Foundations of Risk Management (FRM)

This area focuses on your knowledge of foundational concepts of risk management and how risk management can add value to an organization. The broad areas of knowledge covered in Foundations‐ related readings include the following:

• Basic risk types, measurement and management tools • Creating value with risk management • The role of risk management in corporate governance • Enterprise Risk Management (ERM) • Financial disasters and risk management failures • The Capital Asset Pricing Model (CAPM) • Risk‐adjusted performance measurement • Multifactor models • Information risk and data quality management • Ethics and the GARP Code of Conduct

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Foundations of Risk Management

Frm Section Foundations of Risk Management

1. The dependent and independent variable in the capital allocation line equation are most likely:

Dependent Variable Independent Variable A. Expected return Total risk B. Total risk Market risk premium C. Expected return Market risk premium D. Market Risk

2. The minimum variance frontier most likely consists of:

A. Individual assets only B. Only the safest assets C. Individual assets and portfolios D. Portfolios only

3. An investor will be indifferent between two investments with:

A. Different expected returns, if the investment with the lower expected return entails a lower level of risk. B. The same expected returns, if the investments have different levels of risk. C. Different expected returns, if the investment with the higher expected return entails a lower level of risk. D. The same expected risk but potentially safer returns.

4. Consider the following statements:

Statement 1: All the portfolios on the capital market line are perfectly positively correlated.

Statement 2: A risk-free asset has zero correlation with all other risky assets.

Which of the following is most likely?

A. Both statements are incorrect. B. Both statements are correct. C. Only one statement is correct.

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5. An analyst gathered the following information regarding three portfolios. Which portfolio is most likely to plot below the Markowitz efficient frontier?

Portfolio Expected Return Standard Deviation A. 8% 13% B. 15% 16% C. 11% 20%

6. The greater the disparity between an investor’s cost of borrowing and the risk-free rate:

A. The greater the slope of the CML B. The more significant the kink in the CML C. The greater the expected return on the market portfolio D. The greater the potential alpha of the portfolio

7. Can the CML be applied to price individual assets and inefficient portfolios?

Individual Assets Inefficient Portfolios A. Yes Yes B. No No C. Yes No D. No Yes

8. Jennifer invests 30% of her funds in the risk-free asset, 45% in the market portfolio, and the rest in Beta Corp, a U.S. stock that has a beta of 0.9. Given that the risk-free rate and the expected return on the market are 7% and 16% respectively, the portfolio’s expected return is closest to:

A. 13.08% B. 16.00% C. 15.10% D. 12.50%

9. A portfolio that lies to the left of the market portfolio on the CML is:

A. A borrowing portfolio B. A lending portfolio C. An efficient portfolio D. Is most likely to generate alpha

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10. Which of the following statements is most accurate?

A. If the beta for an asset is greater than 1, it will lie above the security market line. B. Beta can be viewed as a standardized measure of unsystematic risk. C. Any security that plots below the security market line is considered overpriced. D. Any security along the efficient frontier will not change the beta of a portfolio when added.

11. The efficient frontier represents:

A. The set of portfolios that has the maximum rate of return for every given risk level, and the minimum risk for every level of return. A point on the efficient frontier will dominate a point that is directly above it. B. The set of portfolios that has the minimum risk for every level of return. A point on the efficient frontier will dominate any point that is directly to the left of it. C. The set of portfolios that has the maximum rate of return for every given risk level, and the minimum risk for every level of return. A point on the efficient frontier will dominate a point directly below it. D. The set of portfolios that has the maximum rate of return for every given risk level. A point on the efficient frontier will dominate any point that is directly to the left of it.

12. ______standardizes risk by dividing the covariance of an asset with the market portfolio by the variance of the market portfolio.

A. Correlation coefficient B. Treynor measure C. Standard deviation D. Beta

13. Beta of an asset is defined as:

A. The variance of the market return, divided by the covariance of the asset return with the market return. B. The covariance of the asset return with the market return, divided by the variance of the market return. C. The covariance of the asset return with the market return, divided by the variance of the asset return. D. The standard deviation of the market return, divided by the covariance of the asset return with the market return.

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14. The correlation coefficient between the market and stock A is 0.33. The market has an expected return of 12% and a coefficient of variation of 1.4. The security has a variance of 0.03. Its beta with respect to the market equals ______.

A. 0.24 B. 0.34 C. 0.19 D. 0.46

15. Which of the following is most likely?

A. The lower the diversification ratio, the greater the risk reduction benefits of diversification and the greater the portfolio effect. B. The higher the diversification ratio, the greater the risk reduction benefits of diversification and the greater the portfolio effect. C. The lower the diversification ratio, the lower the risk reduction benefits of diversification and the greater the portfolio effect. D. The lower the diversification ratio, the higher the risk reduction benefits of diversification and the lower the portfolio effect.

16. An analyst gathered the following information regarding two stocks:

Stock A Stock B Beta 0.7 1.1 Current market price $20 $35 Expected dividend $1 $1 Expected price at year end $23 $37

Assuming a risk-free rate of 5% and the expected market return of 12%, which of the following statements is most accurate?

A. Stock A is overpriced and therefore the analyst should sell it. B. Stock B is underpriced and therefore the analyst should buy it. C. Stock A is underpriced and therefore the analyst should buy it.

17. Susan has a portfolio whose standard deviation is estimated to be 11.68%. She is thinking of adding another asset to her portfolio whose standard deviation of returns is the same as her existing portfolio, but has a correlation coefficient with the existing portfolio of 0.65. If she adds the new asset to her portfolio, the standard deviation of the new portfolio will be:

A. Equal to 11.68% B. Less than 11.68% C. More than 12.68% D. Between 11.68% and 12.68%

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18. Which of the following approaches to risk is most likely to be consistent with taking a portfolio perspective?

A. Measuring risk based on the relative total risk of securities. B. Measuring risk based on relative total risk multiplied by the correlation of a security with other assets. C. Measuring risk based on relative total value at risk of securities. D. Measuring risk based on relative variance to a peer group of securities.

19. What remains in a market portfolio that cannot be diversified away?

A. Security market line B. Unsystematic risk C. A noncomplete diversified portfolio D. Systematic risk

20. A two-factor APT model and three assets that are consistent with this model are given below:

E(R) = 5% + 7% × S1 − 9% × S2

What is the expected return of a portfolio composed of these assets that has a sensitivity of 1.25 to factor 1 and 2.45 to factor 2?

A. 8.21% B. −8.3% C. −7.45% D. 11.45%

21 . Which of the following is an assumption of the arbitrage pricing theory (APT)?

A. Perfectly competitive capital markets B. A market portfolio that contains all risky assets and is mean-variance efficient C. Normally distributed security returns D. Quadratic utility function

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22. The arbitrage pricing theory assumes:

A. That capital markets are perfectly competitive, that investors always prefer more wealth to less wealth with certainty, and the utility function is quadratic in nature. It does not assume that the stochastic process generating asset returns can be represented as a K factor model, or that security returns are normally distributed. B. That capital markets are perfectly competitive, security returns are normally distributed, and that the stochastic process generating asset returns can be represented as a K factor model. It does not assume that the utility function is quadratic in nature, or that there is a market portfolio that contains all risky assets and is mean-variance efficient. C. That capital markets are perfectly competitive, that investors always prefer more wealth to less wealth with certainty, and that there is a market portfolio that contains all risky assets and is mean-variance efficient. It does not assume that the stochastic process generating asset returns can be represented as a K factor model, or that security returns are normally distributed. D. That capital markets are perfectly competitive, investors always prefer more wealth to less wealth with certainty, and that the stochastic process generating asset returns can be represented as a K factor model. It does not assume that the utility function is quadratic in nature, or that there is a market portfolio that contains all risky assets and is mean-variance efficient.

23. With respect to the definitions of risk and risk management, which of the following statements is most accurate?

A. Risk is the potential size of a loss and risk management is the quantification of the difference between expected losses and unexpected losses. B. Risk is the variation of economic outcomes and risk management is the management of unexpected losses. C. Risk management is the minimization of the variance of unexpected variables and maximizing the variance of the known variables (return) where risk is the variation of both of these variables. D. Risk management is the minimization of unexpected losses and risk is the variation between known and unknown risks.

24. Which of the following is not a step in the risk management process?

A. Mapping risk exposures to asset classes B. Determination of: accept risk, transfer risk, avoid risk C. Translate mapped risk factors into a Gaussian value at risk D. Evaluate performance or risk management and modify if needed.

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25. Classification of risk types has dangers of its own because of the risk of oversimplification or other problems. Which of the following is not a tool or procedure used in risk management?

A. “Silo” or business unit risk management B. Quantification tools and measures C. Qualitative assessment D. Enterprise risk management

26. Expected losses and unexpected losses are important concepts in risk management. Which of the following statements regarding these different types of losses is most accurate?

A. Expected losses are those that can be expected during the normal course of business, such as operational risk losses or credit risk losses. B. Unexpected losses are losses that come from risk factors that are incorrectly omitted from a risk model. C. Expected losses are those that can be extended into the future by the square root of time rule under certain assumptions. D. Unexpected losses are the sum of losses expected by a risk model and losses that exceed the expectations under the model assumptions.

27. The range of risk management types extends beyond simply managing market risks. Enterprise-level risk management incorporates many types of potential sources of risks. Which of the following statements correctly pairs one of these risk types with its potential impact on an organization facing the risk?

