2001 Financial Risk Manager Examination

Global Association of Risk Professionals 2001 Financial Risk Manager Exam
2001 Financial Risk Manager Examination
Session I
Saturday, November 17, 2001
9:00 a.m. 11:30 a.m.
Abu Dhabi New York City

Bahrain Prague
Boston Rio de Janeiro
Chicago Sao Paulo
Frankfurt San Francisco
Hong Kong Seoul
Houston Singapore
Istanbul Sydney
Johannesburg Taipei
Kuala Lumpur Tel Aviv
London Tokyo
Lugano Toronto
Madrid Utrecht
Minneapolis Vancouver
Montreal Winnipeg
Moscow Zurich
Mumbai/Bombay
November 17, 2001 2001 GARP

The Global Association of Risk Professionals would like to thank the

following individuals for their generous contributions of professional time
and effort in the compilation of the 2001 Financial Risk Manager
Examination:
Marcelo Cruz
Antonio Duarte
Neels Erasmus
Dan Galai
Lisa Godar
Manos Hatzakis
Ken Kapner
George Montgomery
Gary Pickholz
Nick Reed
Jean-Paul St. Germain
Sorin Straja
Andrew Street
Fred Vacelet
And
The Members of the FRM Committee of GARP:

Sandeep Arora, John Paul Broussard, Steve Lerit, Susan Mangiero,
Elliot Noma, Sergey Smirnov, Michael C.S. Wong
November 17, 2001 i 2001 GARP

Table of Contents
Session I (9:00 a.m. 11:30 a.m.)
Credit Risk Management (32 Questions) ................................................. I - 2
Regulation and Compliance (13 Questions)........................................... I - 11
Operational and Integrated Risk Management (20 Questions).............. I - 16
November 17, 2001 I-1 2001 GARP

Credit Risk Management

1. Which of the following is usually regarded as a credit event under ISDA
definitions?
a. The calling back of a bond that has a borrower call option provision
b. The upgrading of the borrowers credit rating
c. Failing to pay a coupon on another bond
d. Announcing that projected future earnings are going to be much lower

than before
2. Which of the following is the best-rated country according to the most important
ratings agencies:
a. Argentina
b. Brazil
c. Mexico
d. Peru
3. Suppose you are given the current value of firms assets as 200 million, the
current value of its liabilities as 160 million and the standard deviation of asset
values as 20 million. What would KMV calculate as the approximate distance
from default? (This question did not count when the exam was graded)
a. 1 standard deviation
b. 2 standard deviations
c. 2.5 standard deviations
d. Cannot not be determined from the information given.
4. Assume two companies of a similar rating and credit risk profile, based in two
different countries. What is most likely to invalidate the comparison between
default swaps on these two companies?
a. Currency risk
b. Differences in recovery rates
c. Cultural differences
d. Different jurisdiction for the contract

5. What is the approximate probability of exactly one default over the next year from
a portfolio of 20 BBB-rated obligors? (Assume the 1-year probability of default for
a BBB-rated counterparty to be 4% and obligor defaults to be independent from
one another) (This question did not count when the exam was graded)
a. 2%
b. 4%
c. 45%
d. 96%
6. Standard and Poors rating agency have compiled actual default rates using data
over the last twenty years, what are their approximate computed odds for the
default of a CCC rated bond over a five year period?
a. 1 in 100
b. 1 in 50
c. 1 in 10
d. 1 in 2
7. Choose the most complete answer that describes the type of events that cause a
bond to exit from the original population.
a. Default
b. Default, call and sinking fund
c. Default, coupon and time to maturity
d. Default, lower interest rate, sinking fund
8. Which of the following 10-year swaps has the highest potential credit exposure?
a. A cross-currency swap after 2 years
b. A cross-currency swap after 9 years
c. An interest rate swap after 2 years
d. An interest rate swap after 9 years

9. A BB bond has a probability of default of 1% over the next year, assuming an

even spread of default probability over the year what is the probability of default
in the first month?
a. 0.084%
b. 0.84%
c. 0.009%
d. 1%
10. Consider two bonds, one AA rated and the other B rated. Which of the following
is true?
a. The marginal default rate of the B rated bond declines over a long time
period (say 10 years) compared with the AA rated bond
b. The marginal default rate of the B rated bond increases over a long time
period (say 10 years) compared with the AA rated bond
c. The marginal rates of default stay roughly the same over all time scales
d. The ratio of marginal default rate between the two bonds stays constant at
all times
11. A money market fund invests in Treasury bills. What is the principal risk that the
fund manager must hedge for?
a. Interest rate risk
b. Default risk
c. Funding liquidity risk
d. Asset liquidity risk

12. A pool of high yield bonds is placed in an SPV and three tranches (including the
equity tranche) of bonds are issued collateralized by the bonds to create a
Collateralized Bond Obligation (CBO). Which of the following is true?
a. At fair value the value of the issued bonds should be less than the
collateral
b. At fair value the total default probability, weighted by size of issue, of the
issued bonds should equal the default probability of the collateral pool
c. The equity tranche of the CBO has the least risk of default
d. The yield on the low risk tranche must be greater than the yield on the
collateral pool
13. A US bank makes a loan to a Mexican company of $250m, which collateralized

at 110% with Mexican Government Bonds. For unsecured loans, the bank uses
1yr 95% VaR which comes to $25m. Also, there is a 1% probability of the
company defaulting. Assuming a very strong correlation between collateral value
and company default, what is the fair value amount the bank should charge to
cover the risk of taking a loss on the deal assuming a zero recovery rate and
collateral value after default?
a. $2,500,000
b. $25,000,000
c. $5,000,000
d. $25,000
14. To what sort of option on the counterpartys assets can the current exposure of a
credit-risky position better be compared?
a. A short call
b. A short put
c. A short knock-in call
d. A binary option

