Questions Market Risk Measurement and Management

FRM
Part II Exam

By AnalystPrep

Questions - Market Risk Measurement and Management
Last Updated: Dec 19, 2020
1
© 2014-2020 AnalystPrep.
Table of Contents
Estimating Market Risk Measures: An Introduction and

61 - 3
Overview
62 - Non-parametric Approaches 13
63 - Parametric Approaches (II): Extreme Value 24
64 - Backtesting VaR 37
65 - VaR Mapping 45
Messages from the Academic Literature on Risk Measurement
66 - 58
for the Trading Book
67 - Correlation Basics: Definitions, Applications, and Terminology 64
Empirical Properties of Correlation: How Do Correlations
68 - 78
Behave in the Real World?
69 - Financial Correlation Modeling—Bottom-Up Approaches 84
70 - Empirical Approaches to Risk Metrics and Hedging 89
71 - The Science of Term Structure Models 100
The Evolution of Short Rates and the Shape of the Term
72 - 111
Structure
73 - The Art of Term Structure Models: Drift 117
74 - The Art of Term Structure Models: Volatility and Distribution 132
75 - Volatility Smiles 142
76 - Fundamental Review of the Trading Book 149
2
Reading 61: Estimating Market Risk Measures: An Introduction and
Overview
Q.1471 During a job interview for the role of assistant financial risk manager, Jacob Lee was
asked to describe the advantages of geometric returns over arithmetic returns. He mentioned
the following point:
I. The geometric mean takes into account the compounding that occurs from period to period.
II. In the world of finance, the arithmetic mean is usually an appropriate method for calculating
multi-period average returns if the one-period returns are volative.
Which of the above-mentioned points is/are correct?
A. Only Point I is correct
B. Only Point II is correct
C. Both I and II are correct
D. Neither I nor II is correct
Q.1472 If the arithmetic returns are 0.10, which of the following equations gives the
corresponding geometric returns?
A. Rt = ln(0.10)
B. Rt = ln(1.10)
C. Rt = ln(1.90)
D. Rt = ln(0.90)
Q.1473 Value at Risk (VaR) measures the level of financial risk over a predefined time period. Out
of the following, which method is not used to calculate VaR?
A. Historical Simulation (HS)
B. Parametric Approaches
C. Abnormally Distributed Profits/Losses
D. Normally Distributed Arithmetic Returns
3
Q.1474 VaR is a quantile that demarcates the tail region and non-tail region. Which metric is
used to calculate the size of the tail?
A. Standard deviation
B. Confidence level
C. Number of observations
D. Variance
Q.1475 If Profit/Losses (P/L) are distributed normally with standard deviation 18 and mean 12,
then what is the value of the corresponding VaR using a 95% confidence interval?
A. 9.87
B. -17.61
C. 13.956
D. -13.956
Q.1476 If the natural log of X is distributed normally, then the random variable is:
A. Normally distributed
B. Lognormally distributed
C. Seminormally distributed
D. Equally distributed
4
Q.1477 Which of the following statements regarding the estimation of the expected shortfall (ES)
is false?
A. The ES can be estimated as an average-tail-VaR because it's actually the probability-

weighted average of tail losses
B. The ES can be estimated with the help of a 'closed-form' solution
C. A 'closed-form' solution is more preferable than the average-tail-VaR because the

formula and its application is widespread in all parametric distributions
D. The average-tail-VaR is more preferable method to estimate the Expected Shortfall

(ES) as it has higher applicability and is easier to implement
Q.1478 One of the easiest coherent risk measures is estimating expected short fall (ES). What
happens to the Expected Shortfall (ES) when the number of observations, n is increased?
A. The ES falls
B. The ES rises
C. The ES stays constant
D. The ES moves but not in a consistent manner
Q.1479 A generally coherent risk measure tends to involve increasingly sophisticated weighting
functions. Which of the following is a suitable replacement for the equal weights in the 'average
VaR' to estimate any risk measure?
A. Average weights
B. Exponential weights
C. Weights appropriate to risk exposure being estimated
D. None of the above.
5
Q.1480 The key to estimating coherent risk measures lies in the:
A. Ability to assign weights accurately
B. Ability to calculate exponential value accurately
C. Ability to estimate quantiles
D. Ability to approximate risk exposure
Q.1481 The precision of a risk measure estimate is evaluated by means of the corresponding
standard error(s). The quantile (VaR) standard error depends on which of the following?
A. f(q), sample size n and p
B. p, standard error s and variance of q
C. sample size n, p and square root of error
D. variance of q, sample size n and f(q)
Q.1482 A portfolio has a beginning period value of $200. The arithmetic returns follow a normal
distribution with a mean of 5% and a standard deviation of 10%. Calculate VaR at both the 95%
and 99% confidence levels, respectively:
A. $23, $36.6
B. $43, $56.6
C. $1.65, $2.33
D. $23, $43
6
Q.1483 In an exam, Tom Lee was asked to give three core issues regarding risk measures
commonly used in practice. Lee responded by saying that before embarking on risk
measurement, one must decide on:
I. The weighs to assign, and

II. The desired level of analysis
Which of the above-mentioned point(s) is/are incorrect regarding risk measures to use before
embarking to measure risk?
A. Only Point I is incorrect
B. Only Point II is incorrect
C. Both I and II are incorrect
D. Neither I nor II is incorrect
Q.2628 You are assigned to calculate the monthly VaR for the stock of Apex Inc. You are provided
with the following data for the ten worst returns of the stock during the last 100 months:
-12%, -7%, -32%, -26%, -24%, -20%, -19%, -17%, -15%, -14%
Which of the following is closest to the monthly VaR for Apex using a confidence level of 95%?
A. -32%
B. -17%
C. -12%
D. -14.5%
7
Q.2629 Jason Tyler has invested $100,000 in the shares of Kraken Corp. To calculate the market
risk of his portfolio, Tyler gathers the monthly returns for the security over the last 500 months.
The 10 worst returns during this period were:
-30%, -27%, -24%, -23%, -22%, -21%, -20%, -19%, -18%, -16%
What is the monthly VaR for Tyler’s investment using a confidence level of 99%?
A. $30,000
B. $16,000
C. $21,000
D. $27,000
Q.2630 Given a normally distributed profit and loss distribution with an annual mean of $500,000
and standard deviation of $50,000, calculate the VAR at a confidence level of 99%.
A. $598,000
B. $383,500
C. $616,500
D. $402,000
Q.2632 An analyst has gathered the following information about a portfolio which has normally
distributed geometric returns:
Mean 10%
Standard Deviation 40%
Portfolio 100 million
What is the 95% lognormal VAR for this portfolio?
A. $74.7 million
B. $35.3 million
C. $42.8 million
D. $113.4 million
8
Q.2633 Jimmy Ray, a risk analyst at Alcoa Bank, has just performed a historical simulation for
estimating the VAR for the fixed income portfolio of the bank based on the returns for the last
500 trading days. The 10 worst one day returns generated in the simulation are:
-9,111, -8,669, -8,127, -7,098, -6,712, -6,698, -5,743, -5,189, -4,811, -4,775
Which of the following is the 99% one day expected shortfall for the portfolio?
A. 8.1452
B. 6.712
C. 9.111
D. 7,943
Q.2636 Jacob Watson is a risk manager for a large bank. Presently, he is estimating the VaR for
the equities portfolio of the bank. He is considering estimating the VaR using both a normal
distribution assumption and a lognormal distribution assumption. He has gathered the following
information about the portfolio:
Value of the portfolio USD 1 million
Mean 15%
Volatility 25%
What would be the 1 year 99% VaR for the portfolio under the two assumptions?
A. Normal distribution: $495,000; Lognormal distribution: $460,000
B. Normal distribution: $460,000; Lognormal distribution: $495,000
C. Normal distribution: $432,500; Lognormal distribution: $351,000
D. Normal distribution: $499,000; Lognormal distribution: $432,500
9
Q.2815 If the geometric return Rt over some period of time is 8.62%, what is the arithmetic
return?
A. 0.0831
B. 0.0862
C. 0.0255
D. 0.0900
Q.2816 If the geometric returns Rt is 0.013 over a specified period, then the arithmetic returns
must be:
A. 0.032562
B. 0.245861
C. 0.013085
D. 0.056894
Q.2817 Assuming that the P/L over a specified period is normally distributed and has a mean of
14.1 and a standard deviation of 28.2. What is the 95% VaR and the corresponding 99% VaR?
A. The 95% VaR is 32.289 and the 99% VaR is 51.4932
B. The 95% VaR is 36.495 and the 99% VaR is 51.556
C. The 95% VaR is 55.236 and the 99% VaR is 36.49551
D. The 95% VaR is 36.225 and the 99% VaR is 41.586
10
Q.2818 The arithmetic returns rt, over some period of time, are normally distributed with a mean
of 1.55 and a standard deviation 1.07. The portfolio is currently worth 1 unit. Calculate the 95%
VaR and the 99% VaR.
Q.2819 Let’s assume that the geometric returns Rt, are normally distributed with mean 0.079
and standard deviation 0.312. Further, assume that the portfolio is currently worth 1 unit.
Calculate the 95% and 99% lognormal VaR.
Q.3006 If the arithmetic returns rt over some period of time are 0.09, what are the geometric
returns?
A. 0.0831
B. 0.08618
C. 0.02546
D. None of the above
11
Q.3008 Assume the profit/loss distribution for XYZ is normally distributed with an annual mean
of $30 million and a standard deviation of $5 million. The 1% VaR is closest to:
A. 11.25 million
B. -30 million
C. -18.35 million
D. -18 million
Q.3011 Assume you are dealing with a stock "A" that displays a highly negatively skewed
distribution comprised of the past 260-days returns. Suppose you have P1 = A and P2 = -A,
meaning P1 is long stock A and P2 is short stock A. Which statement is most likely to be accurate
about a 99% VaR?
A. VaR (P1) > VaR (P2)
B. VaR (P1) < VaR (P2)
C. VaR (P1) = VaR (P2)
D. Cannot be concluded from the given information
Q.3036 What would be the 95% parametric VaR of a portfolio made of two independently
normally distributed stocks – A and B, with A⁓N(0.5,1) and B⁓N(3,15). Assume that P=(A+B)
A. 56×P
B. 4.87×P
C. 3.08×P
12
Reading 62: Non-parametric Approaches
Q.1484 In order to compile historical simulation data, one would need to assemble historical P/L
or return observations on the positions in the current portfolio. The series of historically
simulated P/L would form the basis of historically simulated VaR and ES. Which of the following
would be correct regarding the simulated series?
I. This series would not be same as the actual P/L earned on the portfolio.
II. It would show the P/L earned on the current portfolio.
III. This series would give an accurate measurement of the actual P/L.
A. Point I
B. Point II
C. Point III
Q.1485 There are different benefits of parametric methods over nonparametric methods. An
FRM manager will consider non-parametric methods as the most natural choice for high-
dimension problems. Which of the following is NOT an advantage of nonparametric methods?
A. It is easy for non-parametric methods to accommodate high dimensions
B. In non-parametric methods, there is no difficulty in dealing with variance-covariance