A. Foreign exchange risk is exposure to a foreign currency. As foreign currency volatility increases, the correlation between cross-currency investments and profitability on a risk-adjusted basis also increases. B. Operational risks stem from management failures, system failures, employee theft, or external events such as earthquakes or terrorism. Risks from derivatives trading fall outside the operational risks bucket and would not increase operational risk. C. One type of liquidity risk is the risk that a company can’t raise capital to fund ongoing operations or roll over its debt. One way to mitigate liquidity risk is to use overnight repo to raise cash. D. Commodity price risk can arise from changes in the price of products needed within the supply chain of a company. Basis risk can arise when trying to hedge commodity price risk with a product whose price moves are not perfectly correlated with commodity price risk.

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28. Ambrose Inc. is a manufacturer that is dependent on plastic from the Philippines. Ambrose wants to hedge its exposure to plastic price shocks over the next 10.5 months. Futures contracts, however, are not readily available for plastic.

After some research, Ambrose identifies futures contracts on other commodities whose prices are closely correlated to plastic prices. Futures on Commodity A have a correlation of 0.85 with the price of plastic, and futures on Commodity B have a correlation of 0.92 with the price of plastic.

Futures on both Commodity A and Commodity B are available with 3-month and 12-month expirations, but Ambrose needs only a 10.5 month hedge. Ignoring liquidity considerations, which contract would be the best to minimize basis risk?

A. Futures on Commodity B with nine months to expiration B. Futures on Commodity A with three months to expiration C. Futures on Commodity A with nine months to expiration D. Futures on Commodity B with three months to expiration

29. One of the ways corporations incentivize senior management to increase the firm’s value is to grant options or securities tied to the firm’s stock. Some options, however, can reduce managerial incentives to manage risk within the firm. Which is likely the best example of a security that actually reduces a manager’s incentive to manage risk?

A. Deep in-he-money call option on the firm’s stock B. Deep out-of-the-money call option on the firm’s stock C. At-the-money call option on the firm’s stock D. Long position in firm’s stock

Note: In the real world, rarely would a single manager influence the price of a stock. The idea here is to test intuition in a way that GARP may ask on exam day.

30. Your bank is implementing firm-wide enterprise risk management (ERM). Which of the following is most likely an implication of this change with respect to how a company manages its business?

A. ERM focuses more on maximizing firm value than managing risk. B. ERM disaggregates risk factors that previously may have been examined on a standalone basis for firm risk calculations. C. ERM is a transition to a mind-set of a defensive stance against unknown or downside risks to earnings. D. Changes in correlation can be a significant source of risk in any firm. ERM explicitly captures diversification benefits among business units by managing risk at the business unit level, as close as possible to the source of the risk.

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31. Which of the following is not a benefit of adopting an ERM initiative?

A. Better risk reporting B. Higher cost of capital to investors C. Organizational effectiveness D. Improved business performance

32. Which of the following is not typically a responsibility of a chief risk officer (CRO)?

A. Designing a system of key risk factors, reporting mechanisms, and key risk exposures B. Providing the core leadership of implementing an enterprise risk management (ERM) platform C. Allocating operational capital to business activities based on risk and optimizing the firm’s risk profile D. Developing the quantification of the firm’s risk appetite via specific risk limits

33. Within the context of enterprise risk management (ERM), what is the difference between a top-down and bottom-up approach and why are both necessary within ERM?

A. In a bottom-up approach, risk limits are set at the business unit level and summed up to the top. For economic capital this is advantageous since it calculates the potential diversification among each of the business lines. B. In a top-down approach the risk limits are set at the senior level and distributed down but do not calculate the potential impact of diversification across each business line. C. Both are necessary because of the need to make sure risk limits, when aggregated across businesses, are consistent with the objectives of senior management. D. In both the bottom-up and top-down approaches, the risk allocation is the same regardless of where the analysis begins.

34. There are seven main components of an ERM program. Which of the following is not one of those components?

A. Shareholder management B. Line management C. Risk transfer D. Technology resources

35. The inappropriate hedge used by Metallgesellschaft in the case study can be best described as:

A. Used futures contracts with a notional value mismatch. B. Sold slightly different futures contracts at different expirations and simply allowed each one to expire. C. Bought futures contracts in related commodities and cash settling the contract prior to expiration. D. Managed long-term risk exposure with short-term futures and replaced expiring futures with long-term futures when they expired.

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36. In the event of large losses by a firm, the first culprit to blame is the risk management function. In what circumstances can large losses actually be a failure of risk management?

A. The risks were properly calculated but the risks should not have been taken. B. Traders made assumptions about correlation that weren’t captured by an overly simplistic VaR model. C. The firm chose to meet a trading target and exceeded a VaR limit. D. VaR calculations made assumptions about correlations that were overly simplistic.

37. Under the assumption that risk managers don’t manage risks—traders do—which of the following is not a type of a risk management failure?

A. Mismeasurement of known risks B. Failure to communicate known risks to top management C. Failure in the implementation of risk limits D. Failure to use the right risk metrics

38. If a failure of risk management is really a failure of risk measurement, then which of the following is least likely to be an example of a risk management failure?

A. Using the wrong distribution of returns B. Using the wrong correlation assumption among positions C. A risk that is known but is ignored D. Using risk-adjusted returns

39. If an indifference curve intersects the investor’s capital allocation line at two different points it is most likely that:

A. The investor is not maximizing her total utility. B. The higher of the two points offers a higher level of utility. C. The portfolios are leveraged portfolios. D. The portfolio lies along the efficient frontier.

40. Consider the following statements:

Statement 1: The risk-return characteristics of portfolios that combine the risk-free asset with a risky asset or a portfolio of risky assets lie along a straight line.

Statement 2: All other things remaining the same, the greater the slope of the capital allocation line, the better the risk-return characteristics of portfolios that lie on it.

Which of the following is most likely?

A. Only Statement 1 is correct. B. Only Statement 2 is correct. C. Both statements are correct. D. Neither statement is correct.

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41. Which of the following statements is least accurate?

A. An optimal portfolio for an investor occurs when the indifference curve is tangent to the efficient frontier. B. The efficient frontier represents a set of portfolios that have the maximum expected risk for every given level of expected return. C. The slope of the indifference curve represents the amount of extra return required by the investor to take on an additional unit of risk. D. The point of tangency to the efficient frontier represents the maximum risk that a portfolio can take.

42. The minimum variance frontier most likely consists of:

A. Individual assets only. B. Portfolios only. C. Individual assets and portfolios. D. Only risk-free assets.

43. Consider the following statements:

Statement 1: As correlation falls, the curvature of the line between the two assets’ risk-return profiles decreases.

Statement 2: The expected return of the portfolio decreases as the correlation coefficient of the two assets decreases.

Which of the following is most likely?

A. Only one statement is correct. B. Both statements are incorrect. C. Both statements are correct.

44. Beta is least likely defined as:

A. The ratio of the covariance of the stock’s return and the market return to the standard deviation of market returns. B. The correlation between the asset and the market times the ratio of the standard deviation of the asset to the standard deviation of the market. C. A measure of the sensitivity of the return on the asset to the market’s return. D. A measure of the relationship between an asset return and a diversified market return.

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45. The SML and CAPM can be used to price:

A. Individual assets and efficient portfolios only, not inefficient portfolios. B. All assets and portfolios. C. Efficient and inefficient portfolios, but not individual assets. D. Only individual assets.

46. Which of the following statements is most accurate?

A. The capital market line plots returns against market risk. B. The security market line plots returns against total risk. C. The capital market line plots returns against standard deviation. D. Assets on the efficient frontier don’t increase overall risk when added to a portfolio.

47. If the covariance of the market’s returns with a stock’s returns is 0.007, and the standard deviation of the market’s returns is 0.07, the stock’s beta is closest to:

A. 0.1 B. 1.43 C. 0.72 D. 0.46

48. Jessica is considering investing in two assets, A and B, with betas 2.1 and 1.6 respectively. Her broker tells her that the return on the market portfolio is 14% and that the risk-free rate is 6%. Given that the expected return on both the assets is 20%, she should most likely invest in:

A. Asset B only B. Asset A only C. None of the assets

49. According to the efficient frontier theory, an asset is considered efficient if:

A. It has a higher rate of return than other assets in its portfolio class. B. No other asset with equal payment characteristics offers a higher return, or no other asset with an equal return offers more favorable payment characteristics. C. No other asset with an equal expected return offers lower risk, or no other asset with equal risk offers a higher expected return. D. It has a higher risk-adjusted rate of return than other assets in its portfolio class.

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50. The slope of the SML in an economy is 8.9%. The risk-free rate prevailing in the economy is 4.9%. A security has a correlation coefficient of 0.23 with the market. The market’s standard deviation is 15% while that of the security is 19%. The expected return on the portfolio equals ______.

A. 7.49% B. 12.39% C. 13.66% D. 14.19%

51. A security is fairly priced under CAPM and you have estimated its expected return to be 12.6%. If you can invest in a risk-free asset at 5.3% and the beta of your security is 0.79, the risk premium demanded by the investors to invest in the market portfolio is ______.

A. 8.98% B. 9.24% C. 12.83% D. 14.54%

52. Which of the following assumptions are part of the CAPM?

A. There are no taxes or transaction costs. B. Investors have heterogeneous expectations. C. All of these answers are correct. D. Investors can lend but not borrow, at the risk-free rate.

53. Jane Boyd is an FRM candidate and has just registered for the last class required to complete her MBA program. The class relates to investments and is taught by Professor John Stratton. Stratton uses a unique teaching methodology, wherein portions of each session are actually taught by the students. Specifically, every week, a student will prepare a presentation relating to their chosen area of study.

The student will present to the class and will face questions from the professor and students upon completion. Boyd has chosen to do her presentation on portfolio theory.

Upon completion of the presentation, the students asked Boyd the following question: Which of the following statements regarding beta is correct?

A. Beta is a measure of the covariance between the asset return and the market return. B. Beta is a measure of diversification. C. Beta is a measure of systematic risk. D. Beta is a measure of unsystematic risk.