15. Which expression for determining a market risk factor is correct?
a. RAROC risk factor = 2.33 X weekly volatility X 52 X (1 - tax rate)
b. RAROC risk factor = 2.33 X weekly volatility X 52 X (1 - tax rate)
c. RAROC risk factor = 2.33 X weekly volatility X 52 X tax rate
d. RAROC risk factor = 2.33 X weekly volatility X 52 X tax rate
16. A portfolio consists of 20 well diversified A rated bonds, assuming a default

probability of 1% per annum, what is the approximate probability of sustaining no
losses on the portfolio over the next 12 months?
a. 80%
b. 82%
c. 85%
d. 99%
17. For a given bank, which framework is less likely to convince regulators of a good
credit risk exposure management system?
a. Mertons model
b. Raroc
c. KMV system
d. Mac Kinseys Credit Portfolio View
18. The US Government Bond Zero Curve give a 1-year semi-annual yield of 4%, on
the same basis a corporate security has a yield of 5%. What is the market
implied 1-year default probability of the corporate security? The recovery rate is
88.6%.
a. 0.974%
b. 1.000%
c. 9.000%
d. 0.184%

19. You work for a bank that lends to lots of different companies. Your boss asks you
to quantify the impact of diversifying credit risk across industries. Which
statement is true?
a. The dollar standard deviation of a loan portfolio goes down as the number
of loans in the portfolio goes up, as long as the loans are negatively
correlated with each other.
b. The dollar standard deviation of a loan portfolio goes down as the number
of loans in the portfolio goes up, as long as the loans are positively
correlated with each other.
c. The dollar standard deviation of a loan portfolio goes down as the number
of loans in the portfolio goes up, as long as the loans are independent of
each other.
d. The dollar standard deviation of a loan portfolio does not depend on

correlation among the loans.
20. Credit-linked notes contain, more typically, as an embedded instrument, a:
a. Credit spread option
b. Guarantee
c. Total return swap
d. Credit default swap
21. The current exposure to credit risk of a financial obligation is best defined as:
a. The mark to market value or replacement value of the obligation
b. The current value plus potential future exposure of the obligation
c. The mark to market value times the recovery rate
d. Depends on the credit rating of the obligor

22. The current mark to market value of a 5y Interest Rate Swap is positive $2m with
a counterparty whose S&P credit rating is BB, which of the following schematic
equations best describes the credit risk of this position over a one year horizon?
a. $2m x 5y x 1 = $10m
b. $2m x default rate (0.01) = $20,000
c. $2m x default rate (0.01) x recovery rate (0.4) = $8,000
d. $2m x default rate (0.01) x {1 recovery rate} (0.6) = $12,000
23. What is the central assumption made by CreditMetrics?
a. An asset or portfolio should be thought of in terms of its diversification.
b. An asset or portfolio should be thought of in terms of the likelihood of

default.
c. An asset or portfolio should be thought of in terms of the likelihood of

default and in terms of changes in credit quality over time.
d. An asset or portfolio should be thought in terms of changes in credit

quality over time.
24. In the credit risk model of KMV which of the following best describes the basic
methodology?
a. Modified method of Merton to deduce the net value of the firm as an

option using equity price volatility as a proxy for asset price volatility
b. Uses bond yield credit spread to determine default probability
c. Uses historical studies of actual default rates from S&P
d. Uses GARCH forecasting techniques based on industry sector

performance

25. The market trades a 1-year bond at 50bp credit spread, and a 3-year bond at
60bp. In the USD market conditions as of fall 2001 and with a recovery rate of
50%, what is the implicit probability of default before year 3?
a. 1%
b. 2%
c. 3%
d. 4%
26. If the incremental annual default probability of an obligor is 10% in year one and
20% in year two, what is the survival rate at the end of year two assuming a
recovery rate of zero?
a. 72%
b. 70%
c. 80%
d. 90%
27. What can be said about default correlations in CreditMetrics?
a. Default correlations can be estimated by ratings changes
b. Firm-specific aspects are more important than correlation
c. Past history is insufficient to judge default correlations
d. Default correlations can be estimated by equity valuation
28. What element is not directly part of the CAMEL approach to determining country
risk?
a. Asset quality of the country's natural, human and economic resources
b. Current account balance of payments
c. Country's access to hard, convertible currency from reserves
d. Legal framework for foreign companies doing business in that country

29. Which of the following models can least be used to price credit derivatives?
a. Madan-Unal
b. Heath-Jarrow-Morton
c. Duffie-Singleton
d. Jarrow-Turnbull
30. Moodys and Standard & Poors ratings at investment grade means that default
probability is less than:
a. 5%
b. 3%
c. 1%
d. 0.1%
31. What is the main issue in modeling a credit spreads stochastic process like that
of an equity?
a. Dividends
b. Influence of interest rates
c. A credit-spread process shows jumps
d. In case of equity split or other operations
32. Which of the following input is NOT common to the most widely used portfolio
credit risk models:
a. Spread curves
b. Recovery rates
c. Default correlations
d. Credit exposures
November 17, 2001 I - 10 2001 GARP

Regulation and Compliance Risk Management

33. Which of the following types of financial contracts do the BIS require a specific
risk charge
a. Forward Foreign exchange contract
b. Interest rate swap contract
c. FRA contract
d. Debt security future contract
34. Which of the following proposals was implemented in the New Basle Capital
Accord.
a. The use of advanced credit portfolio models for setting capital

requirements
b. The use of mark-to-model/market accounting in the determination of

minimum capital requirements
c. Introduction of risk bucketing approaches, with differentiated capital

charges tied to ratings
d. Increased weights for cross border lending to private companies
35. The Bank of International Settlements promotes cooperation and financial

stability of:
a. All European countries
b. No countries, it is an advisory organ to central banks
c. Most countries in the world
d. OECD countries
November 17, 2001 I - 11 2001 GARP

