All theory chapters:

1. Risk is described as unexpected volatility in asset prices or earnings.

2. VaR is the maximum expected loss for a given confidence level assuming normal market
returns. It is the minimum expected loss for a given significance level.

3. Funding liquidity risk refers to the risk that an institution will not be able to: raise cash
necessary to make debt payments, fulfill cash, margin, and collateral requirements of
counterparties, meet capital withdrawals resulting in a loss.

4. Settlement risk is the risk that a counterparty will fail to deliver its obligation.

5. Market liquidity can be expressed in the following forms: (1) bid-ask spread, (2) market
depth, and (3) market resiliency. The bid-ask spread can be thought of as the loss that
would be sustained by a trader who sells an asset and then immediately buys it back.
The higher the spread, the lower the market liquidity, and vice versa.

The length of time it will take an asset to regain its price after the price has fallen temporarily.

6. Funding liquidity can be expressed in the following forms: (1) margin/haircut funding
risk, (2) rollover risk, and (3) redemption risk. Rollover risk refers to the risk that investors
may not be able to roll over short-term debt to finance the purchase of an asset.

The risk that arises when a decline in the collateral value of an asset results in an increase in
margin requirement, requiring additional equity capital.

7. Liquidity risk is the risk of sustaining significant losses due to the inability to take or exit a
position at a fair price.

8. Hedging operational risk covers a firm's activities in production (costs) and sales (revenue),
which is essentially the income statement. Financial position risk pertains to a firm's
balance sheet.

9. Hedging through the use of derivatives instruments such as swaps and options may be
cheaper than purchasing an insurance policy.

10. Hedging may result in operational improvements within a firm.

11. Exchange-traded instruments cover only certain underlying assets and are quite
standardized (e.g., maturities and strike prices) in order to promote liquidity in the
marketplace.

12. A static hedging strategy is a simple process. In contrast, a dynamic hedging strategy is a
more complex process that recognizes that the attributes of the underlying risky position
may change with time. Significantly more time and monitoring efforts are required with a
dynamic hedging strategy.
13. The board would watch out for the interests of shareholders as well as other
stakeholders, such as debtholders, by considering if any of management's decisions contain
extreme downside risk.

The board should maintain its independence from management. A key measure involved
would be that the chief executive officer (CEO) would not also be the chairman of the
board because there is already an inherent conflict with the CEO being on both the
management team and the board of directors.

14. A firm's risk appetite reflects its tolerance (especially willingness) to accept risk. There
must be a logical relationship between the rm's risk appetite and its business strategy.
As a result, business strategy planning meetings require input from the risk management team
right from the outset to ensure the consistency between risk appetite and business strategy.

15. The role of the board of directors in governance would include the review and analysis
of: The firm's risk management policies. The firm's periodic risk management reports. The
firm's appetite and its impact on business strategy. The firm's internal controls. The firm's
financial statements and disclosures. The firm's related parties and related party transactions.
Any audit reports from internal or external audits. Corporate governance best practices for the
industry. Risk management practices of competitors and the industry.

16. The senior management functional unit approves business plans and targets, sets risk
tolerance, establishes policy, and ensures performance.

17. Advantages of CDOs include: increased profit potential, direct risk transfer, and loan
access. Through the securitization process, banks will effectively transfer credit risk to
investors.

Disadvantages of CDOs include: encourages increased risk taking, risk concentration

potential, and high complexity.

18. The existence of credit derivatives did not cause the financial crisis of 2007–2009, but the
misuse of these products certainly did. Investors used CDS contracts for speculation rather
than risk mitigation. Collateralized debt obligations also held a very complex mixture of
mortgages that included both subprime loans and adjustable-rate loans as well.

19. Disadvantages of the OTD model include: moral hazard, misaligned incentives, and
opaqueness. The OTD model encourages a focus on short-term profitability instead of
long-term stability or sustainability, which is a misaligned incentive.