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54. Which of the following is not an assumption of the CAPM?

A. All investors have the same expectations regarding expected return, variances, and covariances. B. All assets are marketable and markets are perfectly competitive. C. Investors’ buy and sell decisions do not affect the prices prevailing in the market. D. Investors are able to borrow at the market rate of return and lend at the risk-free rate of return.

55. Assume that security J has a beta of 1.3 and that the risk-free rate of return in the market is 6%. Additionally, the equity risk premium is 8%. What is the expected return on security J?

A. 15.8% B. 16.4% C. 8.6% D. 14.8%

56. Dolly Drew, FRM, works for Delight Capital. Delight Capital would like to examine portfolio concepts with regards to quantitative analysis.

Dolly has been asked by the senior partner in the firm to report on portfolio concepts for next week’s partners meeting. The senior partner has done some preliminary research on portfolio concepts and has provided Dolly with a question that she would like answered.

Which of the following is the correct calculation of beta?

A. Beta = var(Ri, Rm) / var(Rm) B. Beta = cov(Ri, Rm) / var(Rm) C. Beta = cov(Ri, Rm) / var(Ri) D. Beta = var(Rm) / cov(Ri, Rm)

57. What is the correlation between the small-cap and the stock market?

Expected Return Standard Deviation Beta Small Caps 17% 15% 1.32 S&P 500 11% 9% Bonds 7% 6% International Stocks 19% T-bills 4%

A. 0.7863 B. 0.7546 C. 0.7920 D. 0.7234

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He selects a model that has a reasonable but small number of factors. He uses the difference in monthly returns between the managed portfolios and the market index represented by the S&P 500, represented as RTN, as the dependent variable. The independent variables are the S&P 500 return less the 90‐day T‐bill rate represented as MKT, the monthly returns to a passive portfolio of high EPS stocks less the returns of a passive portfolio of low EPS stocks represented by EPSS, and the monthly returns to a passive portfolio of small cap stocks less the returns of a passive portfolio of large cap stocks, represented by LCSC.

The following results were derived for the historical data:

RTN = −.0025 + .15MKT − .08EPSS − .07LCSC

Which of the following is not a reason to support the case for active portfolio management?

A. Failure of the CAPM beta to explain returns B. Excess volatility in market prices C. The existence of market anomalies D. Efficient frontier theory

59. Suppose that the correlation of the return of a portfolio with the return of its benchmark is 0.92, the volatility of the return of the portfolio is 14%, and the volatility of the return of the benchmark is 8%. What is the beta of the portfolio?

A. 1.00 B. 1.61 C. 1.64 D. −1.35

60. CAPM has many assumptions that are unrealistic in the real world. The arbitrage pricing theorem builds on the CAPM to resolve some of the limitations. What is true of CAPM?

A. All investors universally prefer less risk assuming the same return. B. Assumes capital gains tax affects all investors equally. C. Works only for log-normally distributed asset prices, not returns. D. Investors’ expectation about future returns are very different.

61. Which of the following portfolio performance measures equals the slope of the capital allocation line?

A. Sharpe ratio B. Jensen’s alpha C. Treynor ratio D. Sortino Ratio

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62. Which of the following is most likely based on systematic risk? A. Sharpe ratio B. Treynor ratio C. M2 D. Information ratio

63. Which of the following most likely indicates the maximum fee an investor should pay a portfolio manager? A. Sharpe ratio B. Jensen’s alpha C. Treynor ratio D. Sortino ratio

64. Assume that you are concerned only with systematic risk. Which of the following would be the best measure to use to rank order funds with different betas based on their risk-return relationship with the market portfolio? A. Treynor ratio B. Sharpe ratio C. Jensen’s alpha D. Sortino ratio

65. You have the following information on a portfolio in your bank. You have no other information.

Risk-free rate = 1% Portfolio return = 12% Benchmark return = 7% Standard deviation = 8% Tracking error = 2%

Which of the following is correct? A. The information ratio is 0.67. B. The information ratio is 1.60. C. The Sharpe ratio is 1.375. D. The Sharpe ratio is 2.67.

66. You are an analyst comparing manager performance. You expect the portfolio to return 12% and expect a standard deviation (risk) of 18%. The beta of this portfolio you know to be 0.90. The expected return of the market is 11% with a standard deviation of 14%. You expect the 2016 risk-free rate to be 1%. What is the Treynor measure? A. 0.060 B. 0.122 C. 0.36 D. 0.090

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67. An analyst gathered the following information:

Risk-free rate: 5% Market risk premium: 6% Beta: 0.8

The required rate of return for the stock is closest to:

A. 6% B. 5.8% C. 3.5% D. 9.8%

68. Which of the following statements is most accurate?

A. A security whose required rate of return is greater than the expected rate of return is considered overvalued and plots above the security market line. B. If the stock’s alpha is positive, it is considered undervalued and plots above the security market line. A security whose estimated rate of return is greater than the required rate of return is considered overvalued and plots below the security market line.

69. A regression of ABC Stock’s historical monthly returns against the return on the S&P 500 gives an alpha of 0.003 and a beta of 0.95. Given that ABC Stock rises by 4% during a month in which the market rose 2.25%, calculate the unexpected return on ABC Stock.

A. 1.75% B. 1.56% C. 2.44% D. 1.88%

70. The important factor to consider when adding an asset to a diversified portfolio is:

A. The standard deviation of the asset B. The range of returns of the asset C. The risk of the asset D. The covariance of the asset returns with the other asset returns in the portfolio

71. Which of the following statements is true of the arbitrage pricing theory (APT)?

A. There may be numerous factors influencing the return on an asset. B. Covariance with the market is the only relevant factor influencing the return on an asset. C. Standard deviation and inflation are the two factors influencing the return on an asset. D. There are only three factors influencing the return on an asset.

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72. John Quentin is a graduate student in mathematics currently applying for a job as a quantitative portfolio analyst with CMB Partnership. However, while Quentin is well versed in mathematics, his knowledge of portfolio theory is cursory. He would like to learn more about mean‐variance analysis and general portfolio theory concepts before he interviews with CMB’s managing director.

Which of the following is the primary determinant of portfolio standard deviation?

A. The expected return of the individual assets B. The standard deviation of the individual assets C. The number of securities in the portfolio D. The average covariance between the assets

73. Which of the following is not an example of a multifactor model?

A. Statistical factor models B. Macroeconomic factor models C. Fundamental factor models D. Systematic factor models

74. Which of the following is least likely a benefit of an effective data aggregation strategy?

A. Operational efficiency B. Reduced probability of losses C. Enhanced strategic decision making D. Reduced legal risks

75. Which of the following is not one of the principles outlined by the Basel Committee for data aggregation and reporting?

A. Enterprise governance and infrastructure B. Risk data aggregation capabilities C. Risk reporting practices D. Regulatory reporting

76. Which of the following is not a responsibility of each GARP member with respect to professional integrity and ethical conduct?

A. GARP members shall act with integrity in all dealings. B. GARP members shall accept no gifts greater than $500. C. Members shall be mindful of cultural differences regarding ethical behavior. D. Members shall exercise reasonable judgment.

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77. Which of the following is least likely to be a consequence of a GARP member violating the GARP code of conduct?

A. Reporting of the member to the regulatory authority of that member’s country. B. Suspension of the member for five years. C. Suspension of the member permanently. D. Removal of the right to use the FRM designation.

78. Of each of the following, which was not a key factor that led to the housing bubble?

A. Increased credit protection and tranching of credit risk. B. Shortening securitized products’ maturity to fit money market demand. C. The bank’s balance sheet effect that sparked liquidity spirals and fire sales. D. A general risk in popularity of securitized and structured products.

79. Maturity mismatch refers to the short-term nature of borrowing to finance long-duration assets. When liquidity crunches begin to occur in the marketplace, the price (spread) of short-term borrowing gets more expensive to represent the changing risk in the marketplace. In the regulated banking space, this maturity mismatch is less of a concern because the amount of funding relative to assets is known by regulators and there are regular stress tests to measure liquidity risk. How did the rise of shadow banking create a trigger for a liquidity crisis out of an asset that is typically so short-term and secure?

A. The capacity for a bank to enter into a repo transaction, where they borrowed cash secured with collateral but promised to repurchase that asset in the future, created new low-cost capital that could be invested in higher-return structured products. B. Because of low rates, money market funds searching for yield could purchase short-term asset-backed commercial paper (ABCP) with maturity dates of 90 days or a year. Even better, these ABCPs came with a liquidity backstop or guarantee by the bank that sold them. C. Shadow banks are particularly susceptible to runs on banks and since many of these shadow banks (hedge funds or private equity groups) have the same few counterparties, a simultaneous demand for liquidity could be a significant trigger for a deepening liquidity crisis. D. The large increase in the issuance of short-term commercial paper and smaller haircuts in the repo markets was a source of liquidity during the crisis. Ultimately, this extra liquidity injection couldn’t overcome the crisis of confidence among dealers and shadow banks.

80. Which of the following is not a correct step in correcting collateralized debt obligations (CDOs) or is an incorrect description of CDOs?

A. One step is to gather diversified portfolios of mortgages, loans, corporate bonds, and other receivables into an asset pool. B. One step is to try to sell a slice of the pool of assets that matches a particular customer’s credit risk profile. C. Unlike the interest rate swap curve that serves as a reference rate for swaps, there is no index that prices credit default swaps or can be traded like the S&P 500. D. The dividing line between different tranches is very important for selling to clients, but the so-called “toxic waste” is held by the bank actually selling the CDO.

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81. Credit default swaps (CDSs) have a unique payoff structure in that the value of the swap is contingent on an event specific to a reference entity (typically a bond or a corporate debt issuer), not a strike price, as in a plain-vanilla swaption. Of the following, which is not typically a credit event that would trigger a CDS payout?