36. Which of the following most reflects the Basle Committee on Banking
Supervisions approach to calculating regulatory capital for operational risk?
a. Operational risk capital charge would be linked to fixed percentage of a

single risk indicator.
b. Operational risk capital charge would be determined from a decomposition

of business into standardized lines associated with broadly defined risk
exposure weighted by a beta factor.
c. Operational risk capital charge would be determined from a decomposition

of business into standardized lines associated with risk exposures and a
gamma term taking into account the operational loss of the institution.
d. All of the above.
37. Which of the following is least likely to be a principle use for the buyer of a credit
default swap?
a. Reduction of regulatory capital
b. Portfolio adjustments
c. Protection for mark-to-market exposures
d. Hedging counterparty credit exposure
38. A Bank subject to the Basel Accord makes a loan of $100m to a firm with a risk
weighting of 50%. What is the basic on balance credit risk charge?
a. $8m
b. $4m
c. $2m
d. $1m
November 17, 2001 I - 12 2001 GARP

39. The June 1999 Basle Committee on Banking Supervision issued proposals for
reform of its 1988 Capital Accord (the Basle II Proposals). These proposals
contained MAINLY:
I. Settlement risk management

II. Capital requirements
III. Supervisory review
IV. The handling of hedge funds
V. Contingency plans
VI. Market discipline
a. I, III and VI
b. II, IV and V
c. I, IV and V
d. II, III and VI
40. What is the Internal Models Approach?
a. A method of calculating regulatory capital using a firms own internal

market risk model and data.
b. Using standardized models from the regulatory to calculate capital.
c. Making forecasts on credit ratings using inside information.
d. Using the FEDs own propriety risk model to calculate capital

requirements.
41. Which of the following qualitative standards must be met in an Internal Models
Approach?
a. Comprehensive stress testing of the portfolio with back testing
b. Independent review of the trading units
c. Involvement of senior management
d. All of the above
November 17, 2001 I - 13 2001 GARP

42. Which of the following best describes the quantitative parameters of the Internal
Models Approach?
a. 10 day trading horizon, 99% confidence interval, minimum 1 years data,

minimum quarterly updates.
b. 1 day trading horizon, 95% confidence interval, 5 years data, updated

weekly.
c. 1 day trading horizon, 99% confidence interval, minimum 1 years data,

updated monthly.
d. 10 day trading horizon, 97.5% confidence interval, minimum 5 years data,

updated daily.
43. The value of the VaR calculated under the Internal Models Approach is subject to
a multiplicative factor. What is it?
a. 3
b. A minimum of 3, but can be higher
c. 4
d. 1
44. In the Internal Models Approach, an exception occurs when an actual P&L
results exceeds the VaR forecast. How many times may this occur before the
model falls into the penalty Red Zone? (This question did not count when
the exam was graded)
a. 4 times a year
b. 6 times a year
c. 9 times a year
d. 10 times a year
November 17, 2001 I - 14 2001 GARP

45. The Basel Accord computes the credit exposure of derivatives using both
replacement cost and an add-on to cover potential future exposure, which of
the following is the correct credit risk charge for a purchased 7 y OTC equity
index option of $50m notional with a current mark to market of $15m with no
netting and a counterparty weighting of 100%?
a. $1.6m
b. $1.2m
c. $150,000
d. $1m
November 17, 2001 I - 15 2001 GARP

Operational and Integrated Risk Management

46. From the regulators point of view, operational risk is concerned with:
a. Events that affect the cost basis and foregone revenue
b. Events that affect exclusively the foregone revenue
c. Events that affect the cost basis directly
d. Events that affect the cost basis directly and, in some cases, indirectly
47. To avoid rogue traders, what policy is most appropriate?
a. Set compensation and incentives for the performance the bank wants,
according to the bank's risk appetite
b. Pay traders well enough for them not to need to behave unreasonably
c. Set enough control processes for traders (phone-tapping, audits,

performance measurement, etc.)
d. Get traders throughout the bank to share their bonuses
48. Which of the following most reflect an operational risk faced by a bank
a. A counterparty invokes force majuere on a swap contract.
b. The Federal Reserve unexpectedly cuts interest rates by 100 bps.
c. A power outage shuts down the trading floor indefinitely with no back-up
facility.
d. The rating agencies downgrade the sovereign debt of the bank sovereign
counterparty.
49. Which of the below is the term used within the insurance industry to refer to the
effect of a reduction in control of losses by an individual insured due to the
protection provided by insurance?
a. Control trap
b. Moral hazard
c. Adverse selection
d. Control hazard
November 17, 2001 I - 16 2001 GARP

50. The MAIN challenge of banks (as of fall 2001) in operational risk is to:
a. Comply with BIS requirements.
b. Recruit enough competent people for this function.
c. Use the best quantitative model for operational risk.
d. Define an operational risk framework.
51. Which of the terms below refers to the situation where the various buyers of
insurance have different expected losses, however, the insurer (or the capital
market, as the seller of insurance) is unable to distinguish between the different
types of hedge buyer and is therefore unable to charge differentiated premiums?
a. Moral hazard
b. Average insurance
c. Adverse selection
d. Control hazard
52. Who should assess operational risk of operating units?
a. Management
b. Operating divisions
c. External consultants
d. Regulators
53. The causes and effects of the operational events are very often confused. For
example, it is very common to see operational risk types as human or people
risk or even system risk, although these types of events are, in general, merely
the causes of the risk and not the effect, the latter being the monetary
consequence (or the impact in the P&L). Identify below a correct set of cause-
effect relationship in operational risk:
a. Earthquake penalty paid to the regulators
b. Lost legal suit lawyers fees plus legal charges
c. Interest claims human error
d. Fines paid to the stock exchange- frauds
November 17, 2001 I - 17 2001 GARP