20. Equity tranche has the highest risk and will absorb the first losses in the ABS asset pool.

21. Wrong-way risk occurs when the value of the collateral is negatively impacted by the
same factors that cause the firm to potentially default on a loan.

22. The CAPM is often times thought of as a special case of the APT since CAPM has only one
factor, the market portfolio. APT has fewer assumptions than CAPM.

23. APT does not require that security returns be normally distributed.
24. It is not necessary to assume that asset returns are normally distributed. The arbitrage
pricing theory (APT) model allows for different characteristics of return distributions to
be captured by the factors in the model. The APT model also does not require the
existence of a market portfolio that is mean- variance efficient. These assumptions are
necessary for the capital asset pricing model (CAPM).

25. A large number of available assets for investment allow investors to eliminate non-
systematic risk through diversification. (Assumption of APT)

26. The CAPM can be thought of as a subset of the APT, multifactor model. Therefore, fewer
assumptions are needed for the APT model than the CAPM. Although it could be included
as a factor, the APT does not require an investment in the market portfolio. APT can be
thought of as a k factor model, while the CAPM is based on the risk-free asset and the
market portfolio.

27. A factor portfolio is a portfolio with a factor sensitivity of one to a particular factor and
zero to all other factors. The expected return on a "factor 1" portfolio is E(RR) = 6.0% +
12.0% (1.00) − 3.0%(0.00) = 18.0%.

28. Basel Committee's guidance and principles regarding data aggregation:

Time frames should be established to integrate data and risk reporting capabilities of
acquired firms. Data aggregation and risk reporting capabilities should be independently
reviewed and validated. A bank’s board of directors should be aware of its compliance with
key governance principles set forth by the Basel Committee.

29. Principle 9 (Clarity and Usefulness) requires that: Reports be tailored to the end user (e.g.,
the board, senior managers, and risk committee members) and should assist them with sound
risk management and decision-making. Reports will include: risk data, risk analysis,
interpretation of risks, and qualitative explanations of risks.

30. Several benefits accrue to banks that have effective risk data aggregation and reporting
systems in place. These benefits include:

An increased ability to anticipate problems. In times of financial stress, effective risk data
aggregation enhances a bank's ability to identify routes to return to financial health. Improved
resolvability in the event of bank stress or failure. By strengthening a bank's risk function, the
bank is better able to make strategic decisions, increase efficiency, reduce the chance of loss,
and ultimately increase profitability.
31. An integrated and centralized framework would significantly increase the efficiency of
managing company risks. Such a centralized approach is called enterprise risk management
(ERM).

ERM is crucial in establishing a firm-wide, integrated set of policies, procedures, and

standards. From senior management's perspective, an ERM system provides an invaluable
overall risk perspective and control.

32. A strong ERM framework has five important dimensions: (1) targets, (2) structure, (3)
identification and metrics, (4) ERM strategies, and (5) risk culture. Targets include: risk
appetite and goals in light of the firm's risk appetite.
33. Scenario analysis does not lead to a quantification of risk because it is qualitative in
nature (though quantitative models are built around scenarios).

34. The FSB has specified four key risk indicators for a strong risk culture: (1) tone from the
top of the organization, (2) effective communication and challenge, (3) incentives, and (4)
accountability.

35. Under an ERM view, risks are viewed as a component of the whole. In a siloed
approach, these are typically treated as separate decisions without a strategic approach
to the overall enterprise risk. Reviewing risks across all business lines, functional areas, and
risk types is a characteristic of ERM.

36. The actions at Banker's Trust led to tighter controls for dealing with clients at other firms.
This case demonstrated the importance of matching trades with a client's needs and
providing price quotes that are independent from the front office. It also demonstrated the
importance of exercising caution with any form of communication that could eventually be
made public, as it could damage a firm's reputation if unethical practices are present.