A. A company falls very short of expected quarterly earnings. B. A company misses a bond payment. C. The reference entity announces a restructuring that dilutes the equity holders 2 to 1 with a senior preferred convertible bond attached to the new equity. D. A credit downgrade by only one of the three major rating agencies.

82. If tranches of structured products can have their own individual default 01s, then it is also true that individual tranches can have their own unique risk factors that impact tranches differently. Of the following tranche traits, which is correctly paired with an accurate description?

A. If correlation among the asset pool is low, then the senior bond has the potential for potentially large losses no matter how thick or thin the tranche actually is. B. The thinness of a tranche changes the risk profile of the senior debt due to the increasing difference between the 95% and 99% VaRs as default probabilities rise and default correlations are high. The reason is that for any tranche, conditioned upon that tranche experiencing a loss, the loss is likely to be large. C. The granularity of the asset pool, assuming all else being equal, can lead to the senior tranche being thicker with little change in the credit VaR of that tranche. D. High default correlation is one way of expressing low systematic risk, given the inverse relationship between equity values (high stock prices) and low credit risks (companies have cash to pay).

83. Many factors contributed to the financial crisis of 2007−2008, but many were related to synthetic residential mortgage securities and the indices used to hedge exposures. Which of these can be tied most directly to the origin of the crisis?

A. The nonstop increase in housing prices and the lack of confidence in counterparties’ ability to meet the mark-to-market over-the-counter (OTC) changes in valuation. B. The collapse of the asset-backed securities (ABS) indices market and the inability to deliver baskets of securities. C. The lack of subprime mortgages issued in the years prior to the panic and the asymmetric need for credit protection in the structured credit indices market. D. The transparency of the residential credit indices market and the reliance traders placed on the pricing information value to hedge risk.

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84. During the period following the 2008 financial crisis, banks began to realize that the lack of liquidity in products thought to be highly liquid was another source of risk previously thought to be minimal. Which of the following types of liquidity risk is correctly defined?

A. Transaction liquidity risk—This is identical to exogenous risk. B. Balance sheet risk—This is where a bank or customer could be forced out of positions because of the changing nature of credit terms. C. Spread liquidity risk—This is a loss of access to repo so a bank can no longer pay for the duration mismatch in its portfolio. D. Rollover liquidity risk—This is the risk that prices of the next futures contract will change in anticipation of investors rolling their positions.

85. Perceptions of counterparty credit risk drive the price of lots of asset classes: LIBOR, credit default swap (CDS), credit insurance, and so on. Which of the following describes how a change in counterparty credit risk can create a “loss loop” and a spillover systemic risk?

A. As counterparty default credit risk increases, the increase in CDS prices triggers additional margin calls and could force banks to obtain funding to meet those calls. B. An increase in counterparty credit risk decreases CDS prices in general and shadow banks that have large holdings of a declining asset will need to raise funding to meet those margin calls. C. An increase in counterparty risk reduces the trust between banks that any institution could survive without a bailout. As the Fed intervenes in the market with liquidity injections, reduced collateral standards, and lower discount window rates, all of these create huge demand for the excess liquidity and create a loss loop where institutional trust deteriorates even further. D. The duration mismatch in modern banking is built on trusting that short-term funding could be obtained to pay for the balance sheet of long-term assets. A decrease in counterparty risk will reduce the cost of short-term funding and balance sheet financing costs.

86. The size of the financial crisis relative to the subprime mortgage market meant there were triggers of the crisis but also vulnerabilities and amplifiers that led to a much wider crisis. Which of the following is correctly paired with its proper description as a trigger or a vulnerability (amplifier) of the crisis?

A. The growth of shadow banking and the use of securitized products to provide liquidity to the market were triggers of the financial crisis. B. The decline of housing prices was a trigger of the crisis. C. The use of short-term debt such as repo agreements to fund balance sheet assets was a trigger of the crisis. D. The growth in the use of securitized products by investors and the losses on those investments were triggers of the crisis.

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87. Which of the following is correctly paired with the way the product type served as a trigger or an amplifier of the financial crisis?

A. Short-term commercial paper triggered a “run on the bank” type mentality as money market funds “broke the buck.” B. Short-term debt backed by longer-dated assets was a trigger of the crisis as the value of those longer-dated assets was pushed lower in price as institutional investors had to meet margin calls. C. Repo agreements are generally considered the most secure form of short-term borrowing because these agreements are collateralized. As perceived credit risk traded higher, banks not renewing these short-term obligations amplified the financial crisis. D. The losses on securitized lending as home prices fell amplified the crisis because of the widening credit spreads and higher prices on CDS contracts that might offer any protection.

88. Which of the following was not a consequence of the failure of Lehman Brothers?

A. A run on credit markets sparked a worsening credit crisis that forced banks to decrease haircuts on repo transactions. B. Money market funds “broke the buck.” C. The U.S. Congress eventually intervened by passing the Troubled Asset Relief Program (TARP). D. Credit spreads widened dramatically, even on some of the safest credit-based products.

89. The financial crisis was not a linear event, meaning that shocks occurred and prices jumped by what financial engineers call a jump diffusion process. There were two distinct periods of nonlinear events for the most recent crisis. Which of the following timeframes is correctly paired with the stat of the markets during that time period? (The two periods are August 2007 and September−October 2008; each date is accurate, but the focus on the crisis may not be.)

A. August 2007—This period of the crisis had no sponsor-backed rescues of money market funds but also increased the market’s expectation that the money market sponsor (issuer or money market mutual fund) would always rescue money market funds. B. September−October 2008—This period of crisis amplified by the money market fund’s sponsors’ reluctance to rescue money market funds was noted for some funds actually “breaking the buck.” C. During the period of August 2007, there was no clear pattern of runs on asset-backed commercial paper in the market emerging yet. This occurred later in 2008. D. The large money market fund that broke the buck in August of 2007, the Reserve Primary Fund, was part of the reason Lehman fell in 2008 because so much of Lehman’s balance sheet was funded by asset-backed commercial paper.

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90. The financial crisis was a worldwide event and several governments around the world acted both unilaterally and collectively to manage the crisis in their countries. Which of the following actions is correctly paired with a policy response by a country, what does that response actually mean, and what short-term impact could it have?

A. Interest rate change—This government policy shift has a broad range of impacts from lowering the cost of credit, reducing the interest cost of using other tools available at the Federal Reserve. Typically the short-term impact here is limited because it takes time for the policy shift to spread through the market. B. Asset purchases—This central bank policy action can have an almost-immediate short-term impact because it can lift impaired assets off a bank’s balance sheet, increasing confidence in that bank’s counterparties and reducing a potential run on the bank. C. Liquidity support—This government stabilization policy move can also have a near- immediate impact as governments offer longer funding terms, higher credit lines, or lower reserve requirements, all of which free up liquidity to support impaired asset prices on the balance sheet. D. Recapitalization—This government policy choice can consist of a capital injection directly to an institution via common stock or preferred equity and can have an immediate impact on an institution’s credit quality and significantly reduce the potential for a run on the bank.

91. As the financial crisis spread beyond just asset prices, the Main Street economy was obviously hit very hard and arguably still has not recovered. Which of the following was not an impact on the real economy?

A. As confidence in the banking and financial sector fell, institutions began hoarding cash, limiting the cash available to Main Street normally expected to finance continuing operations, abruptly forcing many small businesses and even larger companies into layoffs. B. Almost all firms cut back on dividend payments and expenditures and cut contractors’ expenses by statistically significant amounts. C. As the credit crisis deepened, firms sought to roll over existing repo transactions or rely on the short-term commercial paper market instead of maxing out credit lines just in case they needed them. D. Despite the obvious need for cash, there was an overall decrease in the demand for consumer loans.

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Foundations of Risk Management: Answers

1. The dependent and independent variable in the capital allocation line equation are most likely:

Dependent Variable Independent Variable A. Expected return Total risk B. Total risk Market risk premium C. Expected return Market risk premium D. Market Risk

Answer: A

The CAL has expected return on the y-axis and portfolio risk on the x-axis.

2. The minimum variance frontier most likely consists of:

A. Individual assets only B. Only the safest assets C. Individual assets and portfolios D. Portfolios only

Answer: 0004

Assets with low correlations can be combined into portfolios that have a lower risk than any of the individual assets in the portfolio. The minimum variance frontier consists of portfolios that minimize the level of risk for each level of expected return.

3. An investor will be indifferent between two investments with:

Answer: A

An investor will be indifferent between two investments with different expected returns only if the investment with the lower expected return entails a lower level of risk.

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4. Consider the following statements:

Statement 1: All the portfolios on the capital market line are perfectly positively correlated.

Statement 2: A risk-free asset has zero correlation with all other risky assets.

Which of the following is most likely?

A. Both statements are incorrect. B. Both statements are correct. C. Only one statement is correct.

Answer: B

Both statements are correct.

5. An analyst gathered the following information regarding three portfolios. Which portfolio is most likely to plot below the Markowitz efficient frontier?

Portfolio Expected Return Standard Deviation A. 8% 13% B. 15% 16% C. 11% 20%

Answer: C

Portfolio C lies below the Markowitz efficient frontier because Portfolio B offers a higher return at lower risk.

6. The greater the disparity between an investor’s cost of borrowing and the risk-free rate:

A. The greater the slope of the CML B. The more significant the kink in the CML C. The greater the expected return on the market portfolio D. The greater the potential alpha of the portfolio

Answer: B

The slope of the CML for lending portfolios (where a portion of the investor’s funds are invested in the risk-free asset) is dictated by the difference between the risk-free rate and the market portfolio.