matrices and curses of dimensionality
C. The non-parametric approaches can accommodate skewness, fat tails and other non-
normal features
D. The results from non-parametric methods are often hard to communicate
13
Q.1486 There are two bootstrapping approaches: parametric and non-parametric.
I. For a "non-parametric bootstrap", the exercise proceeds from a given data sample that’s
representative of the population. By re-sampling the data, you can reproduce the distribution of
your estimator, or just its mean, variance, etc.
II. In a "parametric bootstrap" you have an assumption on the underlying distribution of the
population up to some parameter. What you do is then estimate the parameter from the data, and
then sample from the assumed distribution with the estimated parameter.
III. In a "non-parametric bootstrap" we make assumptions about how the sample size will be
distributed and resample the parameter.
Which of the following statements correctly define each of these approaches?
A. Point I and III
B. Point I and II
C. Point II and III
Q.1487 The non-parametric density estimation is based on the assumption that a basic historical
simulation does not get the best out of the information at hand. Which of the following examples
demonstrates this drawback?
A. If we have 100 P/L observations, the basic HS only permits us to estimate VaR at
discrete confidence levels, say, 95%
B. If we have 100 P/L observations, the VaR at the 95% confidence level is given by the
seventh-largest loss
C. If we have 100 P/L observations, the VaR at the 95% confidence level is given by the
fourth-largest loss.
D. None of the above.
14
Q.1488 Which of the following methods is NOT used to represent data under non-parametric
density estimation?
A. Histogram
B. Bar Chart
C. Naive Estimators
D. Kernels
Q.1489 All of the following items are generally considered advantages of non-parametric
estimation methods except:
A. little or absolute lack of reliance on covariance matrices
B. Use of historical data
C. Ability to accommodate largely skewed data
D. Availability of data
Q.1490 Estimating historical simulation ES or VaR does not have any theoretical problems;
however, it has a practical problem. Which one is it?
A. As the holding period decreases, the number of observations increases.
B. As the holding period increases, the number of observations decreases.
C. As the holding period decreases, the size of data decreases.
D. As the holding period increases, the size of the data decreases.
15
Q.1491 The theory of order statistics gives us a complete function of VaR (or ES) distribution and
it’s a very easy-to-compute-and-apply approach. Which of the following statements is
INCORRECT regarding estimates of the standard normal VaR based on the conventional
formula?
A. As n increases, the estimated VaR median tends to converge to conventional estimate.
B. The confidence interval is wide as n gets larger and narrow for low values of n.
C. The confidence interval shows a gap between 5 and 95 percentiles.
D. The confidence interval is wider for extreme VaR confidence levels.
Q.1492 Which on of the following statements is most likely correct? A bootstrapping exercise:
A. resampling from our existing data set without replacement
B. assumes that the distribution of returns will remain the same in the past and in the
future
C. assumes that the distribution of returns in future will be markedly different from past
distributions
D. results in a VaR estimate that is a sum of sample VaRs after repeated sampling
Q.1493 The closed-form confidence intervals have limited applicability as we do not have
expressions for standard errors. Which of the following parameters will pose similar problems?
A. Medians
B. Tail probabilities
C. Correlations
D. All of the above
16
Q.1494 In layman’s term, there is a huge problem with volatility as a measurement of risk, at
least for the returns of financial securities. The problem is that excess returns are seen as risky.
This is why in the 80s, J.P. Morgan came with a measurement of risk that only considered
downside risk, the Value at Risk (VaR). One of the methods used to measure the VaR is
bootstrapping. Which of the below statements is an advantage of bootstrapping?
I. Bootstrapping allows us to estimate confidence intervals of any parameter.

II. The underlying assumptions behind bootstrapping are less demanding.
A. Both Point I and II
B. None of the above
C. Point I
D. Point II
Q.1495 Even though bootstrapping has numerous advantages, the bootstrap estimates are
associated with a little bias or error. Which of the following presents an error of bootstrapping?
A. Un-sampling variability
B. Re-sampling variability
C. Dual-sampling variability
D. Bootstrapping variability
Q.1496 One of the drawback of the historical simulation approach is that the discreteness of the
data rules out estimation of VaRs between data points. For example, if there were 100 historical
observations, estimation of the VaR is a straightforward process at the 95% or the 96%
confidence levels, but it is impossible to incorporate a confidence level of, say 95.5%. Which of
the following methods can solve this problem?
A. Applying Brute Force
B. Bootstrapping
C. non-parametric density estimation
D. Use of a large number of re-samples
17
Q.1497 Which of the following is NOT a step from the three-step model developed by Andrews
and Buchinsky to determine B (the number of bootstrap resamples)?
A. Assuming a value "x" and plugging it into the relevant equation to get a preliminary
value of B
B. Simulating B0 re-samples
C. Taking an infinite number of bootstrap re-samples
D. Making an estimate of the sample kurtosis
Q.2631 An analyst performing a historical simulation to measure the VaR of a portfolio uses a
volatility-weighted approach. One month ago, the actual return of the asset was 5% and its daily
volatility estimate was 2%. If the current daily volatility is 1.5%, calculate the volatility-adjusted
return.
A. 0.03
B. 0.0167
C. 0.0375
D. 0.0667
Q.2635 Which of these statements about non-parametric approaches for estimating VAR is not
true?
A. Non-recurrent extreme losses can dominate and skew non-parametric estimates
B. If there is a lot of volatility in the period chosen, the VAR and expected shortfall
estimates will be too high
C. Unlike parametric approaches, non-parametric approaches can easily accommodate

non-normal features like fat tails and skewness
D. Data for these methods can be very difficult to obtain and needs frequent adjustments
18
Q.2820 The mean return from a dataset has been pre-calculated and is given as 0.04. The
standard deviation has also been given as 0.32. With 90% confidence, what will be our
percentage maximum loss? Assume that from our dataset, Z = -1.28 and N(Z) = 0.10 since you
are to locate the value at the 10th percentile.
A. 36.96%
B. 11.27%
C. 11.32%
D. 36.72%
Q.2821 Which of the following is NOT an advantage of non-parametric methods?
A. When combined with add-ons, non-parametric methods are capable of refinement and
potential improvement
B. Non-parametric methods can accommodate any type of position including derivative

positions
C. Non-parametric methods are not subject to the phenomenon of ghost effect or shadow
effects
D. Non-parametric methods can accommodate fat tails, skewness and other abnormal
features to parametric approaches
Q.2822 There are 30 observations in a dataset. The worst 10 return observations (in %) are listed
below:
[-20, -18, -18, -17, -15, -14, -12, -10, -7, -3]
What is the VaR at the 90% confidence?
A. 17%
B. 18%
C. 16%
D. 15%
19
Q.3007 You are a VaR analyst on a trading floor and one of the traders has complained to you
about the historical VaR of one of his stock: he argues that over the past 3 trading days, the end–
of-trading stock price has been flat and as a result, no movement is expected from his VaR. You
noted however that though the stock price has remained flat, interest rates have moved. In these
circumstances, is the trader right?
A. Yes, the trader is right: as long as the stock price didn't move, the risk remains
unchanged
B. No, the trader is wrong: even if the stock price did not move, then the risk of that
stock should change
C. Yes, the trader is right: price is the only determinant of daily VaR
D. None of the above: further analysis is required
Q.3010 You have been hired on a popular trading floor and one of the traders comes over and
asks about the impact of price changes on her VaR - made of a single long position in stock KKJL.
Yesterday's closing price was USD 100.
You are using a 95% confidence historical VaR based on a 260 days moving window of historical
data. In this time period, the 16 worst 1-day returns from for KKJL as of yesterday were as
follows (in %): -9.5, -8, -7.6, -7.4, - 7.2, -7.18, -7.1, -6.9, -6.57, -6.56, -6.45, -6.4, -6.25, -6.05, -5.99,
-5.85.
Suppose that the stock price decreased by 10% between yesterday and today.
What will be the 95% confidence VaR in absolute terms?
A. USD 6.25
B. USD 5.625
C. USD 6.625
D. Cannot be concluded from the given information
20
Q.3012 Under age-weighted historical simulation,
A. more recent observations are weighted more and distant observations weighted less
B. all observations are weighted equally
C. the decay parameter takes a value of 1
D. the historical window of observations must not exceed 250 days
Q.3035 Paul is using the age-weighted historical simulation approach to estimate the VaR of a
stock portfolio, with a historical sample size of 100 days and a decay factor of 0.96. Over the
recent past, the portfolio has registered the following returns:
Return Periods Ago(Days)

−3.2% 109
−3.3% 75
−2.3% 66
−1.3% 22
−3.0% 45
Determine the weight on the return earned 45 days ago
A. 0.05
B. 0.0025
C. 0.0065
D. 0.006751
21
Q.3037 You have been hired on the trading floor and one of the traders comes over and asks
about the impact of a price change on her VaR made of a long position in stock A, whose value
stood at 100 as of yesterday.
Assume you are using a 95% confidence historical VaR (based on 260 days moving window of
historical data). Further, assume that the 16 worst 1-day returns of stock as of yesterday were as
follows:
-9.5, -8, -7.6, -7.4, - 7.2, -7.18, -7.1, -6.9, -6.57, -6.56, -6.45, -6.4, -6.25 -6.05, -5.99,-5.85.
Assume the price of the stock increased by 10% between yesterday and today. What will the
value of today's 95% VaR (in absolute value)?
A. $6.25
B. $6.655
C. $10
D. Cannot conclude
22
Q.3039 Let's assume you are requested to calculate the historical VaR of the below portfolio with
P = A + B with A = 10 and B = 100.
Assume also a correlation of 0.2 between the past 300 historical returns of stocks A and B.
The table below displays the five worst returns of each stock by date.
Stock A Stock B
Return Date Rank Return % Return Date Rank Return %
Day 1 1 −7.50 Day 1 1 −9.00
Day 2 2 −7.00 Day 2 2 −8.50
Day 3 3 −6.50 Day 3 3 −8.00
Day 4 4 −6.40 Day 4 4 −7.90
Day 5 5 −6.25 Day 5 5 −7.80
Based on the above the 99% historical VaR of P in absolute value will be:
A. $7.11
B. $1.74
C. $6.92
D. $8.54
23
Reading 63: Parametric Approaches (II): Extreme Value
Q.2175 Extreme events have a very low probability of occurrence but are nonetheless taken very
seriously in the financial world. Which of the following best explains why?
A. Extreme events tend to recur at rather regular time intervals
B. Extreme events rarely have warning signs and thus markets cannot prepare for them
in any way
C. Extreme events are normally very costly and can create a “ripple” effect on the global
market
D. No models have been developed to accurately predict and estimate the effects of
extreme events in qualitative terms
Q.2176 It’s normally very difficult and problematic to model extreme events mainly because of:
A. A lack of models that can estimate the effects of certain extreme but possible events
B. A lack of qualified personnel to oversee the modeling process
C. A lack of credible, reliable input data
D. The fact that extreme event modeling requires a considerable investment of time and
expertise
Q.2177 Extreme events can best be modeled through the application of:
A. The central limit theorem
B. The standard normal distribution
C. Extreme-value theorems
D. The exponential distribution
24
Q.2178 The following is the probability distribution function of the generalized extreme value
distribution:
1
⎧
⎪ −
⎪ exp [−(1 + ξ(X−μ) ) ξ ] ,
⎪ ξ≠0
σ
H ξ,μ, α =⎨
⎪
⎪
⎩ exp [−exp (−
⎪ (X−μ)
)] , ξ=0
σ
Where X satisfies the condition (1+\frac{\xi(X-\mu)}{\sigma} > 0)