54. What can be used to manage reputational risk?
I. Elimination of external communication by employees

II. Strong ethical values at all levels of hierarchy
III. As much transparency as possible
IV. An efficient public relations department
a. I only
b. II and IV
c. II and III
d. I and IV
55. Which of the following affirmations is TRUE? Operational risk:
a. Does not impact market and credit risk measurement.
b. Does not impact market risk measurement but has some impact in credit
risk measurement.
c. Does not impact credit risk measurement but has some impact in market
risk measurement.
d. Impacts both market and credit risk measurement.
56. The concepts of potential risk versus real risk:
a. Are related to mathematical modeling: Extreme Value Theory applies

better to potential risks.
b. Are defined by BIS (1988).
c. Mean little more than an attitude: potential risks can be accepted, real
risks are to be eliminated.
d. Potential risks have a less than 1% probability of occurring.
November 17, 2001 I - 18 2001 GARP

57. Unlike credit risk, when the calculated expected credit losses might be covered
by general and/or specific provisions in the balance sheet, in operational risk,
due to its multidimensional nature, the treatment of expected losses is more
complex and restrictive. Recently, with the issuing of IAS37 by the International
Accounting Standards Board, the rules have become clearer as to what can (or
cannot) be subject to provisions. Which of the operational risk types below can
clearly be provisioned (given that a figure can be reasonably estimated)?
a. Transaction processing risk
b. Legal risk
c. Systems risk
d. Interest expenses
58. What is the percentage of minimum regulatory capital that, according to the
Basel Committee on Banking Supervision September 2001 paper, would provide
a reasonable cushion and produce required capital amounts in line with the risks
faced by large, complex organizations?
a. 10%
b. 12%
c. 15%
d. 20%
59. The success of information technology projects is defined as a use of the project
in a banking production environment. The impact of failure includes
implementers loss of credibility, disruption to business and cost of software. How
can project risk be best assessed? Probability of success is:
a. More than half, impact of failure is limited, success brings a minor direct
return.
b. More than half, impact of failure is high, as is impact of success.
c. Less than half, impact of failure is low, impact of success is high.
d. Less than half, impact of failure is high, as is impact of success.
November 17, 2001 I - 19 2001 GARP

60. What is kurtosis? What is its role in statistical distributions?
a. Kurtosis measures the nature of the spread of the values around the
mean. It represents the 4th moment of a distribution. A small kurtosis
indicates a sharp peak in the middle of a distribution. A population with
high kurtosis is usually called leptokurtic. The kurtosis plays an important
role in distinguishing those distributions that place additional probability on
larger values.
b. Kurtosis represents the 3rd moment of a distribution. A small kurtosis

indicates flatness in the middle of the distribution. A population with low
kurtosis is usually called leptokurtic. Skewness (and not kurtosis) plays an
important role in distinguishing those distributions that place additional
probability on larger values.
c. Kurtosis can be verified in the four initial moments of a distribution and

measures the mean of a distribution.
d. Kurtosis can be seen in the second and fourth moments of a distribution

and measures the standard deviation of a distribution.
61. How is the risk of so-called catastrophic losses dealt with?
a. Through Raroc models.
b. Only insurance companies can offer a partial cover.
c. Through VaR, preferably delta-gamma approach.
d. By mitigation, with reserves in capital.
62. Which of the below are methods to estimate parameters of operational loss
distributions?
I. Moments
II. Probability-weighted moments
III. Maximum likelihood
IV. Econometric
a. I and III
b. I, II and III
c. IV
d. III and IV
November 17, 2001 I - 20 2001 GARP

63. What is likely to be the most appropriate policy to manage technology risk?
a. Have regular technology audits performed by an external consultant.
b. Stick to proven technologies.
c. Outsource as many technology functions as possible.
d. Make sure every area is password-protected.
64. The operational VaR is generated through the aggregation of the following
general stochastic processes:
a. Region and severity
b. Brownian motion and frequency
c. Poisson and frequency
d. Severity and frequency
65. Testing the fitness of the operational loss distributions to the data is fundamental.
Which one of the below is NOT a goodness-of-fitness test?
a. Kolmogarov-Smirnov
b. Anderson-Darling
c. Macaulay
d. Cramer-Von Mises
November 17, 2001 I - 21 2001 GARP

2001 Financial Risk Manager Examination
Session II
Saturday, November 17, 2001
12:30 p.m. 3:00 p.m.
Abu Dhabi New York City

Bahrain Prague
Boston Rio de Janeiro
Chicago Sao Paulo
Frankfurt San Francisco
Hong Kong Seoul
Houston Singapore
Istanbul Sydney
Johannesburg Taipei
Kuala Lumpur Tel Aviv
London Tokyo
Lugano Toronto
Madrid Utrecht
Minneapolis Vancouver
Montreal Winnipeg
Moscow Zurich
Mumbai/Bombay
November 17, 2001 2001 GARP

Table of Contents
Session II (12:30 p.m. 3:00 p.m.)
Quantitative and Fixed Income Analysis (19 Questions)......................... II - 2
Capital Markets and Market Risk Management (39 Questions).............. II - 7
Legal, Accounting and Tax Risk Management (7 Questions) ............... II - 17
November 17, 2001 II - 1 2001 GARP

Quantitative Analysis
66. Calculate the duration of a two-year bond paying a annual coupon of 6% with
yield to maturity of 8%. Assume par value of the bond to be $1,000:
a. 2.00 years
b. 1.94 years
c. 1.87 years
d. 1.76 years
67. Consider the following currency swap: Counterparty A swaps 3% on 25 million