The slope of the CML for leveraged or borrowing portfolios (where the weight of the market portfolio of the investor’s portfolio is greater than 100%) is dictated by the difference between the cost of borrowing and the market portfolio.

The greater the difference between the risk-free rate and the cost of borrowing, the greater the significance of the kink in the CML.

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7. Can the CML be applied to price individual assets and inefficient portfolios?

Individual Assets Inefficient Portfolios A. Yes Yes B. No No C. Yes No D. No Yes

Answer: B

The CAL and the CML only applied to efficient portfolios, not to individual assets or inefficient portfolios. They use total risk on the x-axis, and since only systematic risk is priced, they can be used only for efficient portfolios (those with no unsystematic risk and whose total risk therefore was the same as their systematic risk).

A. 13.08% B. 16.00% C. 15.10% D. 12.50%

Answer: A

Beta of the portfolio = w1R1 + w2R2 + w3R3

Beta of the portfolio = (0.3 × 0) + (0.45 × 1) + (0.25 × 0.9) = 0.675

Expected return of the portfolio = Rf + R (Rm − Rf)

Expected return of the portfolio = 0.07 + 0.675 (0.16 − 0.07) = 0.1308 or 13.08%

9. A portfolio that lies to the left of the market portfolio on the CML is:

A. A borrowing portfolio B. A lending portfolio C. An efficient portfolio D. Is most likely to generate alpha

Answer: B

A portfolio to the left of the market portfolio on the CML is less risky, as investors lend a proportion of their funds at the risk-free rate.

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10. Which of the following statements is most accurate?

Answer: C

Beta can be viewed as a standardized measure of systematic risk.

All efficiently priced securities should lie on the security market line. Beta only determines where the security will lie on the security market line. If the beta for an asset is greater than 1, the asset has a higher normalized systematic risk than the market, which means that it is more volatile than the overall market portfolio and plots to the right of the market portfolio on the SML.

11. The efficient frontier represents:

Answer: A

The efficient frontier is the set of portfolios that has the maximum rate of return for every given risk level, and the minimum risk for every level of return. Any utility-maximizing investor will prefer a point on the frontier to one below it. But no point on the frontier dominates any other point on the frontier. Only an investor’s particular utility curves determine which point on the efficient frontier will be chosen as optimal.

12. ______standardizes risk by dividing the covariance of an asset with the market portfolio by the variance of the market portfolio.

A. Correlation coefficient B. Treynor measure C. Standard deviation D. Beta

Answer: 0004

Beta can be viewed as a standardized measure of systematic risk because it relates the covariance of any ith asset within the market portfolio to the variance of the market portfolio.

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13. Beta of an asset is defined as:

Answer: B

The covariance of the asset return with the market return, divided by the variance of the market return.

Beta is a measure of systematic risk that relates an asset’s covariance with the variance of the market portfolio. The higher an asset’s beta, the more systematic risk it has.

A. 0.24 B. 0.34 C. 0.19 D. 0.46

Answer: B

The coefficient of variation equals the standard deviation divided by the mean. This gives the standard deviation of the return on the market equal to 1.4 × 12% = 16.8%. The standard deviation of the security equals square root (0.03) = 17.32%. Now, the beta of the security equals the covariance between the security and the market divided by the market variance. Also, the covariance equals the product of the correlation coefficient and the individual standard deviations. Hence, the covariance between the security and the market equals 0.33 × 0.1732 × 0.168 = 0.0096. Therefore, the beta of the security equals 0.0096 / (0.16822) = 0.34.

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15. Which of the following is most likely?

Answer: A

The diversification ratio is the ratio of the standard deviation of an equal-weighted portfolio to the standard deviation of a randomly selected component of the portfolio. The lower the diversification ratio, the greater the risk reduction benefits of diversification and the greater the portfolio effect.

16. An analyst gathered the following information regarding two stocks:

Stock A Stock B Beta 0.7 1.1 Current market price $20 $35 Expected dividend $1 $1 Expected price at year end $23 $37

Assuming a risk-free rate of 5% and the expected market return of 12%, which of the following statements is most accurate?

Answer: C

Required return of Stock A = 5% + 0.7 (12% − 5%) = 9.9%

Expected return of Stock A = (23 − 20 + 1) / 20 = 20%

Since the expected return of Stock A is greater than its required return, it is underpriced and therefore the analyst should buy it.

Required return of Stock B = 5% + 1.1 (12% − 5%) = 12.7%

Expected return of Stock B = (37 − 35 + 1) / 35 = 8.57%

Since the expected return of Stock B is less than its required return, it is overpriced and therefore the analyst should sell it.

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A. Equal to 11.68% B. Less than 11.68% C. More than 12.68% D. Between 11.68% and 12.68%

Answer: B:

Whenever the correlation coefficient is less than+ 1, diversification benefits occur and reduce the overall standard deviation of the portfolio.

18. Which of the following approaches to risk is most likely to be consistent with taking a portfolio perspective?

Answer: B

Taking a portfolio perspective considers the risk of an asset versus the risk of other assets at the portfolio level, rather than risk in isolation. By considering the correlation of a security versus other assets the investor will be focusing correctly on the risk impact on the total portfolio rather than the stand alone risk of individual assets. The first and second choices consider the risk of a security in isolation hence do not take a portfolio approach.

19. What remains in a market portfolio that cannot be diversified away?

A. Security market line B. Unsystematic risk C. A noncomplete diversified portfolio D. Systematic risk

Answer: D

A market portfolio includes all risky assets such as non-U.S. securities, real estate, coins, stamps, and so forth. Since the portfolio contains all risky assets, the risk unique to individual assets, called unsystematic risk, is diversified away. But the variability in all the risky assets caused by macroeconomic variables, called systematic risk, remains in the market portfolio.

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20. A two-factor APT model and three assets that are consistent with this model are given below:

E(R) = 5% + 7% × S1 − 9% × S2

What is the expected return of a portfolio composed of these assets that has a sensitivity of 1.25 to factor 1 and 2.45 to factor 2?

A. 8.21% B. −8.3% C. −7.45% D. 11.45%

Answer: B

The expected return of the portfolio can be determined simply from the given APT equation.

E(R) = 5% + 7% (1.25) − 9%(2.45) = −8.3%

21. Which of the following is an assumption of the arbitrage pricing theory (APT)?

A. Perfectly competitive capital markets B. A market portfolio that contains all risky assets and is mean-variance efficient C. Normally distributed security returns D. Quadratic utility function

Answer: A

Expected Return Standard Deviation Beta Small Caps 17% 15% 1.32 S&P 500 11% 9% Bonds 7% 6% International Stocks 19% T-bills 4%

One of the major assumptions of the APT is perfectly competitive capital markets. The other answer choices are assumptions made by the CAPM, but not by the APT model. The APT model makes considerably fewer assumptions than the CAPM, and is superior to it in this way.

The correlation between the small cap stocks and bonds is .30, and the composition of the tangential portfolio (T) is 55% small cap and 45% bonds.

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22. The arbitrage pricing theory assumes:

Answer: A

The arbitrage pricing theory (APT), developed by Ross in the early 1970s, makes the three assumptions that are offered in the answer. In contrast to the CAPM, it does not assume quadratic utility functions, normally distributed security returns, or a market portfolio that contains all risky assets and is mean-variance efficient.

23. With respect to the definitions of risk and risk management, which of the following statements is most accurate?

Answer: B

The first answer is incorrect since risk is not simply the size of losses, but is also related to the likelihood of those losses occurring. Losses are almost secondary to understanding the variables like mean and variance in a risk assessment, not just putting them in dollar terms. The third answer is wrong because the known variable isn’t always return and the reference to maximizing return is a distractor. We want to minimize unexpected losses, not unexpected variables. The

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last answer is true: We would want to minimize unexpected losses; but risk is not the variation between known and unknown risks, it is the variation of a distribution of outcomes and we can quantify that in a number of ways, specifically the moments of the distribution that describes the ranges of potential outcomes.

24. Which of the following is not a step in the risk management process?

Answer: C

This is maybe too straightforward, but remember that a Gaussian or normal distribution is not the only distribution that defines outcomes in risk scenarios. The other answer choices are correct parts of the process and can be remembered.

25. Classification of risk types has dangers of its own because of the risk of oversimplification or other problems. Which of the following is not a tool or procedure used in risk management?

A. “Silo” or business unit risk management B. Quantification tools and measures C. Qualitative assessment D. Enterprise risk management

Answer: A

Again this is oversimplified, and don’t expect too many questions like this on the exam. Risk management from a top-down or bottom-up approach will treat the business units or silos differently, and that is called enterprise risk management (ERM); however, there isn’t a unique or distinct treatment of silo risk management. This falls under enterprise risk management. The second and third answers are both other tools used in risk management.

26. Expected losses and unexpected losses are important concepts in risk management. Which of the following statements regarding these different types of losses is most accurate?

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Answer: C

Think of expected losses as a measure of VaR, that is, it’s a loss amount associated with a confidence level over a specified time frame. Under certain assumptions we can use the square root of time to extend that potential loss into the future. Unexpected losses are those that exceed the upper limit of the expectation. It is not the sum of the expected losses and the tail losses as described in the last answer. Keep in mind that the reason this exam is so tough is that it requires the use of intuition or how to use tools in other circumstances, in this case, knowing you can extend VaR estimates by the square root of time rule.

Answer: D

For the first answer choice, an increase in foreign exchange rate volatility would actually decrease profitability because of the increased uncertainty around translating foreign currency into the domestic currency. For the second choice, it is important to know that operational risks can arise from almost anywhere, including areas typically associated with market risks, so there is a lot of overlap. That is one of the problems with relying on strict definitions of the type of risk because a trading desk may have many types of risk. For the third choice, using overnight repo to fund the balance sheet actually increases the risk a company won’t be able to fund its balance sheet.