37. The Barings collapse did not result from technological limitations. Management is
responsible for auditing and ensuring the quality of the information it receives. Barings
management failed to do so and received information without questioning it. Reports
contained incomplete account information on gains and losses. Management also failed to
detect a signal that something might be wrong in that the size of Leeson's reported profits
were inconsistent with and out of proportion to the trading strategy he was supposedly using.
Technological limitations were not an issue in the Barings case.

38. Barings Bank collapse was the result of poor operational controls characterized by poor
reporting systems, weak management oversight, and poor organizational structure.

39. The failure to supervise the actions of its trader is an example of operational risk.

40. LTCM's models underestimated the extent to which securities prices would move
together in times of economic crisis. The models also failed to anticipate that multiple
economic shocks might occur in clusters through time (i.e., be positively autocorrelated) as
economic history suggests. Poor management oversight and financial reporting standards
are not issues in the LTCM case.

41. The collapse of Barings Bank was not an instance of flawed hedging models, but one of poor
operational control. Leeson had previously incurred huge trading losses that, if revealed,
would have cost him his job.

42. After securitization, banks have less incentive to be careful in making loans because
much of the risk will be borne by other institutions. Instead of retaining loans and carrying
the risk of default of borrowers, banks can transfer this risk to investors through
securitization.

43. The creation of a CDO might be thought of as a three-step process: (1) form a diversified
portfolio, (2) slice the portfolio into tranches, and (3) sell tranches to investors. Different
groups of investors have varying appetites for risk. The most senior tranches are sold to
institutions that desire or require instruments with high credit ratings, such as pension funds.
 The equity tranches are usually retained by the CDO issuer to give that bank incentive to
monitor the loan.

44. A decline in lending standards and abundance of cheap credit led banks to offer credit
at low interest rates and lenient terms. This environment of cheap money and plentiful
borrowing opportunities led to a flood of real estate purchases, which generated a housing
boom. An increase in demand for U.S. securities by foreign governments experiencing trade
surpluses put downward pressure on interest rates. The Fed adopted a lax interest rate policy
that promoted low interest rates to fend o deflation after the bursting of the internet bubble.

45. The main trigger was the prospect of losses on subprime mortgages. The losses on
subprime mortgages caused MBSs to be downgraded, causing a run on ABCP that
contained the MBSs.

46. The financial crisis that stemmed from rising mortgage delinquencies and falling housing
prices led to a worldwide liquidity crisis because institutions had (1) taken on too much
leverage, (2) generated large maturity mismatches between assets and liabilities, and (3)
become too interconnected.

47. Preservation of confidentiality applies to the information that an analyst learns from: current
clients, former clients, and prospects.

48. An investment firm will violate the GARP Code of Conduct if she makes this change in her
investment process without promptly notifying her clients of the change.

49. GARP Members shall make full and fair disclosure of all matters that could reasonably
be expected to impair independence and objectivity or interfere with respective duties to
their employer, clients, and prospective clients.

50. The Investment Banking Department of MLB&J often receives material non-public
information that could have considerable value to MLB&J's brokerage clients. To comply
with the GARP Code of Conduct, MLB&J should most appropriately: restrict
proprietary trading in the securities of companies about which the Investment Banking
Department has access to material non-public information.

51. If the GARP Code and certain laws conflict, then laws and regulations will take priority.

52. Violations of the Code of Conduct may result in permanent removal from GARP membership.

Violations of the Code of Conduct may result in temporary suspension from GARP
membership.
Violations of the Code of Conduct could lead to a revocation of the right to use the FRM
designation.

53. To comply with Standard 3.1, Johnson must not discuss with her charitable foundation
anything regarding her client and her client's intentions. It does not matter that her client
intends to give money to charities in the near future.