What is represented by μ,α, and ξ respectively?
A. The location parameter, the scale parameter, and the shape parameter
B. The scale parameter, the location parameter, and the shape parameter
C. The mean, the variance, and the shape parameter
D. The mean, the shape parameter, and the location parameter
Q.2179 The following is the probability distribution function of the generalized extreme value
distribution:
1
⎧
⎪ −
⎪ exp [−(1 + ξ(X−μ) ) ξ ] ,
⎪ ξ≠0
σ
H ξ,μ, α =⎨
⎪
⎩ exp [−exp (− (X−μ) )] ,
⎪
⎪ ξ=0
σ
ξ(X−μ)
Where X satisfies the condition 1 + >0
σ
If ξ > 0, the GEV becomes the:
A. Frechet distribution
B. Pareto distribution
C. Gumbel distribution
D. Weibull distribution
25
Q.2180 If ξ < 0, the GEV becomes the Weibull distribution, but this distribution is rarely used to
model financial returns mainly because:
A. Its cumulative distribution has heavier than normal tails and very few empirical
financial returns are heavy-tailed
B. Its cumulative distribution has lighter than normal tails and very few empirical
financial returns are light-tailed
C. It’s asymmetric
D. It’s symmetric
Q.2181 For the standardized Gumbel distribution, the 10% quantile is equal to:
A. -0.5
B. 0.8340
C. -0.3445
D. -0.8340
Q.2182 For the standardized Frechet distribution with ξ=0.3, the 5% quantile is equal to:
A. -0.9000
B. -0.8340
C. -0.4567
D. -0.9349
26
Q.2956 Suppose that we are informed that in a U.S. stock market, the location parameter of the
limiting distribution, μ, is 2, the scale parameter, σ, is 0.6, and the tail index, ξ, is 0.4. Apply
these parameters in the Fréchet VaR formula to calculate the estimated 95% VaR and 99.5% VaR,
respectively. Assume n =100.
A. 95% VaR: 1.340; 99.5% VaR: 1.657
B. 95% VaR: 1.657; 99.5% VaR: 1.119
C. 95% VaR: 1.28; 99.5% VaR: 2.477
D. 95% VaR: 1.657; 99.5% VaR: 1.876
Q.2957 Assuming that we are given the following parameters based on the empirical values from
/
contracts on futures clearing companies; β = 0.7, ξ = 0.12, u = 3%, Nu = 5%. Compute the VaR
n
and the Expected Shortfall at 99.5%, respectively.
A. VaR: 1.674; Expected Shortfall: 2.453
B. VaR: 4.856; Expected Shortfall: 5.905
C. VaR: 1.453; Expected Shortfall: 2.420
D. VaR: 1.667; Expected Shortfall: 2.554
27
Q.3993 To retrieve the value at risk (VaR) for the U.S stock market under the generalized
extreme-value (GEV) distribution, a risk analyst uses the following equation which characterizes
a heavy-tailed Fr´echet distribution.
σn
VaR α = μ n − [1 − (−nln (α))−ξn ]
ξn
The analyst uses the following somewhat "realistic" parameters:

Location, μ = 3.0%
Scale, σ = 0.70%
Tail index, ξ = 0.30%
If the sample size, n = 100, then which is nearest to the implied 99.90% VaR?
A. 2.3651%
B. 2.547%
C. 3.521%
D. 5.3216%
Q.3994 In FRM parlance, an extreme value is one that has a low probability of occurrence but
potentially disastrous (catastrophic) effects. The main challenge posed by extreme values is that:
A. They do not conform to any of the established loss distributions
B. They can only be fully characterized by multiple loss distributions
C. They are too big such that the resulting loss estimates are infinitely large
D. There are only a few observations from which a credible, reliable analytical model can
be built
28
Q.3995 Simon is trying to fit a distribution to the extreme loss tail of a historical financial return
dataset. He does not have a good fit for the parent distribution, and has therefore not settled on
an appropriate extreme value theory (EVT) approach. He decides to conduct a hypothesis test
and concludes that the tail index is insignificant. In this scenario, which of the following
distributions should he use?
A. Gumbel
B. Fr´echet
C. Normal
Q.3996 Vanessa is trying to fit a distribution to the extreme loss tail of a historical financial
return dataset. After studying the data and consulting with end users, she has established the
following:
I. The loss data somewhat cluster; that is, losses are not strictly i.i.d.
II. The end users do prefer that the extreme loss tail distribution itself exhibit right-skew;
aka, positive skew
III. The distribution F (x) is actually unknown; i.e., it could be anything
IV. The parent distribution is non-normal
Which of the established issues, in theory, effectively DISQUALIFIES the generalized extreme-
value (GEV) distribution as a candidate for application?
A. I only
B. II and IV
C. III only
D. None of these issues disqualify the GEV distribution
29
Q.3997 Which of the following statements about Extreme Value Theory (EVT) and its application
to value at risk are true?
I. EVT extends the Central Limit Theorem to the distribution of the tails of independent,
identically distributed random variables drawn from an unknown distribution.
II. For empirical stock market data, the shape parameter in EVT is positive implying tails
that disappear more slowly than a normal distribution.
III. EVT can help avoid a shortcoming of the historical simulation method which may have
difficulty calculating VaR reliably due to a lack of data in the tails.
A. I only
B. II only
C. II and III only
D. All the above statements are correct.
Q.3998 The returns of a portfolio of stocks quoted in the S&P 500 share index over the last year
follow a distribution that is approximately normal. A trainee analyst removes some of the very
best performing stocks and produces reports based on the altered portfolio of returns. Which of
the following statements about the returns of the altered portfolio is/are correct?
I. The distribution of returns of the altered portfolio is likely to be negatively skewed

II. The distribution of returns of the altered portfolio is likely to be positively skewed
III. The mean return is likely to be lower compared to the original portfolio.
IV. The median return is likely to be higher compared to the original portfolio
A. II, III, and IV
B. I and II
C. II and III
D. I and III
30
Q.3999 Which of the following statements about Extreme Value Theory (EVT) and its application
to value at risk is incorrect?
A. Unlike conventional approaches for estimating VAR, EVT considers only the tail
behavior of the distribution
B. Unlike conventional approaches for estimating VAR that assume that the distribution
of returns follows a unique distribution for the entire range of values, EVT allows the
returns to follow an unknown distribution.
C. EVT establishes the optimal point beyond which all values belong to the tail and then
separately models the distribution of tail events.
D. By segregating the tail of the distribution, EVT effectively ignores extreme events and
losses
Q.4000 For the standardized Gumbel, determine the 5% quantile, 95% quantile and the 99%
quantile, respectively.
A. -1.0972; 2.9702; 4.6001
B. -2.0845; 0.0052; 0.0041
C. 4.5614; 3.8542; 2.7823
D. -1.0965; 0.0052; -2.0485
Q.4001 In reality, natural and financial disasters are often related, and risk managers endeavor
to have some awareness of multivariate extreme risks. In this regard, why do risk managers limit
themselves to the study of a small number of financial variables at a time?
A. A lack of sufficient data
B. The curse of dimensionality
C. Multivariate extremes are sufficiently rare that we need not worry about them
D. The study of multivariate extremes is costly and time consuming.
31
Q.4002 In financial risk management, the clustering of high-severity risks is referred to as:
A. Multivariate risk analysis
B. Tail dependence
C. Univariate extreme value theory
D. Dimensional analysis
Q.4003 In practice, risk analysts prefer the Peaks-over-threshold (POT) approach over the
generalized extreme value approach because the POT approach:
A. Is less time consuming
B. Is more efficient in the use of data
C. Does not require the analyst to choose a threshold
D. All of the above
Q.4004 To retrieve the value at risk (VaR) for the U.S stock market under the generalized
extreme-value (GEV) distribution, a risk analyst uses the following somewhat "realistic"
parameters:
Location, μ = 4.0%
Scale, σ = 0.80%
Tail index, ξ = 0.5%
If the sample size, n = 100, then which is nearest to the implied 99.90% VaR?
A. 0.0225
B. 0.05852
C. 0.04123
D. 0.02512
32
Q.4005 Assume the following observed parameter values:
β = 0.60
ξ = 0.30
μ = 1%
Nμ
n
= 5%
Compute the VaR at 99% confidence and the corresponding expected shortfall.
A. VaR = 2.25% ; ES = 3.5%
B. VaR = 2.2548% ; ES = 0.5252%
C. VaR = 2.2413% ; ES = 3.6304%
D. VaR = 1.5825% ; ES = 2.2385%
Q.4006 Dyer and Blair Investment bank has an active position in commodity futures and is using
the peaks-over-threshold (POT) approach (EVT) to estimate value at risk (VaR) and expected
shortfall (ES) in accordance with extreme value theory. After careful consideration, the firm's
risk managers have settled on a threshold level of 5.00% to evaluate excess losses. This choice of
the threshold is informed by the realization that 3.0% of the observations are in excess of this
threshold value. As displayed below, empirical analysis suggests the two other distributional
parameters: scale, β = 0.70; and shape (aka, tail index), ξ = 0.25.
Parameter Value
Loss threshold, u 5.00%
No. of observations, N 700
No. of observations that exceed threshold, N(u) 21
N(u)/N 3.00%
Scale, β 0.70%
Shape, aka, tail, ξ 0.25%
Determine the VaR at the 99% confidence level.
A. 0.02225
B. 0.04125
C. 0.05885
D. 0.03
33
Q.4007 Kelvin Streetman is evaluating the extreme risks associated with active contracts on a
futures clearing house. He intends to use the peaks-over-threshold (POT) approach (EVT) to
estimate value at risk (VaR) and expected shortfall (ES) in accordance with extreme value theory.
Kelvin has set parameters at some empirically plausible values denominated in % terms as
displayed below:
Parameter Value
Loss threshold, u 5.00%
No. of observations, N 700
No. of observations that exceed threshold, N(u) 21
N(u)/N 3.00%
Scale, β 0.70%
Shape, aka, tail, ξ 0.25%
At the 99.0% confidence level, the position's VaR under the POT approach is 5.885%. Which is
nearest to the corresponding 99.0% expected shortfall (ES)?
A. 0.075426
B. 0.071133
C. 0.01885
D. 0.0225
Q.4008 Extreme value theory (EVT) is a branch of applied statistics developed to address study
and predict the probabilities of extreme outcomes. Which of the following statements about EVT
and its applications is incorrect?
A. The peaks-over-threshold approach provides the natural way to model exceedances

over a high threshold; which then determines the number of observed exceedances;
the threshold must be sufficiently high to apply the theory, but sufficiently low so that the
number of observed exceedances is a reliable estimate.
B. EVT estimates are subject to considerable model risk, and EVT results are often very
sensitive to the precise assumptions made.
C. Because observed data in the tails of distribution is limited, EV estimates can be very
sensitive to small sample effects and other biases
D. EVT asserts that distributions justified by the central limit theorem can be used for
extreme value estimation.
34
Q.4009 According to the Fisher-Tippett theorem, as the sample size n gets large, the distribution
of extremes converges to:
A. a uniform distribution
B. a normal distribution
C. a generalized extreme value distribution
D. a generalized Pareto distribution
Q.4010 As the threshold level, u, gets large, the Gnedenko–Pickands–Balkema–DeHaan (GPBdH)

theorem states that the distribution above-threshold observations converges to:
A. a normal distribution
B. a generalized extreme value distribution
C. a generalized Pareto distribution
D. a uniform distribution
Q.4011 In setting the threshold in the POT approach, which of the following statements is most
accurate? Setting the threshold relatively low makes the model:
A. more applicable but decreases the number of observations in the modeling procedure.
B. less applicable and decreases the number of observations in the modeling procedure
C. more applicable but increases the number of observations in the modeling procedure.
D. less applicable but increases the number of observations in the modeling procedure.
35
Q.4012 The peaks-over-threshold approach generally requires:
A. fewer estimated parameters than the GEV approach and shares one parameter with
the GEV.
B. fewer estimated parameters than the GEV approach and does not share any
parameters with the GEV approach
C. more estimated parameters than the GEV approach and shares one parameter with
the GEV.
D. more estimated parameters than the GEV approach and does not share any
parameters with the GEV approach.
36
Reading 64: Backtesting VaR
Q.1498 Value-at-risk (VaR) models are used for predicting risks; therefore, there must be a
proper process of validation which checks the adequacy of a model. There are various tools and
models to check validation such as oversight, independent review, stress testing, and
backtesting. Which of the following statements are CORRECT about backtesting?
I. Backtesting is a statistical framework which provides verification that actual and projected
losses are in line
II. Backtesting compares the history of VaR forecasts to actual (realized) returns
III. Backtesting involves conducting reality checks which make up useful information for
investment decisions
A. Both I and II
B. Both II and III
C. Both I and III
D. All of the above
Q.1499 While conducting backtesting of VaR as an FRM manager, an accurate model is one
where:
A. The frequency of confidence levels is greater than the number of exceptions
B. The frequency of confidence levels is lower than the number of exceptions
C. The frequency of confidence levels is equal to the number of exceptions
Q.1500 The theory of order statistics gives us a complete function of VaR (or ES) distribution and
it’s a very easy-to-compute-and-apply approach. Critics of VaR models contend that:
A. VaR models are based on static portfolios
B. The market prices used in VaR models do not depict volatility
C. VaR models are based on the assumption that managers rebalance the portfolios t-day
period
D. VaR models are based on the assumption that portfolios are actively managed
37
Q.1501 While carrying out backtesting of a leading bank’s VaR model, you have made the
following findings: the bank is currently calculating the 1-day VaR at a confidence level of 99%.
However, based on your findings you suggest changing the confidence level from 99% to 95%.
Which of the following statements would justify your stance?
A. While conducting backtesting with a 90% confidence interval, the probability of