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Answer: A

In order to minimize basis risk, one should choose the futures contract with the highest correlation to price changes, and the one with the closest maturity, preferably expiring after the duration of the hedge.

A. Deep in-he-money call option on the firm’s stock B. Deep out-of-the-money call option on the firm’s stock C. At-the-money call option on the firm’s stock D. Long position in firm’s stock

Note: In the real world, rarely would a single manager influence the price of a stock. The idea here is to test intuition in a way that GARP may ask on exam day.

Answer: B

Deep out-of-the-money calls in theory would encourage more risk and less hedging because the calls are worthless without a significant rise in the stock price. With an at-the-money call, managers could still be incentivized to take greater risks but with less pressure to increase the valuation of the company. A deep in-the-money call would have a similar investment profile as a long equity position would provide the least managerial incentive to reduce risk management.

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30. Your bank is implementing firm-wide enterprise risk management (ERM). Which of the following is most likely an implication of this change with respect to how a company manages its business?

Answer: A

This is a bit tricky. Ultimately, ERM is about maximizing firm value and an integrated, high-level approach to managing risk is the way to do that. With that in mind, the second answer is wrong because it refers to risk factor disaggregation rather than integration. The third answer is wrong because ERM is a proactive way to prevent unknown or downside risks from occurring. For the last answer, while correlation changes do pose risks, ERM that manages risks at the business-unit level would actually not capture the diversification benefits among business units. Only a top-down approach can look “across silos” and see the firm-level risks the bank faces and take appropriate action to hedge or mitigate those risks whether they are market, credit, or operational risks.

31. Which of the following is not a benefit of adopting an ERM initiative?

A. Better risk reporting B. Higher cost of capital to investors C. Organizational effectiveness D. Improved business performance

Answer: B

This may be a little too obvious, but the important point here is that there are going to be other readings, especially from the Bank of International Settlements, that generate really obvious questions and answers. Know that the exam in no way is going to be this straightforward, but I at least want you to see the three incorrect answer choices which are, in fact, benefits of adoption and ERM program.

32. Which of the following is not typically a responsibility of a chief risk officer (CRO)?

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Answer: C

A chief risk offer will allocate economic capital, not operational capital, across business units. We are going to see operational risk capital later on, but it is a relatively minor element of a firm’s risk management policy.

33. Within the context of enterprise risk management (ERM), what is the difference between a top-down and bottom-up approach and why are both necessary within ERM?

Answer: C

The first and second answers are both the opposite of the impact with respect to correlation of risks across business lines. What GARP wants you to know is that when risk is allocated starting at the bottom, there is no visibility to the potential diversification impact so that potential information is lost. Only by performing both top down and bottom up can there be any differences in total risk noticed, and the difference would be the potential reduction in risk, not an increase in risk because of the subadditivity property of VaR.

34. There are seven main components of an ERM program. Which of the following is not one of those components?

A. Shareholder management B. Line management C. Risk transfer D. Technology resources

Answer: A

The first answer should be stakeholder management, meaning an active communication of the aims of ERM across the leadership of the business. I think all of this preliminary focus on ERM is a very low priority. What you really need to focus on is how different approaches to bottom-up versus top-down ERM impact the quantification of correlation among business units and how that may impact the economic capital calculations needed to support the business. If this seems too easy—it is. This is just to set up the important stuff later. All other answer choices are main components, so they are in correct.

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35. The inappropriate hedge used by Metallgesellschaft in the case study can be best described as:

Answer: D

Answer choices 2 and 3 are true, in fact, but don’t represent inappropriate hedges. The answers in choices 2 and 3 often happen in the real world and don’t imply a poor hedging strategy. The duration mis-match, while seemingly sound in the context of liquidity considerations, was the issue with etallgesellschaft Bank.

36. In the event of large losses by a firm, the first culprit to blame is the risk management function. In what circumstances can large losses actually be a failure of risk management?

Answer: D

The issue here is that risk managers don’t manage risk. Traders manage risk. Risk management should really be called “risk measurement.” A large loss is a failure of risk management only if it was a failure of risk measurement. The first, second, and third answer choices are all decisions the firm or traders make and only the last choice is a failure of risk measurement that could lead to a large financial loss.

37. Under the assumption that risk managers don’t manage risks—traders do—which of the following is not a type of a risk management failure?

A. Mismeasurement of known risks B. Failure to communicate known risks to top management C. Failure in the implementation of risk limits D. Failure to use the right risk metrics

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Answer: C

The six types of risk management failures you should know are:

1. Mismeasurement of known risks 2. Failure to take risks into account 3. Failure in communicating the risks to top management 4. Failure in monitoring risks 5. Failure in managing risks 6. Failure to use appropriate risk metrics

So notice that all of these are failures of measurement or communication. Only in the third answer choice do we have a failure caused by an action, violating a risk limit that could lead to a failure. Risk measurement is ultimately a very passive function within a bank; there typically is limited enforcement capacity within risk management to force a trader out of a position. Always put yourself in the mind-set that risk management is really risk measurement or risk communication, and you will get these questions right.

38. If a failure of risk management is really a failure of risk measurement, then which of the following is least likely to be an example of a risk management failure?

A. Using the wrong distribution of returns B. Using the wrong correlation assumption among positions C. A risk that is known but is ignored D. Using risk-adjusted returns

Answer: D

This is fairly straightforward and the point here again is just to understand that risk managers don’t manage risk—they measure it. Traders manage risk and so a risk management failure is a failure in measurement. Large losses due to ignored losses or losses that were known but chosen to ignore are also risk management failures.

39. If an indifference curve intersects the investor’s capital allocation line at two different points it is most likely that:

Answer: A

An investor maximizes her utility when her indifference curve is tangent to the CAL. If the indifference curve intersects the CAL at two different points, an investor can optimize her utility by moving to an indifference curve that lies further northwest.

All points on a given indifference curve offer the same level of utility. It is not necessary for the portfolios to be leveraged portfolios.

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40. Consider the following statements:

Statement 1: The risk-return characteristics of portfolios that combine the risk-free asset with a risky asset or a portfolio of risky assets lie along a straight line.

Statement 2: All other things remaining the same, the greater the slope of the capital allocation line, the better the risk-return characteristics of portfolios that lie on it.

Which of the following is most likely?

A. Only Statement 1 is correct. B. Only Statement 2 is correct. C. Both statements are correct. D. Neither statement is correct.

Answer: C

The risk-return characteristics of portfolios that combine the risk-free asset with a risky asset or a portfolio of risky assets lie along a straight line as the correlation between the risk-free asset and any risky asset equals zero. All capital allocation lines have a constant gradient or slope.

Portfolios on capital allocation lines with a steeper positive slope dominate all portfolios that lie on CALs with a lower slope (that lie below it).

41. Which of the following statements is least accurate?

Answer: B

The efficient frontier represents a set of portfolios that have the minimum expected risk for every given level of expected return. Alternatively, it represents the set of portfolios that have the maximum expected return for every given level of risk.

42. The minimum variance frontier most likely consists of:

A. Individual assets only. B. Portfolios only. C. Individual assets and portfolios. D. Only risk-free assets.

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Answer: B

43. Consider the following statements:

Statement 1: As correlation falls, the curvature of the line between the two assets’ risk-return profiles decreases.

Statement 2: The expected return of the portfolio decreases as the correlation coefficient of the two assets decreases.

Which of the following is most likely?

A. Only one statement is correct. B. Both statements are incorrect. C. Both statements are correct.

Answer: B

As correlation falls, the curvature of the line between the two assets’ risk-return profiles increases. The expected return of the portfolio does not vary with the correlation coefficient of the two assets.

44. Beta is least likely defined as:

Answer: A

Beta is the ratio of the covariance of the stock’s return and the market return to the variance of market returns.

45. The SML and CAPM can be used to price:

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Answer: B

The SML and the CAPM can be applied to any security or portfolio, regardless of whether it is efficient. This is because they are based only on a security’s systematic risk, not total risk.

46. Which of the following statements is most accurate?

Answer: C

The capital market line plots returns against total risk as measured by the standard deviation of returns.

47. If the covariance of the market’s returns with a stock’s returns is 0.007, and the standard deviation of the market’s returns is 0.07, the stock’s beta is closest to:

A. 0.1 B. 1.43 C. 0.72 D. 0.46

Answer: B

Variance of market’s returns = 0.072 = 0.0049 Beta = 0.007 / 0.0049 = 1.43

A. Asset B only B. Asset A only C. None of the assets

Answer: A

Required return on Asset A = 0.06 + [2.1 × (0.14 − 0.06)] = 22.8%

The required return on Asset A (22.8%) is more than the expected return (20%). Therefore, Jessica should not invest in it.

Required return on Asset B = 0.06 + [1.6 × (0.14 − 0.06)] = 18.8%

The required return on Asset B (18.8%) is less than the expected return (20%). Therefore, Jessica should invest in it.

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49. According to the efficient frontier theory, an asset is considered efficient if:

Answer: C

No other asset with an equal expected return offers lower risk, or no other asset with equal risk offers a higher expected return. Any risk averse investor should invest in an asset considered to be efficient, since it offers better risk characteristics than inefficient assets.

A. 7.49% B. 12.39% C. 13.66% D. 14.19%

Answer: A

The Security Market Line (SML) is a plot of the expected returns on securities against their betas. The CAPM implies that the slope of the SML equals the market risk premium and the intercept equals the risk-free rate. Hence, the data given in the problem implies that the market premium is 8.9%.