54. There are both absolute risk (measured without reference to a benchmark) and relative risk
(measured against a benchmark) measures of market risk.
55. 1. An insufficient training lead to misuse of order management system is an example of
operational risk. 2. Widening of credit spreads represents an increase in market risk. 3.
An option writer not honouring the obligation in a contract is a credit risk event. 4. When
a contract is originated in multiple jurisdictions leading to problems with enforceability,
there is legal risk.

56. Systematic risk cannot be eliminated by diversification. Unsystematic risk can be

reduced by diversification.

57. The output of a simulation can used to generate a value at risk (VaR).

58. Probabilistic approaches include sensitivity analysis, scenario analysis and simulations.

59. Simulation allows for the deepest assessment of uncertainty because it lets analysts specify
distributions of values rather than a single expected value for each input.

60. Developing the organization's risk appetite statement is the responsibility of

management. It is the Board's role to review and provide appropriate feedback on
management's work with regard to the risk appetite statement. Determining if the risk
appetite may cause risks in other areas of the organization is consistent with the Board's
oversight role.

61. Risk tolerance is a measure of an organization's willingness to take risk.

62. A risk appetite statement states a broad level of risk across the organization the firm is
willing to accept in order to pursue value creation.

63. There are four possibilities for managing risk: 1. Risk avoidance: risks that are not congruent
with stated policy should be avoided. 2. Risk transfer: risk hedging 3. Risk reduction:
diversification 4. Risk retention: the risk is acceptable.

64. Which of the following data issues is least likely to increase risk for an organization?

A. Duplicate records. B. Data normalization. C. Nonstandard formats. D. Data

transformations.

65. Consistency refers to the comparison of one element of data across two or more different
databases.

66. The completeness principle recommends that a bank be able to capture and aggregate all
data on the material risks to which it is exposed across the organization.

67. Decision trees depend on a successful outcome in one step before moving on to the next
step. Sensitivity analysis involves changing one variable at a time. Scenario analysis
estimates outcomes and values under several possible fixture scenarios. Simulation is a
complex tool that looks at distributions of values.

68. The Board of Directors is ultimately responsible for risk oversight. Effective risk
governance simply requires clear accountability; authority; and methods of
communication; it is not necessary to have multiple levels. The point of risk governance is
 to consider the methods in which risk-taking is permitted, optimized, and monitored; it
is not necessarily to minimize the amount of risk taken.

69. providing deep out-of-the-money calls as an incentive could cause managers to take
substantially higher risks and perform, less hedging.

70. A failure to minimize losses on credit portfolios is not necessarily a failure of risk
management.

71. Standard deviation of returns for each of the three portfolios is higher than the standard
deviation of the market portfolio, reflecting a low level of diversification.

72. Jensen’s alpha is the most appropriate measure for comparing portfolios that have the same
beta.

73. The Treynor measure is most appropriate for comparing well-diversified portfolios. That is
the Treynor measure is the best to compare the excess returns per unit of systematic risk
earned by portfolio managers, provided all portfolios are well-diversified.

74. The higher the IR, the better „informed‟ the manager is at picking assets to invest in.

75. IR=E (Rp-Rb)/Tracking Error

76. Jensen’s alpha:

E(Rp) represents expected return of portfolio & E(Rm) represents expected return of market.

77. The Jensen's alpha is equal to the y-intercept, or the excess return of the portfolio when
the excess market return is zero.

78. The risk aversion coefficient for a risk-neutral investor equals zero. The risk-free asset
has zero risk so it offers the same level of utility to all investors.

79. The lower the diversification ratio, the greater the risk reduction benefits of
diversification and the greater the portfolio effect.

80. 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.

81. Beta is the ratio of the covariance of the stock's return and the market return to the
variance of market returns.
 Beta is 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.
Beta is a measure of the relationship between an asset return and a diversified market return.

82. The CAL and the CML only applied to efficient portfolios, not to individual assets or
inefficient portfolios.

83. 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.

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

85. Maximum fee an investor should pay a portfolio manager: Jensen's alpha.

86. 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.

87.