committing a Type 1 error is small as compared to the probability of Type 1 error when
backtesting with 95% and 99% VaR models.
B. The accuracy of the VaR model and the basis of accepting/rejecting the model have a
greater reliability at a 95% confidence level VaR as compared to at a 99% confidence
level.
C. While conducting backtesting with a 95% confidence interval, the probability of

rejecting the VaR models is higher at a 95% confidence level than at a 99% confidence
level.
D. There are fewer chances of a 95% VaR model being rejected based on backtesting as
compared to a 99% VaR model.
Q.1502 Matthew Hopkins is invited to interview for a position as a financial risk manager. After
completing an initial set of questions, the interviewer asks for the interpretation of the following
case: a $20 million 15-day VAR figure having a confidence level of 95%. Which of the following
represents the CORRECT interpretation?
A. There is a 5 percent chance that there will be a gain of greater than $20 million in a
time period of 15 days
B. The corresponding VAR of the following day is $20 million, with a confidence interval
of 95%
C. The amount of minimum loss spread over the next 15 days is at least $20 million with
a confidence of 95%
D. The amount of loss spread over the next 15 days is expected to be less than $20
million in 95 percent of case scenarios
38
Q.1503 The notion of backtesting generally includes the comparison of profits and losses on a
daily basis. The 1996 Market Risk Amendment sheds light on the framework of backtesting.
Which of the following metrics are considered critical for such a process?
I. The number of outliers

II. The size of the outliers
III. The risk measure to use
A. I and II
B. II and III
C. II only
Q.1504 A detailed analysis of backtesting reveals that there are two major areas where
backtesting applies: in the calculation of the Value at Risk (VaR) and in the calculation of EPE1
profiles. Considering this, the Basel Committee has stated very clear rules as to how to perform
the VaR backtest, along with factors distinguishing good and bad models. Which of the following
statements about the Basel Committee guidelines are CORRECT?
I. The Basel rules for backtesting are directly derived from the failure rate test.
II. As per Basel Committee, 5 exceptions are acceptable and fall under the green zone.
III. When exceptions fall in the red zone and become greater than or equal to 10, an automatic
penalty is generated.
A. I and II
B. II and III
C. I and III
D. All of them
39
Q.1505 It is a well-known fact that backtesting requires the application of quantitative, most
often statistical methods, for the purpose of determining whether a model for the assessment of
risk is adequate or not. Which of the following categories form part of the Basel Committee
guidelines regarding exceptions?
I. Model accuracy could be improved

II. Basic integrity of the model
III. Bad Luck and Intraday trading
A. I and II
B. II and III
C. I and III
D. All of them
Q.1506 Designing a verification test is actually a situation where there is a tradeoff between
Type I error and Type II error. As an FRM student, complete the decision errors in the following
table. (Answer choices are in order of i, ii, iii, iv.)
Model
Decision Correctl Incorrect
Accept i ii
Reject iii iv
A. Ok, Type 1 error, Ok, Type 2 error
B. Ok, Type 2 error, Type 1 error, Ok
C. Type 1 error, Ok, Type 2 error, Ok
D. Ok, Ok, Type 1 error, Type 2 error
40
Q.1507 The Basel Committee is based on the assumption that regulators operate under diverse
constraints. The Basel rules are derived from the failure rate test, in which an analyst has to first
select the rate of the Type 1 error and then try to pick a test with a low Type 1 error. Based on
this knowledge, which of the following categories involves deviation due to risk NOT being
measured precisely?
A. Model accuracy could be improved
B. Basic integrity of the model
C. Bad luck
D. Intraday trading
Q.1508 The underlying crux behind backtesting is that faulty models and bad luck must be
separated, or there must be a balance between Type I and Type II errors. However, backtesting
has certain limitations. Which of the following is NOT a limitation of backtesting?
A. Inability to model strategies affecting historic prices
B. Potential curve fitting which means past successful strategies do not work in future
C. Requirement of past conditions with adequate details
D. Reducing volatility
Q.1509 Generally, the backtesting model focuses on unconditional coverage as it does not
account for time variations or conditioning in data. As a result, exceptions can bunch closely or
cluster in time. Which of the following backtesting outcomes does NOT raise a red flag?
I. At 95% confidence level, 12 exceptions occur on an annual basis and are spread evenly.
II. At 95% confidence level, 12 exceptions occur on an annual basis and 9 of these occurred over
last 3 weeks.
III. At 95% confidence level, 12 exceptions occur on an annual basis - one exception per month.
A. I and II
B. II and III
C. I and III
D. All of them
41
Q.2637 Jason Black, a risk analyst at a large multinational bank, is backtesting the VaR model of
the bank. The model being tested is a daily, 98% VaR model. If the backtest is conducted for one
year at a 95% confidence level, what is the acceptable number of daily losses that will lead Black
to conclude that the model is calibrated correctly?
A. 6
B. 9
C. 12
D. 5
Q.2638 A model gives a VaR value of $9.5 million for a portfolio at a 99% confidence interval. A
one-year backtest conducted at the 90% confidence level reveals that losses exceeded $9.5
million on 12 occasions. The model is accepted as accurate. Assuming 224 days in a year, which
of these statements is most likely true?
A. A Type I error has occurred
B. A Type II error has occurred
C. Both Type I and Type II errors have occurred
D. The model has been accepted correctly
42
Q.2640 Willy Jones and Craig Atherton are two junior risk analysts. They have recently been
assigned to perform a 1-year backtest of a 1 day 98% VaR model, assuming 225 days in the year.
During the next few days, they exchange a number of emails regarding the assignment:
Email 1 - Jones forecasts the number of expected exceptions for the model to be 4.5.
Email 2 - Atherton replies that according to the Basel Committee’s prescribed penalty zones, the
yellow zone starts at six exceptions and attracts a multiplier of four.
Email 3 - Jones states a type II error occurs when an accurate model is rejected.
The contents of which of the emails is/are not true?
A. Emails 1 and 2
B. Emails 2 and 3
C. Emails 1 and 3
D. All three emails
Q.2641 What is the number of exceptions that are forecasted during the backtesting of a VaR
model that is constructed using a 95% confidence interval over a 1000-day period?
A. 100
B. 10
C. 25
D. 50
Q.2642 According to the Basel Committee rules for the backtesting of VaR, which of the following
statements in relation to the number of exceptions and the corresponding capital multiplier is
NOT accurate?
A. If the number of exceptions is between 5 and 9, the bank will fall in the yellow zone.
B. If the number of exceptions is between 5 and 9, a capital multiplier of 3 will be

applied.
C. If the number of exceptions exceeds 10, a capital multiplier of 4 will be applied.
D. Banks in the red zone will be charged the highest penalty.
43
Q.2643 The Basel Committee has defined four major reasons for exceptions found during
backtesting. These include all of the following, except:
A. Model not calibrated to market conditions
B. Model lacks basic integrity
C. Intraday trading
D. Bad luck
Q.2824 The management of a financial institution reports that on a particular year, the daily
revenue fell short of the downside 95% VaR band on 24 occasions (days), or more than 5% of the
time. Ten of these 24 occurrences fell within the May to July period. Assuming 252 days in the
year, test if this was a faulty model or bad luck using the binomial distribution.
A. 8.32; it is a faulty model
B. 2.16; it is bad luck
C. 1.01; it is bad luck
D. 3.3; it is a faulty model
44
Reading 65: VaR Mapping
Q.1511 Risk measurement is widely practiced in the financial sector to establish the risk
characteristics of trading instruments and portfolios. This is done via several methods some of
which can be time-consuming and complex because it is literally impractical to measure all risk
factors individually. Hence, the VaR method is used through the process of mapping to:
A. Simplify a portfolio by mapping positions on selected risk factors
B. Simplify a portfolio by mapping positions on all risk factors which can have a minor or
major impact on the performance of an instrument
C. Simplify portfolio by mapping positions on only five risk factors
D. Simplify portfolio by mapping positions on all abnormal risk factors which can impact
the performance of an instrument
Q.1512 Mapping is a useful process and also an instructive one because it provides useful
judgments about risk drivers of derivatives. Financial institutions cannot always use historical
prices to develop a risk profile for the instrument. In addition, they cannot develop risk profiles
of options on the basis of historic values. Therefore, mapping gives us a way to handle these
practical problems when:
A. Characteristics of instrument do not change over time
B. Characteristics of instrument change over time
C. A large number of factors needs to be measured separately for each position
D. The characteristics of the instrument are only exposed to a single major risk factor
Q.1513 As we know, mapping is the simple process of analyzing the market instruments on
primitive risk factors. Considering this concept, let’s take a single instrument that has a market
value of Vm. It is allocated to specific risk exposures namely X1, X2, and X3. Suppose not all of
the current market value Vm is allocated to these risk factors. What does that imply with regard
to the remaining value?
A. The remainder value is not exposed to any risk
B. The remainder value is allocated to cash which is not a risk factor
C. The remainder value is allocated to a separate set of risk factors
D. The remainder value’s risk exposure is very difficult to measure
45
Q.1514 In the process of mapping, finance experts first need to choose the most effective set of
primitive risk factors against which the market instrument will be positioned to measure risk.
This choice of factors must be balanced between time devotion and accurate risk measurement.
In short, the choice of primitive risk factors should reflect:
A. The easiest way to get better results in the least amount of time
B. The trade-off between models with a large number of factors and less complex models
C. The trade-off between better quality of approximation and faster processing
D. The trade-off between specific risks with significant effects and those with
insignificant effects
Q.1515 Once we have selected the risk factors, then, the next step is to map the portfolio or
instrument positions against these risk factors which can be achieved through any of the three
approaches of mapping, depending on the best suitable approach. In choosing the mapping
approach, which important factor should be kept in mind?
A. Mapping should only preserve the market value of the instrument
B. Mapping should preserve the par value as well as the market risk of the position
C. Mapping should preserve the market value as well as the interest rate risk of the
position
D. Mapping should preserve the market value as well as the market risk of the position
Q.1516 Considering an example of a two-bond portfolio, we calculated the portfolio returns and
the risks associated with those portfolios using the mapping technique. Then, we found some
specific values, say, 2.80 VaR for duration mapping and 2.67 VaR for cash flow mapping. This
notable difference in these values is due to the fact that:
A. Risk measures are not perfectly linear with maturity and correlations are below unity
B. Risk measures are perfectly linear with maturity and correlations are below unity
C. Risk measures are perfectly linear with maturity and correlations are above unity
D. Risk measures are not perfectly linear with maturity and correlations are equal to
unity
46
Q.1517 Benchmarking is the process of evaluating a portfolio’s risk against some standard or
ideal portfolio risk that is considered as the benchmark. Therefore, the VaR of the deviation of
portfolio A relative to the benchmark is
Tracking Error VaR = α√(x – x0)’ Σ(x – x0)
After we performed the necessary calculations for portfolio A, we found the tracking error VaR of
portfolio A which is 0.63 million.
What does this tracking error VaR value imply?
A. The maximum deviation between the index and portfolio A is at most 0.63 million
under normal market conditions
B. The minimum deviation between the index and portfolio A is at most 0.63 million
under normal market conditions
C. The maximum deviation between the index and portfolio A is at most 0.63 million
under abnormal market conditions
D. The minimum deviation between the index and portfolio A is at most 0.63 million
under abnormal market conditions
Q.1518 The stress testing approach of assessing risk exposure represents the link between
calculating VaR through matrix multiplication and movement in underlying prices. This test gives
more direct and appropriate results. Keeping this in mind, which of the following is true about
stress testing as described above?
A. Stress testing is used to evaluate the potential impact on portfolio values of unlikely
events or movements in a set of financial variables
B. Stress testing is a risk management tool that compares predicted results to observed
actual results (historical data)
C. Both A and B options are true
D. None of the above are true
47
Q.1519 Forward contracts are the simplest types of derivatives and their risk can easily be
calculated through basic building blocks forming those contracts. But before buying forward
contracts, an investor needs to make a decision between two alternatives which are economically
equivalent. The usual options available to the investor are to:
A. Buy X units of any asset at price P and sell them at a higher price to potentially earn
profits or enter into a forward contract to buy one unit of the asset in one period
B. Buy X units of any asset at price P and hold them for one period or enter into a
forward contract to buy one unit of the asset in two periods
C. Buy X units of any asset at price P and hold them for one period or enter into a
forward contract to buy one unit of the asset in one period
D. Buy X units of any asset at price P and sell them at a higher price to potentially earn
profits or enter into a forward contract to buy one unit of the asset in one period at the
lowest price possible
Q.1520 One of the methods of cash flow mapping involves decomposing bond risk into the risk of
each of the bond's cash flows. This describes:
A. Principal mapping
B. Duration mapping
C. Cash flow mapping
D. Present value mapping
Q.1521 Financial institutions determine the market values of forward contracts on the basis of
some underlying pricing factors. These factors can include market interest rate, risk and
correlation, etc. Such factors can affect the price on the basis of their volatility and VaR
percentage. What does positive correlation between two factors - A and B - indicate?
A. It indicates that when factor A goes up in value, the value of factor B is likely to
depreciate
B. It indicates that when factor A goes down in value, the value of factor B is likely to
appreciate
C. It indicates that when factor A goes up in value, the value of factor B does remains
unaffected
D. It indicates that when factor A goes up in value, the value of factor B is likely to
appreciate
48
Q.1522 To determine the value of forward contracts, we decompose the forward contract into its
main building blocks which will impose the net effect on the risk and price of the forward
contract. This methodology can also be used for long-term currency swaps which are typically
identical to portfolios of forward contracts. Keeping this scenario in mind, which of the following
statements is true?
A. A 5-year contract to pay dollars and receive Euros is equivalent to a series of 5