To calculate the expected return on the security using the CAPM, we must first find its beta. The beta of the security equals the covariance between the security and the market divided by the market variance. Also, the covariance equals the product of the correlation coefficient and the individual standard deviations. Hence, the covariance between the security and the market equals 0.23 × 0.15 × 0.19 = 0.0066. Therefore:

The beta of the security equals 0.0066 / 0.152 = 0.29.

The CAPM expected return on the security equals 4.9% + 0.29 × 8.9% = 7.49%.

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A. 8.98% B. 9.24% C. 12.83% D. 14.54%

Answer: B

The CAPM expected return relationship is:

R = Rf + β × (Rm − Rf).

Since β = 0.79, the market risk premium equals:

(Rm − Rf) = (R − Rf) / β = (12.6 − 5.3) / 0.79 = 9.24.

52. Which of the following assumptions are part of the CAPM?

A. There are no taxes or transaction costs. B. Investors have heterogeneous expectations. C. All of these answers are correct. D. Investors can lend but not borrow, at the risk-free rate.

Answer: A

There are no taxes or transaction costs. The following are assumptions of the capital market theory:

1. All investors are Markowitz-efficient investors. 2. Investors can borrow or lend any amount at the RFR. 3. All investors have homogeneous expectations. 4. All investors have the same one-period time horizon. 5. All investments are infinitely divisible. 6. There are no taxes or transaction costs involved in buying or selling assets. 7. There is no inflation or any change in interest rates. 8. Capital markets are in equilibrium.

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The student will present to the class and will face questions from the professor and students upon completion. Boyd has chosen to do her presentation on portfolio theory.

Upon completion of the presentation, the students asked Boyd the following question: Which of the following statements regarding beta is correct?

Answer: C

Beta is a measure of the systematic risk of a security relative to the market. Beta is calculated as: Covariance between asset J and the market/Variance of the market return.

54. Which of the following is not an assumption of the CAPM?

Answer: D

Investors are able to borrow at the market rate of return and lend at the risk-free rate of return.

55. Assume that security J has a beta of 1.3 and that the risk-free rate of return in the market is 6%. Additionally, the equity risk premium is 8%. What is the expected return on security J?

A. 15.8% B. 16.4% C. 8.6% D. 14.8%

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Answer: B

The expected return according to the CAPM is given by:

Expected return on asset J = Risk-free rate + (BetaJ)(Equity risk premium).

In our case, we have: 6% + (1.3)(8%) = 16.4%.

56. Dolly Drew, FRM, works for Delight Capital. Delight Capital would like to examine portfolio concepts with regards to quantitative analysis.

Which of the following is the correct calculation of beta?

A. Beta = var(Ri, Rm) / var(Rm) B. Beta = cov(Ri, Rm) / var(Rm) C. Beta = cov(Ri, Rm) / var(Ri) D. Beta = var(Rm) / cov(Ri, Rm)

Answer: B

Beta = cov(Ri, Rm) / var(Rm)

cov(Ri, Rm) = covariance between the return on stock i and the market

var(Rm) = variance of the market

57. What is the correlation between the small-cap and the stock market?

Expected Return Standard Deviation Beta Small Caps 17% 15% 1.32 S&P 500 11% 9% Bonds 7% 6% International Stocks 19% T-bills 4%

A. 0.7863 B. 0.7546 C. 0.7920 D. 0.7234

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Answer: C

Correlation = beta × standard deviation of market/standard deviation of small caps = 1.32 × 9%/15% = .7920

Darren Peters, FRM, has gathered information on all the monthly returns of actively managed portfolios and passive indices. He is using multifactor models, of which he has examined many. Darren determines the optimal number of factors using the R-squares for different models.

He selects a model that has a reasonable but small number of factors. He uses the difference in monthly returns between the managed portfolios and the market index represented by the S&P 500, represented as RTN, as the dependent variable. The independent variables are the S&P 500 return less the 90-day T-bill rate represented as MKT, the monthly returns to a passive portfolio of high EPS stocks less the returns of a passive portfolio of low EPS stocks represented by EPSS, and the monthly returns to a passive portfolio of small cap stocks less the returns of a passive portfolio of large cap stocks, represented by LCSC.

The following results were derived for the historical data:

RTN = −.0025 + .15MKT − .08EPSS − .07LCSC

58. Darren Peters, FRM, has gathered information on all the monthly returns of actively managed portfolios and passive indices. He is using multifactor models, of which he has examined many. Darren determines the optimal number of factors using the R‐squares for different models. He selects a model that has a reasonable but small number of factors. He uses the difference in monthly returns between the managed portfolios and the market index represented by the S&P 500, represented as RTN, as the dependent variable. The independent variables are the S&P 500 return less the 90‐day T‐bill rate represented as MKT, the monthly returns to a passive portfolio of high EPS stocks less the returns of a passive portfolio of low EPS stocks represented by EPSS, and the monthly returns to a passive portfolio of small cap stocks less the returns of a passive portfolio of large cap stocks, represented by LCSC.

The following results were derived for the historical data:

RTN = −.0025 + .15MKT − .08EPSS − .07LCSC

Which of the following is not a reason to support the case for active portfolio management?

A. Failure of the CAPM beta to explain returns B. Excess volatility in market prices C. The existence of market anomalies D. Efficient frontier theory

Answer: D

All are valid reasons to support the case for active portfolio management except for the efficient frontier theory. The efficient frontier theory is the theory that all investors allocate their money between the risk-free asset and the tangency efficient portfolio.

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A. 1.00 B. 1.61 C. 1.64 D. −1.35

Answer: B

The following equation is used to calculate beta:

COVim σi β=i 2 = ×ρim σm σm

where ρ represents the correlation coefficient andσ the volatility.

60. CAPM has many assumptions that are unrealistic in the real world. The arbitrage pricing theorem builds on the CAPM to resolve some of the limitations. What is true of CAPM?

Answer: A

All others are not assumptions of APT or CAPM.

61. Which of the following portfolio performance measures equals the slope of the capital allocation line?

A. Sharpe ratio B. Jensen’s alpha C. Treynor ratio D. Sortino Ratio

Answer: A

The slope of the CAL equals the difference between the asset/portfolio’s return and the risk-free rate divided by the standard deviation of the asset/portfolio.

62. Which of the following is most likely based on systematic risk?

A. Sharpe ratio B. Treynor ratio C. M2 D. Information ratio

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Answer: B

The Sharpe ratio and M2 are based on total risk. The Treynor ratio is based on beta risk only.

63. Which of the following most likely indicates the maximum fee an investor should pay a portfolio manager?

A. Sharpe ratio B. Jensen’s alpha C. Treynor ratio D. Sortino ratio

Answer: B

Jensen’s alpha equals the difference between the portfolio’s actual return and the required return (as predicted by the CAPM) based on the asset’s systematic risk. An investor should not pay the portfolio manager a fee greater than the portfolio’s Jensen’s alpha, as such a fee would take the portfolio’s net return lower than the risk of a passively managed portfolio.

A. Treynor ratio B. Sharpe ratio C. Jensen’s alpha D. Sortino ratio

Answer: A

Systematic risk is the risk that can’t be diversified away and the beta of our portfolio is:

2 βP = (ρPM* σP* σM) / σ where ρPM is the correlation coefficient between the portfolio and the market, σp is the risk of the portfolio, and σM is the risk of the market. In either case, beta explains the volatility of the portfolio compared to the volatility of the market, which captures only systematic risk. The Sharpe ratio is standardized by sigma, not beta, so the

Treynor ratio is the correct ratio to use in this case. The Treynor formula is Tρ = [E(Rρ) − Rf] / βρ, which describes the difference between excess return over systematic risk—the beta—which is what the question asks.

65. You have the following information on a portfolio in your bank. You have no other information.

Risk-free rate = 1% Portfolio return = 12% Benchmark return = 7% Standard deviation = 8% Tracking error = 2%

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Which of the following is correct? A. The information ratio is 0.67. B. The information ratio is 1.60. C. The Sharpe ratio is 1.375. D. The Sharpe ratio is 2.67.

Answer: C

The information ratio is calculated as: (12% − 7%) / 2% = 2.5. The Sharpe ratio is calculated as: (12% − 1%) / 8% = 1.375.

Answer: B

The second answer is the correct answer to complete the formula of the Treynor measure: the expected return of the portfolio minus the risk-free rate divided by the beta of the portfolio.

67. An analyst gathered the following information: Risk-free rate: 5% Market risk premium: 6% Beta: 0.8

The required rate of return for the stock is closest to: A. 6% B. 5.8% C. 3.5% D. 9.8%

Answer: D

Required rate of return = 5% + 0.8 (6%) = 9.8%

68. Which of the following statements is most accurate?

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Answer: B

A security whose required rate of return is greater than the expected rate of return is considered overvalued and plots below the security market line.

A security whose expected rate of return is greater than the required rate of return is considered undervalued and plots above the security market line.

A. 1.75% B. 1.56% C. 2.44% D. 1.88%

Answer: B

ABC Stock’s expected return for the month = 0.003 + 0.95 × 0.0225 = 0.0244 or 2.44% ABC’s company-specific return (abnormal return)= 0.04 − 0.0244 = 0.0156 or 1.56%

70. The important factor to consider when adding an asset to a diversified portfolio is:

A. The standard deviation of the asset B. The range of returns of the asset C. The risk of the asset D. The covariance of the asset returns with the other asset returns in the portfolio

Answer: D

The covariance of the asset returns with the other asset returns in the portfolio.

The standard deviation and the covariances with other assets of a new asset affect the standard deviation of the portfolio. When that portfolio already consists of a large, diversified number of assets, the effect of an additional asset is felt primarily through its covariance with the other assets in the portfolio.