USD for 7.5% on 20 million Sterling. There are now 18 months remaining in the
swap, the term structures of interest rates are flat in both countries with USD
rates currently at 4.25% and Sterling rates currently at 7.75%. The current
Sterling/USD exchange rate is 1.65. Calculate the value of the swap. Use
continuous compounding. Assume 6 months until the next annual coupon and
use current market rates to discount.
a. -1,237,500 USD
b. -4,893,963 USD
c. -7,422,044 USD
d. -8,250,000 USD
68. EVT, Extreme Value Theory, helps quantify two key measures of risk.
a. The magnitude of an X year return in the loss in excess VaR
b. The magnitude of VaR and the level of risk obtained from scenario
analysis
c. The magnitude of market risk and the magnitude of operational risk
d. The magnitude of market risk and the magnitude of credit risk.

69. An option trader is pricing a 1-year option; he is quoted an interest rate of 6%

with semi-annual compounding. In order to price the option correctly he must
convert this rate to a continuously compounded rate. Calculate the continuously
compounded equivalent.
a. 6.00%
b. 5.91%
c. 5.76%
d. 5.63%
70. Consider the following 6x9 FRA. Assume the buyer of the FRA agrees to a
contract rate of 6.35% on a notional amount of 10 million USD. Calculate the
settlement amount of the seller if the settlement rate is 6.85%. Assume a 30/360
day count basis.
a. 12,500
b. 12,290
c. +12,500
d. +12,290
71. Calculate the Modified Duration of a bond with a Macauley duration of 13.083
years. Assume market interest rates are 11.5% and the coupon on the bond is
paid semi-annually.
a. 13.083
b. 12.732
c. 12.459
d. 12.371
72. The lognormal distribution is
a. Positively skewed
b. Negatively skewed
c. Not skewed, i.e., its skew equals 2
d. Not skewed, i.e., its skew equals 0

73. The following instruments are traded, on an ACT/360 basis:
3-month deposit (91 days), at 4.5%

3-6 FRA (92 days), at 4.6%
6-9 FRA (90 days), at 4.8%
9-12 FRA (92 days), at 6%
What is the 1-year interest rate on an ACT/360 basis?
a. 5.19%
b. 5.12%
c. 5.07%
d. 4.98%
74. Options on the Nikkei 225 from Osaka Exchange are traded on a multiplier of
1000. Volatility of the index is expected to be less than 15%. The index is at
12,000.
Which of the following positions has the highest credit exposure?
a. 400 call contracts at an 11,800 strike maturing in 1 month
b. 400 put contracts at a 12,200 strike maturing in 1 month
c. A FRN in JPY issued by an AAA corporate, for 100M JPY
d. Not enough information to tell.
75. A path-dependent option is priced with a variable-node trinomial lattice. What

should be done to reduce computational time without losing too much precision?
a. Set the model to binomial
b. Use same-length time intervals
c. Trim the tree of extreme prices with low probability of occurring
d. Reduce the number of steps
76. A martingale is a:
a. Zero-drift stochastic process.
b. Chaos-theory-related process.
c. Type of time series.
d. Mean-reverting stochastic process.

77. Given the following volatilities for foreign exchange rates:
JPY/USD at 9%
JPY/EUR at 11%
EUR/USD at 7%,
What is the correlation between JPY/EUR and EUR/USD?
a. -58%
b. 62%
c. 34%
d. -34%
78. What is the Net Present Value of a yearly payment starting at 100 and increasing
2% yearly for 15 years when the discount rate is 4%? (rounded to the nearest
tenth)
a. 1,120
b. 1,260
c. 1,470
d. 1,620
79. A bank has sold USD 300,000 of call options on 100,000 equities. The equities
trade at 50, the option strike price is 49, the maturity is in 3 months, volatility is
20%, and the interest rate is 5%. How does it the bank delta hedge? (round to
the nearest thousand share)
a. Buy 65,000 shares
b. Buy 100,000 shares
c. Buy 21,000 shares
d. Sell 100,000 shares
80. Which position is most risky?
a. Gamma-negative, delta-neutral
b. Gamma-positive, delta-positive
c. Gamma-negative, delta-positive
d. Gamma-positive, delta-neutral
81. When pricing an FX option, what factor must be used, on top of the factors used
for Black-Scholes pricing? The:
a. Correlation between currencies.
b. Interest rate differential with USD.
c. Domestic interest rate.
d. Foreign interest rate.
82. The VaR of one asset is100; the VaR of another asset is 150. If their combined
VaR is 220, what is their correlation?
a. 0.92
b. 0.53
c. 0.53
d. 0.92
83. The volatility of an asset, over 1.5 years, is 35%. What is its 1-year volatility if it is
derived from the 1.5 year value?
a. 43%
b. 35%
c. 29%
d. 23%
84. If a counterparty defaults before maturity, which of the following situations will
cause a credit loss?
a. You are short EUR in a 1-year EUR/USD forward FX contract and the
EUR has appreciated.
b. You are short EUR in a 1-year EUR/USD forward FX contract and the
EUR has depreciated.
c. You sold a 1-year OTC EUR call option and the EUR has appreciated.
d. You sold a 1-year OTC EUR call option and the EUR has depreciated.