forward contracts to exchange a set amount of dollars
B. A 5-year contract to pay dollars and receive Euros is equivalent to a series of any
number of forward contracts to exchange a set amount of dollars
C. A 5-year contract to pay dollars and receive Euros is equivalent to a forward contract
to exchange a set amount of dollars
D. A 5-year contract to pay dollars and receive Euros is not equivalent to a series of 5
forward contracts to exchange a set amount of dollars
Q.1523 The valuation of commodity forward contracts is much more complex compared to that of
financial assets such as currencies or stock indices because these commodity-based contracts do
not have well-defined income flows and most of the time do not make monetary payments.
Rather, items are consumed giving an implied benefit called convenience yield, which
represents:
A. The quantifiable disadvantage to owning the commodity rather than buying the futures
contract
B. The quantifiable advantage to owning the commodity rather than buying the futures
contract
C. The addition of the risk-free rate and the storage cost
D. The cost of storage cost from holding the commodity
49
Q.1524 A forward rate agreement is a type of forward contracts that allows the contracting
parties to make transactions in a locked interest rate at some future date. The buyer in this
contract locks in the borrowing rate and the seller locks in the lending rate at some future date.
Which statement is true about such a contract if the spot rate is higher than the forward rate at
the time of the transaction?
A. The buyer will be worse off and will receive payments at a lower rate and the seller
will also be worse off by lending at a lower rate
B. The buyer will be worse off and will receive payments at a lower rate while the seller
will benefit by lending at a lower rate
C. The buyer will benefit and will receive payments at a lower rate while the seller will be
worse off by lending at a lower rate
D. Both the buyer and the seller will be in the same position with no effect in benefits and
losses
Q.1525 The forward rate can be defined as the implied rate that makes the return on a T2 period
investment and a T1 period investment equal. That is:
(1+R2T2) = (1+R1T1) [1+F1,2(T2 -T 1)]
It means that if you sold a 5*10 FRA on $50 million, this transaction is equal to borrowing $50
million into 5-month Bills and investing the proceeds into 10-month Bills.
Which of the following formulas is supporting the above statement?
A. Long 6*12FRA = Short 6-month Bills + Long 12-month Bills
B. Long 6*12FRA = Short 12-month Bills - Long 6-month Bills
C. Long 6*12FRA = Long 12-month Bills + Short 6-month Bills
D. Long 6*12FRA = Long 6-month Bills + Short 12-month Bills
50
Q.1526 Interest rate swaps are the most commonly used derivatives because of their less volatile
risk positions. An interest rate swap is an agreement between two parties to exchange interest
rate flows on the basis of fixed to floating rates and vice versa. They can be broken down into
two legs: a fixed leg and floating leg. The fixed leg can be the price on a:
A. Floating-rate note and the floating leg can be equivalent to a coupon-paying bond
B. Coupon-paying bond and the floating leg can be equivalent to a floating-rate note
C. Zero-coupon bond and the floating leg can be equivalent to a floating-paying bond
D. Floating-paying bond and the floating leg can be equivalent to a zero-coupon bond.
Q.1527 Risk measurement is difficult for non-linear derivatives or options because of non-
linearity. To simplify the process, the Black-Scholes model is used.
What is the assumption of this model other than perfect capital markets?
A. Underlying spot prices follow a continuous geometric Brownian motion with constant
volatility
B. Underlying spot rates follow a continuous algebraic Brownian motion with constant
volatility
C. Underlying spot prices follow a stationary geometric Brownian motion with constant
volatility
D. There is no other assumption of this model except for perfect capital markets
51
Q.1528 Consider the Black-Scholes (BS) model for European options. Suppose we drew a graph
showing the relationship between delta (the first partial derivative of a nonlinear option) and
spot prices of options with differing maturities. What would be the relationship observed for
long-term and short-term options?
I. The relationship becomes more nonlinear for short-term options than long-term options
II. The relationship becomes more linear for short-term options than long-term options
III. Linear approximations may be acceptable for options with long maturities when the risk
horizon is short
A. I and III only
B. II and IIII only
C. II only
D. III only
Q.1529 Risk measurement should always be a prioritized endeavor for financial institutions. In
this regard, financial instruments need to be mapped on a set of primitive risk factors. The art of
risk management lies in the ability to choose an appropriate set of risk factors. Keeping this in
mind, which of the following statements is/are true?
I. A large number of risk factors should be incorporated to avoid any future loses
II. Only a few risk factors should be selected to save time and make decisions in a timely fashion
III. There should be proper allocation of primitive risk factors to avoid slow and wasteful
measurements
IV. There should be a proper set of general market and specific risk factors depending on the
position of the instrument
A. I and IV
B. III and IV
C. IV only
D. I and III
52
Q.1530 In practice, we have to keep the number of risk factors small during mapping. These risk
factors include both general market risks and specific market risks for the entire portfolio. Thus
the portfolio return is calculated including variance through the following equation on:
n
V (R P ) = (B2p )V (Rm ) + ∑ (Wi2 )(σgi )
i=1
This decomposition shows that:
A. With less general market risk factors, there will be less specific risk factors for fixed
amount of total risk, (V)(Rp)
B. With more general market risk factors, there will be more specific risk factors for fixed
C. There will be equal general market and specific risk factors for a fixed amount of total
risk, (V)(Rp)
D. With more general market risk factors there will be less specific risk factors for fixed
Q.2644 Adding more general risk factors to a VaR model will most likely:
A. Increase the size of specific risks
B. Decrease the size of specific risks
C. Have no effect on the size of specific risks
D. None of the above. While adding more factors to a model will affect the size of specific
risk it is not possible to determine the exact nature of the change without considering
what factors are added.
Q.2645 All of the following are VAR mapping systems for fixed-income securities, except:
A. Principal mapping
B. Duration mapping
C. Cash flow mapping
D. Interest mapping
53
Q.2825 Determine the forward rate for a 1-year forward contract to exchange US dollars for
Euros. It is estimated that the Euro spot is $1.3988. The 1-year EURO T-bill is quoted at 2.28%
while the 1-year USD T-bill is quoted at 3.33%.
A. 1.41 USD/EURO
B. 1.31 USD/EURO
C. 1.22 USD/EURO
D. 1.5 USD/EURO
Q.2826 A bank has a cash flow decomposition with a duration of 5 years. Given that the VaR of
the index at the 95% confidence level is $2.080 million, with a tracking error of $1.09 million,
calculate the variance improvement relative to the original index.
A. 23.5%
B. 33.6%
C. 72.5%
D. 95.1%
54
Q.2827 The following table gives VaR percentages at the 95% confidence level for a bond with
matuities ranging from one year to 5 years:
Maturity VaR
1 0.4777
2 0.9961
3 1.4264
4 1.9618
5 2.4120
A bond portfolio consists of a $100 million bond maturing in one year and a $100 million bond
maturing in three years. Determine the VaR of this bond portfolio using the principal VaR
mapping method
A. $1.2235m
B. $1.7765m
C. $1.9922m
D. $1.5m
Q.2828 Calculate the current forward rate if you are given that the spot price of 1 unit of the
underlying cash asset is 1.22, with a domestic free rate of 0.037 and τ = 1. The income flow rate
y is 1.92%. (Assume continuous compounding.)
A. 1.24
B. 0.78
C. 1.32
D. 1.50
Q.3015 Which of the following components is NOT a relevant factor while calculating the total
VaR of a USD corporate bond for a US investor?
A. The USD swap interest rate
B. The bond sector's credit spreads
C. The maturity of the bond
D. FX rates
55
Q.3016 Which of the following inputs is NOT required in order to calculate the 99% Monte Carlo
1-day VaR of a portfolio made of two stocks A and B, assuming both stocks have normally
distributed returns?
A. The correlation of the returns between A and B
B. The credit rating of entities A and B
C. The spot values of stocks A and B
D. Normally distributed random numbers
Q.3040 Mapping refers to the process of replacing the current values of a portfolio with risk
factor exposures. More generally, it is the process of replacing each instrument by its exposures
on selected risk factors. Mapping is important because:
A. it helps us to cut down on the dimensionality of covariance matrices and correlations
B. it helps avoid rank correlation problems
C. it greatly reduces the time needed to carry out risk assessment and related
calculations
D. All of the above
Q.3041 If portfolio assets are perfectly correlated, portfolio VaR will equal:
A. Component VaR
B. Marginal VaR
C. Diversified VaR
D. Undiversified VaR
56
Reading 66: Messages from the Academic Literature on Risk
Measurement for the Trading Book
Q.1531 One of the fundamental issues when using VaR for regulatory capital is the horizon over
which VaR is calculated. Scaling up the short-horizon VaR to the desired time period using the
square-root-of-time may compromise the accuracy of VaR because:
A. The tail risk is likely to be overestimated
B. The downward bias tends to decrease as we increase the time horizon
C. The tail risk is likely to be underestimated
D. The upward bias tends to decrease as we increase the time horizon
Q.1532 The intra-horizon VaR is a risk measure that combines VaR over the regulatory horizon
with P&L fluctuations over the short term. Taking intra-horizon risk into account generates risk
measures consistently higher than standard VaR, up to multiples of VaR, and:
A. The divergence is larger for derivative exposures
B. The minimum cumulative loss exerts a distinct effect on the capital of a financial
institution
C. The divergence is smaller for derivative exposures
D. The information is carried on low-frequency P&L
Q.1533 According to academic literature, “time-varying volatility in financial risk factors is

