRM designation. In this scenario,

Donald Lee has clearly breached the security of the examination by sharing actual exam

questions with Martin and Joseph. This act compromises the integrity of the examination and

gives an unfair advantage to Martin and Joseph over other candidates. Martin, by deciding to use

these questions for his preparation, is also in violation of the code. Joseph, despite his decision

not to use the questions, is still in violation of the code. His initial agreement to the plan makes

him complicit in the act, even though he later decided against using the questions. Therefore, all

three individuals have violated the GARP Code of Conduct.

Choice A is incorrect. This statement is not accurate because not only Donald Lee, but also

Martin and Joseph violated the GARP Code of Conduct. Donald Lee violated the code by sharing

exam questions in advance, which is a clear breach of confidentiality and integrity. Martin also

violated the code by deciding to use these questions for his preparation, thus participating in an

unethical practice. Joseph, despite deciding against using these questions, was aware of this

unethical act and did not report it to GARP authorities which makes him complicit.

Choice C is incorrect. While it's true that Donald Lee and Martin violated the code, Joseph too

was in violation despite his decision against using these questions as he failed to report this

unethical act.

Choice D is incorrect. This statement inaccurately absolves Donald Lee from any wrongdoing

when he was actually at the center of this violation by sharing exam questions beforehand.

Q.284 Timothy Bradley, FRM, works as a full-time financial analyst at KenBright Actuarial
Services Limited(KBG). Recently, one of the company's business contacts offered him a part-time
analytical job at KPMG. The work would entail establishing the right balance between equity and
debt finance for KPMG. Timothy should most appropriately:

A. Not accept the work as it violates the Code of Conduct by creating a conflict of
interest.

B. Accept the work as long as he is interested and is familiar with the work.

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 C. Accept the work as long as his full-time employer, KenBright Limited, agrees to all the
terms of the engagement.

D. Accept the role as long as, in her own assessment, it does not interfere with her duties
to KenBright Limited.

The correct answer is C.

According to the Code of Conduct for Financial Risk Managers, it is crucial for members to

maintain full transparency and fairness in all their professional dealings. This includes disclosing

any potential conflicts of interest that could interfere with their duties to their employer, clients,

or potential clients. In Timothy's case, accepting the part-time role at KPMG could potentially

create a conflict of interest with his full-time role at KenBright. Therefore, the most appropriate

course of action would be for him to accept the role only if his current employer, KenBright, fully

agrees to the terms of the engagement. This would ensure that his actions are in line with the

principles of independence, objectivity, and fairness as stipulated by the Code of Conduct.

Choice A is incorrect. While conflicts of interest should be avoided, the mere acceptance of

part-time work does not necessarily create a conflict of interest. It would depend on the nature of

the work and whether it interferes with Timothy's duties at KenBright Limited.

Choice B is incorrect. The decision to accept additional employment should not solely be based

on personal interest and familiarity with the work. Professional conduct guidelines require that

Timothy consider potential conflicts of interest and obtain approval from his current employer,

KenBright Limited.

Choice D is incorrect. Although it's important for Timothy to assess whether the part-time role

interferes with his duties at KenBright Limited, this alone isn't sufficient according to

professional conduct guidelines. He must also seek approval from his current employer before

accepting additional employment.

Q.285 Sally Spicer, FRM, acts as a liaison between Prime Financials (an investment management
firm) and Neiman Inc. (an investment bank). Neiman Inc. intends to issue an IPO and turns to
Prime Financials for underwriting services. As a way of increasing investor confidence, Sally
Spicer has Prime Financials issue a trove of vague and unrealistic financial information that

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paints its clients in better health than it actually is. Which section of the GARP Code of conduct
has most likely been violated by Spicer and her company?

A. Best practices.

B. Professional integrity and ethical conduct.

C. Fundamental responsibilities.

D. Confidentiality.

The correct answer is B.

The GARP Code of Conduct, under the section of Professional integrity and ethical conduct,

stipulates that members must avoid any form of deceit in assessments, measurements, and

processes that are intended to provide a business advantage at the expense of honesty and

truthfulness. In the given scenario, Sally Spicer and Prime Financials have violated this section

by issuing misleading financial information to boost investor confidence. This action is a clear

contravention of the principles of honesty and truthfulness, as it presents the clients in a better

financial state than they actually are. The intention behind this action is to gain a business

advantage, which is explicitly prohibited under this section of the GARP Code of Conduct.

Therefore, the most likely section of the GARP Code of Conduct that has been violated by Spicer

and her company is Professional integrity and ethical conduct.

Choice A is incorrect. Best practices refer to the recommended methods and strategies in risk

management that are accepted as superior to others because they produce results that are

superior to those achieved by other means. In this case, Sally Spicer is not breaching best

practices but rather she is engaging in unethical conduct by releasing misleading financial data.

Choice C is incorrect. Fundamental responsibilities refer to the basic duties of a risk manager

such as maintaining professional competence, acting with integrity, and serving clients with

diligence and objectivity. While Spicer's actions may be seen as a breach of these responsibilities,

her actions more directly violate the principle of professional integrity and ethical conduct.

Choice D is incorrect. Confidentiality refers to the obligation of professionals to protect

sensitive information from unauthorized disclosure. In this scenario, there's no indication that

Spicer or Prime Financials have disclosed confidential information without authorization.

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Q.286 Romney Muriuki, FRM, works as an analyst for an African Insurance firm that has a
presence in 8 central African countries. In a recent report, Muriuki makes the following
statements:
"Based on the fact that the firm has recorded steady growth in customer numbers over the last
decade, and that the insurance penetration currently stands at 3%, I expect the trend to continue
for the next 10 years. I also expect that the company will be able to translate the continually
increasing revenue into significant profits."

The report describes in detail the risks facing the firm, particularly geopolitical risks associated
with African countries. Muriuki's report:

A. Violated the Code by failing to distinguish factual details from his opinion.

B. Did not violate the Code.

C. Violated the code by giving a shallow professional assessment of the insurance market
in Africa.

D. Violated the Code by failing to properly identify all the risks related to operations in
African countries.

The correct answer is B.

Muriuki's report did not violate the Code of Conduct. The Code of Conduct in question here is

likely referring to a professional standard that requires analysts to clearly distinguish between

factual information and their own opinions in their reports. In Muriuki's report, he presents the

historical growth of the firm and the current insurance penetration rate as facts, which they are

since they are based on actual data and events that have occurred. His projection of continued

growth and increased profits is presented as his opinion, which is based on his analysis of the

factual information. He does not present his opinion as a fact, thereby maintaining the

distinction between the two. This is in line with the professional standard, and hence, he did not

violate the Code of Conduct.

Choice A is incorrect. Muriuki's report does not violate the Code by failing to distinguish

factual details from his opinion. He clearly states the facts about the firm's consistent growth

and current insurance penetration rate, and then provides his projection based on these facts.

This is a common practice in risk analysis and does not constitute a violation of the Code of

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Conduct.

Choice C is incorrect. The claim that Muriuki violated the code by giving a shallow

professional assessment of the insurance market in Africa is unfounded. There are no indications

in the question that suggest Muriuki's assessment was shallow or unprofessional. His report

includes both historical data and future projections, which are key components of a

comprehensive market analysis.

Choice D is incorrect. It cannot be concluded that Muriuki violated the Code by failing to

properly identify all risks related to operations in African countries based on this information

provided in this question alone. The question mentions that he emphasized geopolitical risks, but

it doesn't specify whether other potential risks were ignored or overlooked.

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