Capital Markets and Market Risk Management

85. Consider the following single stock portfolio: Stock ABC has a market position of
$200,000 and an annualized volatility of 30%. Calculate the linear VaR with 99%
confidence level for a 10 business day holding period. Assume normal
distribution and round to the nearest dollar.
a. $11,952
b. $27,849
c. $60,000
d. $88,066
86. If two securities have the same volatility and a correlation equal to 0.5, their
minimum variance hedge ratio is:
a. 1:1
b. 2:1
c. 4:1
d. 16:1
87. You would expect the ratio of premiums for two at-the-money call options on the
same underlying equity with the same strike price, one expiring 12 months and
the other 1 month from now, to be close to:
a. 12
b. 6
c. 3.5
d. 2
88. A 3 month European call option on DEF stock with a strike price of $50 is trading
for $2.25. The risk free rate is 10%. The current stock price of DEF stock is $48.
Calculate the value of a corresponding put with the same strike and maturity.
a. $2.00
b. $2.25
c. $3.02
d. $3.57
89. Estimate the forward rate of a 6-month EUR/USD foreign exchange rate
contract. USD LIBOR is 6% and EURIBOR is 4%. The current exchange rate is
0.8800 USD per EUR.
a. 0.9240
b. 0.9064
c. 0.8976
d. 0.8888
90. Which of the following is the riskiest form of speculation using options contracts?
a. Setting up a spread using call options
b. Buying put options
c. Writing naked call options
d. Writing naked put options
91. Using the Black-Scholes model calculate the value of a European call option
given the following information:
Spot rate = 100
Strike price = 110
Risk- free rate = 10%
Time to expiry = 0.5 years
N(d1) = 0.457185
N(d2) = 0.374163
a. $10.90
b. $9.51
c. $6.57
d. $4.92
92. Under usually accepted rules of market behavior, the relationship between
parametric delta-normal VaR and historical VaR will tend to be:
a. Parametric VaR will be higher
b. Parametric VaR will be lower
c. It depends on the correlations
d. None of the above

93. Calculate the price of a 1-year forward contract on gold. Assume the storage cost
for gold is $5.00 per ounce with payment made at the end of the year. Spot gold
is $290 per ounce and the risk free rate is 5%.
a. $304.86
b. $309.87
c. $310.12
d. $313.17
94. An option trader constructs the following position: buys 1 call with a strike price at
X , buys 1 call with a strike price at X and sell 2 calls with a strike X . Where
X < X < X and X = *( X + X ). This strategy is referred to as a
a. Butterfly Spread
b. Bull Spread
c. Strap Spread
d. Strip Spread
95. The option-adjusted duration of a callable bond will be close to the duration of a
similar non-callable bond when the:
a. Bond trades above the call price.
b. Bond has a high volatility.
c. Bond trades much lower than the call price.
d. Bond trades above parity.
96. A company anticipates the purchase British pounds in 6 months. The standard
deviation of the change in British pounds over a 6-month period is calculated to
be 9%. The company chooses to hedge their exposure by buying future contracts
on EUR. The standard deviation of the change in the futures price over a 6-
month period is calculated to be 10% and the correlation coefficient between
British pounds and EUR is 0.70. Calculate the optimal hedge ratio.
a. 1.0
b. 0.90
c. 0.70
d. 0.63
97. Which of the following is NOT a reason why corporates should hedge their
exposures? To:
a. Facilitate optimal investment.
b. Lower the cost of financial distress.
c. Lower transaction costs.
d. Lower the cost of corporate management.
98. What is the most typical underlying used for weather derivatives?
a. The hourly average of temperatures at daylight.
b. Heating/cooling degrees during working days.
c. The average of the daily minimum and maximum temperatures.
d. The number of days of rain.
99. A long position in a put option can be synthetically reproduced by:
a. Long position in the underlying and a short position in a call.
b. Short position in the underlying and a long position in a call.
c. Long position in the underlying and a long position in a put.
d. Short position in the underlying and a short position in a put.
100. Stress testing is best defined as:
a. The absolute maximum loss that a portfolio can incur.
b. As alternative to risk measurement to replace VaR.
c. A 99% confidence level of risk.
d. A way of identifying extreme price changes on a portfolio.

101. What is the scenario most used for stress-test of firm-wide positions?
a. The 1987 equity crash
b. Money tightening by central banks
c. Failure of a specific country
d. Widening of credit spreads
102. A fund manager owns a 50 million USD growth portfolio that has a beta of 1.6
relative to the S&P 500. The S&P 500 Index is trading at 1190. Calculate the
number of futures contracts the fund manager needs to sell to hedge the
portfolio. (The multiplier of the S&P 500 is 250)
a. 105
b. 168
c. 269
d. 283
103. Suppose that at the maturity of futures contracts, the fund manager of the
previous question experiences a decline in value of his portfolio of 15%. The
market index is trading at 1078 and the risk free rate is 3%. Calculate the
effectiveness of the hedge.
a. No Gain, small loss
b. Gain of 32K
c. Gain of 424K
d. Gain of 1500K
104. When the maturity of a plain coupon bond increases, its duration increases:
a. Indefinitely and regularly
b. Up to a certain level
c. Indefinitely and progressively
d. In a way dependent on the bond being priced above or below par

105. Assume that the current spot exchange rate is 0.8950 USD per 1 EUR. An
American bank pays 3.5 percent annual interest rate for a dollar deposit and a
European bank pays 2.75 percent annual interest rate for a EUR deposit. Both
rates are compounded annually. If the interest-rate parity theory holds true,
calculate the no arbitrage forward exchange rate for EUR/USD one year from
now:
a. 0.9015
b. 0.8990
c. 0.8975
d. 0.8950
106. Consider a non-dividend paying stock currently priced at $37. It is known with
certainty that over the next two 3-month periods, the price will either rise by 5%
or fall by 5%. The continuously compounded risk free rate is 7%. Calculate the
value of a six-month European call option with a strike price at $38.
a. $1.065
b. $1.234
c. $1.856
d. $2.710
107. An operator has bought a short condor. His position is:
a. Delta-negative, vega-negative
b. Delta-negative, vega-positive
c. Delta-neutral, vega-negative
d. Delta-neutral, vega-positive
108. What yield curve interpolation method is least indicated?
a. Cubic splines
b. Step-wise interpolation
c. Log-linear interpolation
d. Linear interpolation