important to the VaR.” When the true underlying risk factors exhibit time-varying volatility, the
use of historically simulated VaR without incorporating time-varying volatility can:
A. Reduce pro-cyclicality
B. Under-estimate risk
C. Increase instability
D. Over-estimate risk
57
Q.1534 Multivariate GARCH models such as the BEKK model of Engle and Kroner (1995) or the
DCC model of Engle (2002) can be used to estimate:
I. Time-varying volatilities
II. Correlations
III. Large numbers of positions
A. I and II
B. II and III
C. I, II and III
Q.1535 The amalgamation of VaR models and market liquidity requires a distinction between
exogenous and endogenous liquidity. Which of the following descriptions is correct?
A. The endogenous component of liquidity risk corresponds to the average transaction

costs set by the market for standard transaction sizes
B. The exogenous liquidity risk corresponds to the normal variation of bid/ask spreads
across instruments
C. The endogenous risk of collective portfolio adjustments is easier to include in a VaR

computation
D. The exogenous component corresponds to the impact on prices of the liquidation of a

position in a relatively tighter market
58
Q.1536 Expected shortfall is the most well-known risk measure following the VaR. It is
conceptually intuitive, has firm theoretical backgrounds and is now preferred to VaR. Which of
the following statements about the expected shortfall is/are correct?
I. The expected shortfall does not account for the severity of loss the confidence threshold
II. The expected shortfall is always sub-additive and coherent
III. The expected shortfall mitigates the impact that the particular choice of a single confidence
level may have on risk management decisions
A. I and II
B. II and III
C. I and III
Q.1537 In order to estimate the range and magnitude of the differences between
compartmentalized and unified risk measures, you are required to obtain a simple ratio of these
two measures. After performing relevant calculations, you come to the conclusion that ratio
values greater than one indicate:
A. Risk compounding, and values less than one indicate risk diversification
B. Risk augmentation, and values less than one indicate risk reduction
C. Risk diversification, and values less than one indicate risk reduction
D. Risk augmentation, and values less than one indicate risk compounding
Q.1538 The examination of variable rate loans, in which the interaction between market and
credit risk can be analyzed, is performed by modeling the dependence of credit risk factors on
the interest rate environment. These factors include:
I. Loans' default probabilities

II. The exposure at default
III. Loss-given-default
A. I and II
B. II and III
C. I and III
D. I, II and III
59
Q.1539 Consider yourself as an intermediary who actively runs a VaR-based risk management
system. You start with a balance sheet consisting of risk-free debt and equity. This is followed by
an asset boom, which leads to an expansion in the values of securities. Without any balance sheet
adjustment, this leads to:
A. A reduction in liability
B. An expansion in capital
C. An expansion in equity
D. A reduction in expenses
Q.2647 Which of these is not a disadvantage of VaR?
A. VaR does not consider the worst case losses that lie beyond the VaR confidence level
B. VaR is not subadditive
C. The VaR of different types of assets cannot be compared
D. VaR gets difficult to calculate as the size of the portfolio and the number of assets in
the portfolio increases
Q.2829 Let a balance sheet for an institution be given such that the liabilities side is 759 in debts
and 104 equity shares. Calculate the total leverage.
A. 15.9
B. 21.5
C. 11.6
D. 8.3
60
Q.2830 What type of liquidity risk is most troublesome for complex trading positions?
A. Endogenous
B. Spectral
C. Exogenous
D. Market-specific
Q.2831 Find the weight of an observation 13 days ago if the total number of days in the historical
window is 300 with a 0.8 control rate of memory decay.
A. 0.013
B. 2.2050
C. 0.0205
D. 0.2250
Q.2832 Branch Bank has the proportion of capital to be held per total VaR as 2.9 while the future
value of its assets is $56 million. Calculate the leverage for Branch Bank if the Value at Risk is
$1.6 million.
A. 13.5
B. 22.1
C. 12.07
D. 15.6
Q.2833 Considering arbitrary portfolios A and B, and their combined portfolio C, which of the
following relationships holds for VARs of A, B, and C ?
A. VaRA + VaRB = VaRC
B. VaRA + VaRB ≤ VaRC
C. VaRA + VaRB ≥ VaRC
61
Q.3014 In many banks, aggregate risk is defined using a rollup or risk aggregation model;
capital, as well as capital allocation, is based on the aggregate risk model. Which of the following
is least likely correct regarding risk aggregation?
A. The top-down risk aggregation model assumes that a bank’s portfolio can be cleanly
subdivided according to market, and operational risk measures only
B. The bottom-up risk aggregation model attempts to account for interactions among
various risk factors
C. In the bottom-up aggregation model, the sub-risk levels are aggregated bottom-up
using a joint model of risk
D. None of the above (All options are correct)
62
Reading 67: Correlation Basics: Definitions, Applications, and
Terminology
Q.1540 Financial correlation is the process of measuring the relationship between two or more
financial assets over time. It measures the extent to which two financial variables move with
respect to each other. The original copula approach for collateralized debt obligation is a type of
static financial correlation that measures the default correlation of all assets in the CDO for a
certain time period. Here, the “certain time period” for a CDO is usually equal to:
A. The reinvestment period of the collateralized debt obligation
B. The maturity of the collateralized debt obligation
C. The time up to which the assets of the collateralized debt obligation defaults
D. The time up to which any single asset of the collateralized debt obligation defaults
Q.1541 Assume that an investor has bought $2 million in a bond from Issuer A. They are now
worried about Issuer A defaulting and have purchased a Credit Default Swap (CDS) from Issuer
B. The value of the CDS is mainly determined by the default probability of the reference entity
Issuer A. If the correlation between issuer A and B increases, what will be the impact on the
price of the CDS?
A. The price of the CDS will decrease because there is a greater chance of joint default.
B. The price of the CDS will increase because there is a greater chance of joint default.
C. There will be no impact on the price of the CDS because it is working as a separate
entity.
D. It may increase or decrease depending on the market and economic conditions of the
country.
63
Q.1542 Suppose a correlation swap buyer pays a fixed correlation rate of 0.28 with a notional
value of $10 million for one year for a portfolio of three assets. The following are the realized
pairwise correlations of the daily log returns at maturity for the three assets:
ρ2,1 = 0.7
ρ3,1 = 0.2
ρ3,2 = 0.03
Assuming that for all pairs, i > j, the payoff for the correlation swap buyer is equal to:
A. $0.28 millin
B. $0.31 million
C. $0.3 million
D. $0.25 million
Q.1544 Nowadays in financial markets, investors are hedging their risk of portfolios by keenly
studying correlation and attempting to financially gain from those correlation changes.
Correlation trading is basically trading those assets whose prices are based on the movement of
one or more assets in time. In these correlation assets, the strike price - the price determined at
the start of the option - is commonly used. What does this strike price indicate?
A. The price at which the underlying asset can be bought in the case of a call, and the
price at which the underlying asset can be sold in the case of a put
B. The price at which the underlying asset can be bought at the time the option is created
C. The price at which the underlying asset can be bought in the case of a put, and the
price at which the underlying asset can be sold in the case of a call
D. The right, but not the obligation, to buy or sell a stock at an agreed-upon price within
a certain period of time
64
Q.1545 When buying multi-asset options, investors must take into account any correlation
between the assets. In fact, the higher the correlation of two assets in an option, the higher the
price of that option. What does a negative correlation between the assets of the option indicate?
I. If one asset’s value decreases, on average, the other asset’s price appreciates.
II. If one asset’s value decreases, on average, the other asset’s price also decreases
III. If one asset’s value increases, on average, the other asset’s price appreciates.
IV. One of the two assets is likely to appreciate which will result in a high payoff, compensating
the other asset’s loss.
A. I only
B. I and III
C. I and IV
D. IV only
Q.1546 A quanto option is another correlation option that authorizes a domestic investor to
interchange his potential option payoff (which is in foreign currency) back into its domestic
currency at a fixed exchange rate. This option helps the investor get protected against currency
risk. From a risk management standpoint, the financial institutions which are selling these
correlation options do not have information about two things. These are:
A. The foreign currency amount to be converted into the domestic currency, and
secondly, the exchange rate at option maturity at which the foreign currency payoff will
be converted into the domestic currency.
B. The domestic currency amount to be converted into the foreign currency, and
secondly, the exchange rate at option maturity at which the domestic currency payoff will
be converted into the foreign currency.
C. The foreign currency that’s correlated with the domestic currency, and secondly, the
impact of the correlation on the buying and selling of quanto options.
D. The domestic currency amount to be converted into the foreign currency, and
secondly, the impact of the correlation on the buying and selling of quanto options.
65
Q.1547 A correlation swap is a type of financial variable in which the correlation between assets
can be traded. In a correlation swap, a fixed known correlation is traded against the unknown
correlation that will actually occur. This type of correlation swap protects the investor from a
stock market decline. The payment of a correlation swap for the correlation fixed rate payer at
maturity is:
A. N(pfixed – prealised)
B. μ(prealised – pfixed)
C. N(prealised – pfixed)
D. Nμ(prealised – pfixed)
Q.1548 After the global crisis, financial institutions have become more risk-averse to avoid any
possible losses. For this reason, financial risk management has become a vital part of the
financial sector and VaR is one of the tools of financial risk management used to measure the
market risk of the portfolio. VaR measures the expected maximum loss of a portfolio with respect
to a certain probability for a time t. The equation for VaR is:
VaRp = σp α √x
What do σp and α represent here?
A. σp is the volatility of the portfolio P, which includes the correlation between the assets
in the portfolio, while α is the abscise value of a standard normal distribution
B. σp is the abscise value of a standard normal distribution, while α is the volatility of the
portfolio, which includes the correlation between the assets in the portfolio
C. σp is the volatility of the portfolio P, which does not indicate anything about the
correlation between the assets in the portfolio, while α is the covariance matrix of the
returns of the assets
D. σp is the volatility of the portfolio P, which includes the correlation between the assets
in the portfolio, while α is the covariance matrix of the returns of the assets
66
Q.1549 We have calculated the value of VaR for a two-asset portfolio to analyze the impact of
correlations between the two assets. After going through all calculations of variance with the
given data, we reached a value of VaR. The VaR value for a 10-day two-asset portfolio with a
correlation coefficient of 0.7 on a 99% confidence interval is $1.786 million. What does this value
imply?
A. Only once in a hundred 10-day period will this VaR amount ($1.7486 million) be
exceeded
B. We are 99% confident that we can lose more than $1.786 million of our two asset
portfolio in the next 10 days
C. We are 99% confident that we will not lose less than $1.786 million of our two asset
portfolio in the next year
D. Only once every 10,000 days will this VaR amount ($1.7486 million) be exceeded
Q.1550 Suppose we drew a graph showing the correlation between two assets, and found it to be
negative. It would mean that:
A. If the market value of one asset decreases, the other asset, on average, also decreases,
hence reducing the overall risk.
B. If the market value of one asset decreases, the other asset, on average, increases,
hence reducing the overall risk.
C. If one asset’s value decreases, the other asset’s value, on average, increases, hence
increasing the overall risk.
D. If one asset increases, the other asset, on average, increases, hence reducing the
overall risk.
67
Q.1551 The global financial crisis of 2007-2009 was caused by a number of reasons which may
include high levels of debt, low interest rates, high-level speculation, and mortgage-backed
securities. It was the first correlation-related crisis marked by correlations among bonds and
CDOs and this led to the fall of many hedge funds.
Which statement is true regarding the cause of losses in CDOs?
A. The losses occurred mainly from a lack of understanding of the correlation properties
of financial markets and hedge funds
B. The losses occurred mainly because of the correlation properties of the CDOs
themselves
C. The losses occurred mainly because of a lack of understanding of the correlation