71. Which of the following statements is true of the arbitrage pricing theory (APT)?

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Answer: A

Unlike the CAPM (which assumes that the only relevant factor influencing the return on an asset is its covariance with the market), the APT model allows for numerous factors to influence the return on all assets, including, for example, inflation, GDP, and changes in the interest rate.

John Quentin is a graduate student in mathematics currently applying for a job as a quantitative portfolio analyst with CMB Partnership. However, while Quentin is well versed in mathematics, his knowledge of portfolio theory is cursory. He would like to learn more about mean-variance analysis and general portfolio theory concepts before he interviews with CMB’s managing director.

A. The expected return of the individual assets B. The standard deviation of the individual assets C. The number of securities in the portfolio D. The average covariance between the assets

Answer: D

The average covariance between the assets in a portfolio is the primary determinant of portfolio standard deviation. As the number of securities in the portfolio increases, and the portfolio becomes more diversified, the relative importance of the average covariance between assets increases.

73. Which of the following is not an example of a multifactor model?

A. Statistical factor models B. Macroeconomic factor models C. Fundamental factor models D. Systematic factor models

Answer: D

There are three types of multifactor models. These are fundamental factor models, macroeconomic factor models, and statistical factor models.

74. Which of the following is least likely a benefit of an effective data aggregation strategy?

A. Operational efficiency B. Reduced probability of losses C. Enhanced strategic decision making D. Reduced legal risks

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Answer: D

Data aggregation is aimed at the management of financial risk and financial data. Legal risk falls outside of that scope.

75. Which of the following is not one of the principles outlined by the Basel Committee for data aggregation and reporting?

A. Enterprise governance and infrastructure B. Risk data aggregation capabilities C. Risk reporting practices D. Regulatory reporting

Answer: D

I’ve said before that the questions from the Basel Committee and the Bank of International Settlements are very bland and, I think, low priority. In this case, regulatory reporting is not one of the principles because this type of reporting is not focused on meeting regulatory requirements. This type of data and reporting is for internal data and supervisory review.

76. Which of the following is not a responsibility of each GARP member with respect to professional integrity and ethical conduct?

Answer: B

Unlike the CFA exam, there are few opportunities for “gotcha” questions. The code of conduct is only five pages, so make sure you read it. For this question, there is no dollar limit on gifts other than a consideration that could be reasonably expected to compromise their independence or objective.

77. Which of the following is least likely to be a consequence of a GARP member violating the GARP code of conduct?

Answer: A

What you should know here is that GARP has no regulatory authority and can really only remove the designation from a member. The second answer is true because GARP can decide to suspend a member while an investigation is underway, suspend a member for a defined number of years, or permanently ban the member.

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78. Of each of the following, which was not a key factor that led to the housing bubble?

Answer: C

This choice is correct because it was an aftereffect, not a factor actually leading to the housing crisis. While it is true that as bank balance sheets were marked down and fire sales pushed prices lower, this was a result, not a cause, of the housing bubble. All other answer choices are correct.

Answer: B

The additional information about the liquidity backstop may sound like a positive and a net risk reduction but what actually happened was that longer-term assets were pooled together and tranches of the asset classes were sold with short maturities, even though they were backed by much longer assets. So the longer-term assets had the backing of the banks but the banks themselves were under liquidity pressure themselves and unable to fulfill the short-term redemption requests.

80. Which of the following is not a correct step in correcting collateralized debt obligations (CDOs) or is an incorrect description of CDOs?

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C. Unlike the interest rate swap curve that serves as a reference rate for swaps, there is no index that prices credit default swaps or can be traded like the S&P 500. D. The dividing line between different tranches is very important for selling to clients, but the so-called “toxic waste” is held by the bank actually selling the CDO.

Answer: C

It may be surprising that the last choice is not the correct answer because you would think that the banks want to sell the worst products at the highest prices, but in reality the banks want to monitor these worst loans closely so they keep these on their own balance sheet. The remaining answer choices are all correct.

Answer: A

The third answer may seem like a standout choice because it focuses on the equity holder, but a 2-to-1 dilution means there is a huge increase in leverage, plus the equity holders get a superior bond issue and, in both cases, that makes existing creditors worse off. The standard for any type of restructuring is whether current investors are worse off. For the last answer, any type of downgrade is going to be a credit event. In theory, yes, since this is an over-the-counter (OTC) contract this very specific situation could be written into the master ISDA, but don’t read into questions more than you are given on test day.

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Answer: C

A pool of assets being well diversified does not mean that diversification translates into a different credit VaR, especially when correlations are high.

For a thin tranche, there is almost no difference between the 99% and 95% VaRs in the senior bond credit VaR when correlation is very high. This follows the same pattern that high correlations equal greater risks. The second answer choice says that there is an increasing difference between the two credit VaRs when in reality they are close to the same. The second half of the last answer choice is a distractor and irrelevant to the question, although it is a true statement. If there is high systematic risk, then there is high default risk because high risk implies wide variation, and a wide variation implies states of the world where there may be very significant numbers of defaults. High default correlation being one way of expressing high systematic risk is the right relationship.

Answer: D

Ironically, during the depth of the financial crisis, the credit indices offered by third parties became a liquid and transparent proxy for the value of opaque and illiquid securities because it was the only way to get pricing information from a product that was sliced into many tranches and when many were unsure what risk exposures they had or what their counterparties had. Unfortunately, the index became subject to supply and when liquidity in the assets dried up, the index was the only way to express a view or place a hedge.

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Answer: B

For the first choice, the correct answer here is endogenous risk. Remember that ex- refers to a risk outside of your control and endo- refers to a risk you create by your own actions. This is important to consider, especially when considering large, potentially market-moving trades. The third option is a made-up type of liquidity risk and for the fourth option, rollover risk is a concern but isn’t the risk of a price change in the next futures contract—it is an inability to continue to finance an asset. Always be on the lookout for real concepts you may remember from the curriculum but that are misused in some way.

Answer: A

Since CDS is insurance, if the default risk increases, the cost of that insurance increases. Investors who sold huge amounts of CDS, as AIG did, were effectively long credit risk. As counterparty credit risk climbed higher (credit prices were lower, credit spreads higher), large institutions were forced to raise capital in an already declining market, creating additional systemic risks. For the second answer, the relationship is reversed. Increases in counterparty credit risk increase, not decrease, counterparty credit risks. For the third answer, as the Fed intervenes in the market, institutions that use the additional liquidity provided don’t create additional demand for capital or more deterioration in trusts. The fourth answer is just a true statement and not how loss loops are created.

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Answer: B

For the first answer choice, once housing prices started to decline and the prospect of further losses on subprime mortgages increased, the crisis was triggered, and the growth of shadow banking was an amplifier for the crisis. All other answer choices are described as triggers but you should remember them as amplifiers, or, in the language of this learning objective, a vulnerability.

87. Which of the following is correctly paired with the way the product type served as a trigger or an amplifier of the financial crisis?

Answer: C

What GARP wants you to keep in mind are the distinctions among the triggers and the consequences or amplifications of the trigger. There was really only one trigger—falling home prices—so the first and second choices talk about these assets as triggers. The first choice is mostly made up to sound right if you are guessing, the second choice is correct if we change it to an amplifier, and the last choice has all kinds of things wrong. First, falling home prices was the trigger, and here it is an amplifier. A wider credit spread, all else being equal, means the credit is cheapening in price (pushing yields higher) and credit risk is moving higher, which would drive prices lower, not higher.

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88. Which of the following was not a consequence of the failure of Lehman Brothers?

Answer: A

Obviously, Lehman was a huge event and the first answer choice requires you to remember that a repo haircut is the percentage deducted from the value of the asset used as collateral for the loan. If haircuts are decreasing, it means banks are lending more money on the same collateral, implying an improving credit environment—which clearly wasn’t the case, as Lehman was collapsing.

Answer: B

For the first answer choice, it is false that some sponsors bailed out or injected capital into their money market funds to prevent them from breaking the buck, but it is true that this also changed the market’s perception that this would always be the sponsors’ behavior. Be careful on the exam of questions that make dual statements where one is true and one is false. For the third answer choice, there actually was a clear pattern of runs on asset-backed commercial paper during this time frame. For the last answer choice, the relationship is reversed. It was actually the failure of Lehman that forced the fund to break the buck.

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Answer: D

Be ready on exam day for questions like this that seem right. What is going to get you to pass the test is recognizing when multiple statements are made in answer choices that conflict with each other or answer choices that are partially wrong. In this case, many times the distinction is whether the policy shift was by a central bank or a government and they can often seem very similar.

For the first answer choice, this is a central bank move, not a government policy shift. Keep in mind that central banks, in theory, are financial institutions independent of their governments and they act under a mandate of controlling inflation or financial stability. Governments and legislators can also take actions, as they did during the crisis. For the remainder of the first choice, the answer is largely true.

For the second answer choice, an asset purchase program is a policy move by a government and can include individual asset purchases, asset guarantees, and so on. Thus the second answer choice is wrong because this is not a central bank activity, although it does have an immediate impact. The third answer choice is wrong because liquidity support in the form of changing reserve requirements and longer funding terms are all central bank actions, not choices legislators will make.

For the third choice, liquidity support is a central bank policy tool, so that is incorrectly matched with a government policy description. All of the rest is true.

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Answer: C

For the fourth answer, watch out for what I call the leading negative type of question, as in “despite the obvious reaction” or “contrary to expected behavior,” because I think when taking a test we grab onto those as additional pieces of information. For the fourth answer, there was an obvious need for cash but it is also true that there was a decrease in demand for consumer loans. The negative setup makes this seem false when it is actually true.

The first two answers are both true statements and should be remembered for the exam.

The third option is correct because drawing down lines of credit just in case was an impact of the crisis and the question is asking for an answer choice that “was not an impact” on the real economy.

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