109. What instrument makes a convexity correction necessary for a yield curve?
a. Option-based instruments
b. FRAs
c. Futures
d. Swaps
110. Consider a European call option on a non-dividend paying stock. The current
market price is $100, the strike price is $102, the time to maturity is 9 months and
the risk free rate is 7.25%. Calculate the lower bound of the option price.
a. $3.40
b. $3.22
c. $2.75
d. $2.00
111. Consider the following bearish option strategy of buying one at-the-money put
with a strike price of $43 for $6, selling two puts with a strike price of $37 for $4
each and buying one put with a strike price of $32 for $1. If the stock price
plummets to $19 at expiration, calculate the net profit/loss per share of the
strategy.
a. 2.00 per share
b. Zero no profit or loss
c. 1.00 per share
d. 2.00 per share
112. Which of the following is most true about American options?
a. Early exercise is never optimal.
b. Early exercise of an American call on a non-dividend paying stock is never

optimal.
c. Early exercise of an American put on a non-dividend paying stock is never

optimal.
d. Prior to exercise the value of the American call is always equal to the
European call.

113. An option portfolio exhibits high unfavorable sensitivity to increases in implied

volatility and while experiencing significant daily losses with the passage of time.
Which strategy would the trader most likely employ to hedge his portfolio?
a. Sell short dated options and buy long dated options.
b. Buy short dated options and sell long dated options.
c. Sell short dated options and sell long dated options.
d. Buy short dated options and buy long dated options.
114. Rank the following portfolios from least risky to most risky. Assume 252 trading
days a year and there are 5 trading days per week. (This question did not
count when the exam was graded)
Holding
Period in Confidence
Portfolio VaR Days Interval
1 10 5 99
2 10 5 95
3 10 10 99
4 10 10 95
5 10 15 99
6 10 15 95
a. 5,3,6,1,4,2
b. 3,4,1,2,5,6
c. 5,6,1,2,3,4
d. 2,1,5,6,4,3
115. Consider the following call option with 6-months till expiry. The strike price is
$50, the current stock price is $55 and the value of the option is $5. What does
this imply about the level of 6-month interest rates?
a. Interest rates are positively sloped around the 6-month period.
b. Interest rates are negatively sloped around the 6-month period.
c. Interest rates are at zero for the - month period.
d. Cannot be determined from the information given.

116. Which one of the following statements is FALSE about Latin American stock
markets?
a. The Chilean stock index IPSA is usually less volatile than the Argentinean
stock index MERVAL.
b. The market capitalization of the Brazilian stock market is much larger than
the market capitalization of the Venezuelan stock market.
c. You can only find derivatives contracts on Latin American stock indexes
listed in derivatives exchange in the United States.
d. Two of most important stock indexes in the region are the Argentinean
MERVAL and the Brazilian IBOVESPA.
117. What is the main reason why convertible bonds are generally issued with a call?
a. To make their analysis less easy for investors.
b. To protect against unwanted takeover bids.
c. To reduce duration.
d. To force conversion if in-the-money.
118. When pricing an option with a discrete time model using the same volatility
assumption, as compared to a continuous time model, the value will tend to go:
a. Up
b. Down
c. Up or down, according to the in-the-moneyness of the option
d. Up or down, no rules
119. A corporate bond is convertible at 40 and the corporation has called it for
redemption at 106. The bond is currently selling at 115 and the stock's current
market price is 45. Which of the following would a bondholder most likely do?
a. Sell the bond.
b. Convert the bond into common stock.
c. Allow the corporation to call the bond at 106.
d. None of the above.

120. A trader buys a swaption on a 10-year Libor to 5% semiannual swap, and, to

keep the delta neutral, shorts government bonds. What can be said about the
position?
a. Volatility risk remains, as well as basis risk and interest rate risk
b. Interest rate risk is completely eliminated
c. The position is delta-neutral and gamma-positive, hence profit is locked
d. Basis risk should first be hedged
121. In what case is a position to be revalued with accrual methods instead of mark-
to-market?
a. When the market prices are too volatile
b. When interest accrued is more remunerative than price differences
c. For OTC trades, or when market prices are difficult to get
d. When the position is intended to be kept until maturity, or is matched with

non-financial instruments
122. What is the most important consequence of an option having a discontinuous

payoff function?
a. An increase in operational risks, as the expiry price can be contested or

manipulated if close to a point of discontinuity
b. When the underlying is close to the points of discontinuity, a very high

gamma
c. Difficulties to assess the correct market price at expiry
d. None of the above
123. Which of the following Greeks contributes most to the risk of an option that is
close to expiration and deep in the money?
a. Vega
b. Rho
c. Gamma
d. Delta

Legal, Accounting and Tax Risk

124. Most credit derivatives contracts: (This question did not count when the
exam was graded)
a. Are based upon English law
b. Are written on a one-off basis
c. Have a clause about restructuring
d. Are based upon ISDA agreement
125. What is the most general way accounting discrepancies are dealt with? These
are:
a. Imperatively corrected within the day
b. Transferred to other books
c. Corrected within the day if significantly affecting daily P&L
d. Generally corrected if discrepancies are big, otherwise left in suspense

accounts
126. Which is closer to a definition of money laundering? Money laundering is the