properties of the tranches in the CDOs, not the CDOs themselves
D. The losses occurred because of an economic and financial downfall which eventually
led to the fall of the CDO market
Q.1552 Other reasons for the financial crisis included residential mortgages, giving loans at
lower interest rates, and also the collapse of the subprime mortgage market. All these led to
heavy selling and buying of CDOs and Credit Default Swaps (CDSs).
CDSs are used to protect against the default of the underlying asset. What is the purpose of the
insurance contract underlying a Credit Default Swap?
A. To divide/spread the risk to a large audience and, as a result, reduce the individual
risk of any asset
B. To speculate on the market movement in CDOs
C. To reduce the individual risk of any asset by selling a large number of CDSs/
D. To trade a large number of securities at once to hedge against risk
68
Q.1553 After the global financial crisis of 2007-2009, the financial regulators decided to
implement some rules and regulations for the stability of the financial markets and the banking
sector. For this purpose, the Basel Accords were introduced to deal with the deficiencies of the
banking system. In essence, the purpose of the Basel Accords was:
A. To offer motivations to the banking sector to improve their risk measurement and
management systems
B. To offer motivations to investors to increase their investments in the banking sector
C. To contribute to a higher level of trading in the banking system
D. To invite risk managers and regulators to take part in the wellbeing of the financial
sector
Q.1554 Correlation risk is an important part of market risk which is typically measured with the
help of Value at Risk concepts. Market risk indirectly integrates the correlation risk. Market risk
is also measured using the expected shortfall, characterized as tail risk. Keeping this in mind,
what is the purpose of the expected shortfall?
A. To measure market risk for risky events, typically for the worst 0.1%, 1%, or 5% of
past scenarios.
B. It measures market risk for extreme events, typically for the worst 0.01%, 0.1%, or 1%
of possible future scenarios.
C. It measures market risk for extreme events, typically for the worst 0.1 %, 1%, or 5% of
possible future scenarios.
D. It measures market risk for risky events, typically for the worst 0.01%, 0.1%, or 1% of
past scenarios.
69
Q.1555 The higher the default correlation between assets, the higher the probability that the
investors will lose all of their investments if a single asset’s price declines. However, lenders can
lower the default risk by diversifying their portfolio. What is the best policy for lending
companies to avoid risk and default?
A. Intersector default correlations are typically higher than intrasector default

correlations so the lending companies are recommended to create a sector-diversified
loan portfolio to decrease default correlation risk
B. Intersector default correlations are typically lower than intrasector default

correlations so the lending companies are recommended to create a sector-diversified
C. Intrasector default correlations are typically higher than intersector default

correlations so the lending companies are recommended to specialize in a single-sector
loan portfolio to avoid default correlation risk
D. Intersector default correlations are typically higher than intrasector default

correlations so the lending companies are recommended to specialize in a single-sector
Q.1556 Systemic risk refers to the risks that affect financial markets as a whole. Which of the
following statements gives the correct relationship between systemic risk and correlation risk?
A. Systemic risk and correlation risk are partially dependent
B. Systemic risk and correlation risk are highly independent
C. Systemic risk and correlation risk are independent of each other
D. Systemic risk and correlation risk are highly dependent
70
Q.1557 Concentration risk is a financial loss due to financial exposure. This risk can be
quantified with the help of the concentration ratio. What will be the rule of thumb for the
creditor regarding the concentration ratio?
A. The lower the value of the concentration ratio, the higher the diversification, and the
lower the default risk of the creditor
B. The higher the value of the concentration ratio, the higher the diversification, and the
lower the default risk of the creditor
C. The lower the concentration ratio, the lower the diversification, and the higher the
default risk of the creditor
D. The higher the value of the concentration ratio, the higher the diversification, and the
higher the default risk of the creditor
Q.1558 Suppose that MLA Commercial Bank has lent Rs.10,000 to a single company, named X.
Therefore, MLA Commercial Bank’s concentration ratio is 1. In addition, suppose company X has
a default probability P(x) of 10%. The expected loss from company X is Rs.10,000 x 0.1 =
Rs.1,000. Now, if MLA Commercial Bank lent the same amount of Rs.10,000 among three
different companies, assuming a default risk of 10% each, what will be the concentration ratio
for the bank?
A. 0.5
B. 1
C. 0.3
D. 0.333
71
Q.1559 Correlations and correlation risks form an important part of risk management because
different values of correlation result in different amounts of risk for any portfolio. Higher
correlations can lead to unexpected losses if not properly managed. Therefore, correlation
trading means:
A. Traders should trade assets or implement trading strategies based on correlations

between assets
B. Traders should not trade assets or implement trading strategies on the basis of market
and economic conditions and how they related to single assets
C. Traders should trade assets or implement trading strategies on the basis of market
and economic conditions and how they related to single assets
D. Traders should trade assets or implement trading strategies based solely on

uncorrelated assets
Q.1579 The following are limitations of the Pearson correlation approach, EXCEPT:
A. The Pearson correlation approach is typically not invariant to transformations. After

transformation of data, the information value of the Pearson correlation coefficient is
limited.
B. The Pearson correlation approach only measures linear relationships and most
financial relationships are nonlinear
C. A zero correlation derived by the Pearson approach does not necessarily mean
independence. Therefore, the outcome of the Pearson correlation approach can be
misleading.
D. The variances of the sets, say, X and Y, have to be infinite but finite for distributions
with strong kurtosis
72
Q.2634 A portfolio manager is considering adding one of two stocks to his existing portfolio. He
has gathered the following data to make his decision:
Expected Return Annual Standard Deviation Value Correlation with Portfolio

Existing Portfolio 7% 20% $ 500
Stock 1 5% 15% $ 100 0.5
Stock 2 8% 25% $ 100 0.3
The manager will only add a stock to the portfolio if the VAR of the resultant portfolio does not
exceed a daily VAR limit of $15 at a 99% confidence level. Given the information above, what
should the manager do?
A. Add Stock 1
B. Add Stock 2
C. Add either, if only VAR limit is the consideration, as the VAR of the resultant portfolio
will be the same in both cases
D. Add neither, as the VAR exceeds the VAR limit of $15 in both cases
Q.2639 For a portfolio having long positions in two assets, which value of correlation between
the assets will yield the highest value for VaR?
A. 1
B. 0.5
C. -0.5
D. 0
Q.2646 The VaR of a portfolio is said to be undiversified when the assets in the portfolio are:
A. Positively correlated
B. Perfectly correlated
C. Negatively correlated
D. Not correlated
73
Q.2648 A portfolio consists of two assets X and Y. If $10 million is invested in the two assets in
the ratio 6:4 and the volatility of the two assets is 5% and 10% respectively, what will be the
value of the portfolio VaR at a 99% confidence level if the assets are (i) perfectly correlated and
(ii) uncorrelated?
A. Perfectly correlated: 1.16 million; Uncorrelated: 1.63 million
B. Perfectly correlated: 1.63 million; Uncorrelated: 1.16 million
C. Perfectly correlated: 1.35 million; Uncorrelated: 1.16 million
D. Perfectly correlated: 1.63 million; Uncorrelated: 1.35 million
Q.2649 A portfolio is composed of two assets – A and B. An analyst has gathered the following
information about the portfolio:
Asset Value Return Standard Deviation

A 3 million 5% 3%
B 7 million 7% 5%
What will be the 1-day VaR for this portfolio at a 99% confidence level if the correlation
coefficient between asset A and asset B is 0.4?
A. 0.92 million
B. 0.85 million
C. 1.02 million
D. 0.36 million
74
Q.2650 Calculate the payoff for the buyer of a correlation swap with three assets, a fixed rate of
30%, the notional amount of $2 million, and maturity of 1 year. The pairwise correlations of the
log-returns of the three assets are given in the table below:
Sj =1 Sj =2 Sj =3
Si =1 1 0.9 0.3
Si =2 0.9 1 0
Si =3 0.3 0 1
A. $300,000
B. -$200,000
C. $200,000
D. -$300,000
Q.2651 A bank has issued loans to two companies– A and B. The probabilities of default of A and
B are 5% and 10%, respectively.What is the joint probability of default for the two companies if
their default correlation is 0.6?
A. 3.92%
B. 5.78%
C. 4.42%
D. 7.04%
Q.2652 A bank has given companies A and B loans of $2 million each. Company A has a
probability of default of 5% while that of B is 15%. Calculate the expected loss of the bank under
a worst-case scenario if the default correlation is 0.5 and loss given default is 90%.
A. $167,040
B. $209,576
C. $172,312
D. $307,153
75
Q.2653 What will be the most likely effect of a decreasing concentration ratio on the joint
probability of default?
A. It will increase
B. It is not possible to determine
C. It will decrease
D. The concentration ratio does not affect the joint probability of default
Q.2834 Calculate the payoff of a correlation swap if the number of assets is 3 and the realized
pairwise correlations of the log returns at maturity level are given as 0.24, 0.26, 0.36. You are
also given that the notional amount is $12 million at a 18% fixed rate with 1 year to maturity.
A. $0.29 million
B. $1.28 million
C. $0.24 million
D. $5.04 million
76
Reading 68: Empirical Properties of Correlation: How Do Correlations
Behave in the Real World?
Q.1560 Which of the following statements is/are INCORRECT about equity correlation?
I. Equity correlations fluctuate during expansionary and recessionary periods but in normal
economic periods, equity correlations do not fluctuate.
II. Economic stages only consider equity correlation volatility, not equity correlation levels.
III. Traders don’t need to consider higher equity correlation levels and higher equity correlation
volatility when making decisions.
A. I and II
B. I and III
C. II and III
D. I, II and III
Q.1561 The equity correlation data of a particular country during different economic stages
showed that, in an expansionary economic stage, the correlation volatility was 74.54%. In normal
economic periods, the correlation volatility was 87.66%. In a recessionary economic stage, the
correlation volatility was 89.12%. Based on this information, we can conclude that:
A. Correlation volatility is lower in recessions and normal economic periods but higher in
expansionary periods
B. Correlation volatility is higher in recessionary and normal economic periods but lower
in expansionary periods
C. Correlation volatility is higher in a recession but lower in normal and expansionary

periods
D. Correlation volatility is lower in a recession but higher in normal and expansionary