process to:
a. Make money from vice appear in more tolerant countries.
b. Make money used for weapons trade more discrete, for political. purposes
c. Make proceeds of crime into apparently legitimate capital.
d. Get drugs-related proceeds to escape tax.
127. Convertible bonds are justified as a financial instrument because:
a. For an investor there is an upside but limited downside; for the issuer, the
equity is sold at a higher price.
b. Both investor and issuer benefit from a better tax and regulatory
treatment.
c. The investor can buy the equity with a trial period; the issuer can spread
the dilution effect in time, which is better against unwanted takeovers.
d. The issuer can sell the volatility of the equity, which he knows better than
the investor does.
128. Compared to traditional ways to invest, hedge funds generally are, as a vehicle
for investment:
a. More risky, because they are smaller and less diversified.
b. Less risky, because they are managed by small, more efficient teams.
c. More risky, because they are more leveraged.
d. Less risky, because they hedge their positions.
129. FASB's latest decision about banks' losses related to the events of 11th
September 2001 is that these:
a. Losses must appear as capital losses.
b. Are an extraordinary item.
c. Must be shown as a separate item within extraordinary items.
d. Must appear in the relevant places in the P&L, according to their nature.
130. Liquidity risk is the risk that:
I. The markets get less active, making it difficult to exit

II. The offices get flooded
III. It becomes difficult to borrow money
IV. The process for settlement becomes less smooth
a. I and II
b. II and III
c. I and III
d. I and IV

Answer Key
Question Answer
1 c
2 c
3 b
4 b
5 a
6 d
7 b
8 a
9 a
10 a
11 c
12 b
13 a
14 b
15 a
16 b
17 b
18 c
19 c
20 d
21 a
22 d
23 c
24 a
25 b&c
26 a
27 a
28 d
29 b
30 c
November 17, 2001 A-1 2001 GARP

31 c
32 a
33 d
34 c
35 c
36 d
37 c
38 b
39 d
40 a
41 d
42 a
43 b
44 d
45 a
46 d
47 a
48 c
49 b
50 d
51 c
52 a
53 b
54 b
55 d
56 c
57 b
58 b
59 c
60 a
61 b
62 b
63 a

64 d
65 c
66 b
67 c
68 a
69 b
70 b
71 d
72 a
73 c
74 c
75 a&c
76 a
77 a
78 b
79 a
80 c
81 d
82 b
83 c
84 b
85 b
86 b
87 c
88 c
89 d
90 c
91 c
92 b
93 b
94 a
95 c
96 d

97 c
98 c
99 b
100 d
101 a
102 c
103 b
104 b
105 a
106 b
107 c&d
108 b
109 c
110 a
111 d
112 b
113 a
114 a
115 c
116 c
117 d
118 b
119 a
120 a
121 d
122 b
123 d
124 c
125 d
126 c
127 d
128 c
129 d

130 c

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2001 Financial Risk Manager Examination

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Global Association of Risk Professionals 2001 Financial Risk Manager Exam

2001 Financial Risk Manager Examination

Abu Dhabi New York City

November 17, 2001 2001 GARP

The Global Association of Risk Professionals would like to thank the

The Members of the FRM Committee of GARP:

November 17, 2001 i 2001 GARP

Session I (9:00 a.m. 11:30 a.m.)

Credit Risk Management (32 Questions) ................................................. I - 2

Regulation and Compliance (13 Questions)........................................... I - 11

Operational and Integrated Risk Management (20 Questions).............. I - 16

November 17, 2001 I-1 2001 GARP

Credit Risk Management

b. The upgrading of the borrowers credit rating

c. Failing to pay a coupon on another bond

d. Announcing that projected future earnings are going to be much lower

c. 2.5 standard deviations

d. Cannot not be determined from the information given.

b. Differences in recovery rates

d. Different jurisdiction for the contract

b. Default, call and sinking fund

c. Default, coupon and time to maturity

d. Default, lower interest rate, sinking fund

a. A cross-currency swap after 2 years

b. A cross-currency swap after 9 years

c. An interest rate swap after 2 years

d. An interest rate swap after 9 years

November 17, 2001 I-3 2001 GARP

9. A BB bond has a probability of default of 1% over the next year, assuming an

a. Interest rate risk

c. Funding liquidity risk

d. Asset liquidity risk

November 17, 2001 I-4 2001 GARP

13. A US bank makes a loan to a Mexican company of $250m, which collateralized

c. A short knock-in call

November 17, 2001 I-5 2001 GARP

15. Which expression for determining a market risk factor is correct?

a. RAROC risk factor = 2.33 X weekly volatility X 52 X (1 - tax rate)

b. RAROC risk factor = 2.33 X weekly volatility X 52 X (1 - tax rate)

c. RAROC risk factor = 2.33 X weekly volatility X 52 X tax rate

d. RAROC risk factor = 2.33 X weekly volatility X 52 X tax rate

16. A portfolio consists of 20 well diversified A rated bonds, assuming a default

d. Mac Kinseys Credit Portfolio View

November 17, 2001 I-6 2001 GARP

d. The dollar standard deviation of a loan portfolio does not depend on

20. Credit-linked notes contain, more typically, as an embedded instrument, a:

a. Credit spread option

c. Total return swap

d. Credit default swap

a. The mark to market value or replacement value of the obligation

b. The current value plus potential future exposure of the obligation

c. The mark to market value times the recovery rate

d. Depends on the credit rating of the obligor

November 17, 2001 I-7 2001 GARP

b. $2m x default rate (0.01) = $20,000

c. $2m x default rate (0.01) x recovery rate (0.4) = $8,000

d. $2m x default rate (0.01) x {1 recovery rate} (0.6) = $12,000

23. What is the central assumption made by CreditMetrics?

a. An asset or portfolio should be thought of in terms of its diversification.

b. An asset or portfolio should be thought of in terms of the likelihood of

c. An asset or portfolio should be thought of in terms of the likelihood of

d. An asset or portfolio should be thought in terms of changes in credit

a. Modified method of Merton to deduce the net value of the firm as an

b. Uses bond yield credit spread to determine default probability