periods
77
Q.1562 An investor is willing to make an investment of $100 in a fixed-coupon bond. At maturity,
this bond will revert to exactly the par value of $100. This type of bond gives an example of:
A. Autocorrelation
B. Mean reversion
C. Correlation volatility
D. Correlation levels
Q.1563 An investor is concerned about the figures of the mean reversion and autocorrelation of a
particular set of data. After analyzing the data, it is found that the mean reversion is 72.96%.
Which of the following is closest to the autocorrelation for the data?
A. 0.8171
B. 0.8935
C. 0.8296
D. 0.2704
Q.1564 Which of the following statements is/are NOT true about the properties of Bonds
Correlation:
I. Bonds correlation properties are similar to equity correlation properties but, in a recessionary
economic stage, the correlation levels and correlation volatility of bonds are generally lower.
II. Bonds correlation properties are similar to equity correlation properties, but mean reversion
is not present in bonds correlation.
A. I only
B. II only
C. All of the above
78
Q.1565 The economy of a country is experiencing a positive growth rate but, in the past, the
economy of the country faced recessionary stages several times. An investor is willing to make
an investment but he is not sure that the economy will remain in the expansionary stage in the
near future. How can future recessions be predicted in the country?
A. By using equity correlation, mean reversion and autocorrelation
B. By using future inflation rates
C. By the occurrence of a downturn in equity correlation volatility
D. By analyzing growth rates
Q.1566 Bonds and their default probabilities also have correlation distributions just like equity.
Which of the following best describes the default probability correlation distribution and
correlation distribution for bonds?
A. Both the default probability correlation distribution and the correlation distribution
can be best modeled using the Johnson SB distribution.
B. The default probability correlation distribution shows a normal shape and can be best
modeled using the generalized extreme value distribution, whereas the correlation
distribution can be best modeled using the Johnson SB distribution.
C. The default probability correlation distribution can be best modeled using the Johnson
SB distribution, whereas the correlation distribution can be best modeled using the
generalized extreme value distribution.
D. Both the default probability correlation distribution and the correlation distribution
can be best modeled using the generalized extreme value distribution.
79
Q.1567 According to the correlation volatility study of a particular country, it was found that the
correlation volatility for bonds was 68.38% and the correlation level was 44.12%. For default
probabilities correlation, volatility was 85.22% and the correlation level was 30.34%. If the
equity correlation volatility was 74.31%, then which of the following statements is correct about
correlation volatility?
A. Correlation volatility for bonds is higher and slightly lower for default probabilities as
compared to equity correlation volatility
B. Bonds, equity and default probabilities have the same correlation volatility
C. Correlation volatility for bonds is lower and slightly higher for default probabilities as
compared to equity correlation volatility
D. Both bonds and default probabilities have lower correlation volatility as compared to
equity correlation volatility
Q.2654 Given the following data about a variable S:
St-1 = 40
St = 60
Mean reversion rate = 0.5
Calculate the long-run mean value for the variable.
A. 80
B. 60
C. 100
D. 75
Q.2655 Which of these distributions best fits an equity correlation distribution?
A. Chi squared
B. Generalized extreme value
C. Pareto
D. Johnson SB
80
Q.2835 A correlation data has a long term mean of 52.6%. The averaged correlation was again
observed as 31.26% in April 2011 for the 30 x 30 Dow correlation matrices. Given that the
average mean reversion was 82.1% from the regression function for 40 years, what is the
expected correlation one month later?
A. 23.56%
B. 32.21%
C. 48.78%
D. 38.23%
Q.2836 Using the Vasicek 1977 process, quantify the degree of mean reversion assuming that the
price of a stock at a previous point in time is $12 and the long-term mean is $16 with a mean
reversion rate of $3 given that the change in time Δt is 2.
A. $24
B. $36
C. $27
D. $26.56
Q.2837 The Dow correlation matrices for a given data set today have an average correlation of
0.1645 with a long-term mean of 0.1972. Compute the expected correlation for exactly one year
from today if the average mean reversion is 0.7512.
A. 20.00%
B. 52.12%
C. 51.22%
D. 18.91%
81
Q.2838 Which of the following is the most appropriate definition of autocorrelation?
A. The tendency of a variable to be pulled back to its original mean
B. The degree to which a variable is correlated to its past values
C. The apparent relationship between the variables
D. The relationship between two variables keeping all other variables constant
82
Reading 69: Financial Correlation Modeling—Bottom-Up Approaches
Q.1588 Copula functions, when described clearly, split down into multiple univariate
distributions. For instance:
C[G1(U1), ……. , Gn(Un)] = Fn[F1-1(G1(U1)), …., Fn-1(Gn(Un)); PF
In this illustration, Fi-1 describes:
A. the correlation structure of Fn
B. the inverse of Fi
C. the joint cumulative distribution function
D. the marginal distribution.
Q.1589 Because of appropriate and well-suited properties of the Gaussian copula, it is among the
most widely used copulas in finance.
When applying the n-variate case, which of the following statements is correct if Gx(Ux) is
uniform?
A. The N-1 (Gx(Ux)) are univariate normal, and Mn is standard multivariate normal
B. The N-1 (Gx(Ux)) are multivariate normal, and Mn is univariate normal
C. The N-1 (Gx(Ux)) are standard normal, and Mn is standard multivariate normal
D. The N-1 (Gx(Ux)) are standard normal and Mn is standard normal
83
Q.1590 The following equation gives the Gaussian default time copula:
CGD[Qi (t), ... , Qn(t)] = Mn[N-1(Q1(t)), ... , N-1(Qn(t)); pm]
It reveals that the term N-1 maps the cumulative default probabilities Q of asset i for time t, Qi (t)
to the univariate standard normal distribution, percentile to percentile. Keeping this in mind,
which of the following statements is correct?
A. The 5th percentile of Qi (t) is plotted to the 5th percentile of the standard normal
distribution
B. The 4th percentile of Qi (t) is plotted to the 5th percentile of the standard normal
distribution
C. The 5th percentile of Qi (t) is plotted to the 3rd percentile of the standard normal
distribution
D. The 5th percentile of Qi (t) is plotted to the 10th percentile of the standard normal
distribution
Q.1591 Let’s assume we have only two assets - A and B. Suppose we feed our data to the
Gaussian default time copula function. How many correlation coefficients would we find?
A. One correlation coefficient
B. One correlation matrix Pm
C. Multivariate correlation coefficients
D. Two correlation matrices
84
Q.1592 Suppose we wish to analyze two companies, A and B, using the Gaussian default time
copula. After plotting the cumulative probabilities percentile to percentile to a standard normal
distribution, which of the equations below would we end up with?
A. Mi[N-1 (QA)(t), N-1(Qi(t)); ρ]
B. M2[N-1 (QA)(t), N-1(QB(t)); ρ]
C. M5[N-1 (Q1)(t), N-1(QB(t)); ρ]
D. M2[N-1 (Q1)(t), N-1(Qi(t)); ρ]
Q.1593 To find the default time of an asset which is correlated to the default times of other
assets using the Gaussian default time copula, we would first need to:
A. Derive the sample of normal standard distributions
B. Derive the sample of the correlation matrix
C. Derive the sample of Mn(.) from the multivariate copula
D. Derive any of the components listed above
Q.1594 When deriving the default time copula of an asset which is correlated to the default times
of other assets using the Gaussian default time copula, what is taken as the input from the n-
variate standard normal distribution Mn?
A. The N-variate matrix
B. The average matrix
C. The default time of assets
D. The correlation matrix
85
Q.1595 When flexible copula functions were introduced in the field of finance, they became very
popular immediately. But after some time they drastically lost their importance due to which of
the following unfavorable events/causes?
A. They found out not be helpful in solving complex problems
B. They are tough to apply to all statistical problems
C. They fell into disgrace when the global financial crisis hit in 2007
D. They found out not be helpful in the banking sector
Q.1596 Copula functions are introduced to simplify statistical problems. They enable the joining
of multiple univariate distributions to a single univariate distribution. Which statement truly
supports the above expression of facts?
A. They transform an n-dimensional function into a unit-dimensional function
B. They transform a one-dimensional function into an n-dimensional function
C. They transform a one-dimensional function into a matrix
D. They transform a matrix into an n-dimensional function
Q.1597 To derive the default time of a large number of assets during a simulation, the correlated
default time of multiple assets, the sample of Mn(.), is found through which of the following?
A. The copula decomposition
B. The normal decomposition
C. The cumulative decomposition
D. The Cholesky decomposition
86
Q.2656 A Gaussian copula maps the marginal distribution of each variable to which of the
following distributions?
A. Lognormal distribution
B. Poisson distribution
C. Standard normal distribution
D. Binomial distribution
87
Reading 70: Empirical Approaches to Risk Metrics and Hedging
Q.1598 In any financial investment, you will find embedded financial risks. There are different
methods to minimize such risks which are possible if you are able to locate and assess them.
Some of them include the use of hedging and risk metrics. Which of the following statements
stands TRUE regarding the aforementioned methods?
I. Risk metrics and hedging are mechanisms to provide a quantitative measure of the hidden
financial risks associated with a financial investment.
II. Risk metrics and hedging are mechanisms to provide a quantitative measure of only the
idiosyncratic financial risks associated with a financial investment.
III. Hedging and risk metrics reflect the interdependency of the rates and terms associated with
a financial investment.
A. Both I and II
B. Both II and III
C. Both I and III
Q.1599 Inflation has an impact on the rate of returns associated with different financial
instruments provided and traded in the market. Which of the following statements is FALSE
regarding TIPS (Treasury Inflation Protected Securities)?
I. TIPS provide a relatively low rate of return to investors.

II. TIPS compensates for inflation by providing an inflation risk premium.
III. TIPS are traded at relatively high yields or low prices because their cash-flows aren’t
inflation-protected.
A. Both I and II
B. Both II and III
C. Both I and III
88
Q.1600 The nominal rate, a significant term in Finance, is often seen as the stated/advertised
interest rate on a loan, excluding charges, fees and/or interest compounding. What is the
CORRECT definition of the nominal rate?
A. The nominal rate is the real rate plus the inflation rate
B. The nominal rate is the real rate minus the inflation rate
C. The nominal rate is the real rate plus the interest rate
D. The nominal rate is the real rate minus the interest rate
Q.1601 A 20-year semiannual coupon bond has a DV01 of 0.18125. An investor wishes to hedge
his position in this bond with another 10-year semiannual coupon bond whose DV01 is equal to
0.11369. Calculate the hedge ratio:
A. 1.85
B. 1.59
C. 1.2
D. 1.5
89
Q.1602 Which of the following statements stands TRUE about the following equation of the
Least-Squares Regression Analysis?
ΔtN = α + β ΔytR + εt
I. Changes in the real-bond-yield are represented by ΔtN and changes in the nominal-yield are
represented by ΔytR.
II. Changes in the nominal-yield are the independent variable creating changes in the real-bond-
yield, which is the dependent variable.
III. The slope and intercept for the formula are to be assumed as the investor’s best guess.
IV. The error term shows the real-bond-yield’s change from the model’s predicted change on any
specified day.
A. Both I and II
B. Both II and III
C. All of the above
90
Q.1603 The following table represents the regression analysis of changes in the yield of the
Treasury Bond on changes in the yield of the TIPS (Treasury Inflation-Protected Securities) by
means of the following equation:
ΔtN = α + β ΔytR + εt
No. of Observations 229
R-Squared 56.3%
Standard Error 3.82
Regression Coefficients Value Std. Error
Constant 0.0503 0.2529
Change in Real Yield 1.0189 0.0595
Which of the following statement gives an INCORRECT interpretation of the table above?
A. The change in real yield of 1.0189 means that if the real yield increases by 1.0189
basis points, the nominal yield decreases by 1.0189 bps over the sample period
B. The regression constant term is more or less equal to zero, meaning that the yield
doesn’t trend upwards or downwards when the comparable yield isn’t changing
C. α and β as are normally distributed under the assumption of least squares and
sufficiency of data
D. The table shows R-squared (56.3%) representing the variance of nominal yield’s
changes that can be studied
Q.1604 Hedging is an investment strategy used to minimize the risk of adverse asset price
movements. The hedge is normally carried out by taking an offsetting position in a related
financial instrument. When hedging two securities, one with the real rate of return and the other
with the nominal rate of return, it should be understood that:
A. The risk of the two securities can be measured accurately by DV01 alone
B. The risk of the two securities cannot be measured accurately by DV01 alone
C. The risk of the two securities can be measured accurately by PV01 alone
91
Q.1605 A regression framework is a statistical mechanism in the scope of finance, used widely to
determine the strengths/weaknesses of a relationship between two variables (one dependent and
the other independent). When used for hedging purposes, it provides many advantages.
However, the downside is that:
A. It is able to give an estimation of the hedged portfolio’s volatility
B. A comparison can be made by the trader of the volatility with expected gain for his
verdict on the attractiveness of the risk-return structure
C. The average change in the nominal yield for a given change in the real yield can be
estimated by the trader and he can then make adjustments to the DV01 hedge
accordingly
D. No complete control can be made on the dispersion of the change in the nominal yield
in relation to the change in the real yield
Q.1606 The hedge coefficient makes regression-based hedging difficult because, with the
passage of time, the regression coefficient estimated at one point in time tends to change. It can
be handled by:
I. Estimating the coefficient over different time spans

II. Using available recent data since the more up-to-date the data is, the better will be the result.
III. Assuming the coefficient is always equal to 1.
A. Both I and II
B. Both I and III
C. All of the above
92
Q.1607 Eric Rich, a trader, is making a relative value trade by selling a U.S. Treasury bond and
correspondingly purchasing U.S. Treasury TIPS. Guided by the current spread between the two
securities, Eric decides to short $100 million of the nominal bond and simultaneously purchases
76.2 million of TIPS. Soon afterward, Eric's position is disrupted by a change in the yield on TIPS
in relation to nominal bonds. After running a regression, he determines that the nominal yield
has changed by 1.03540 basis points per basis point in the real yield. By how much should Eric
adjust the hedge?
A. $2 million
B. $2.7 million
C. $79 million
D. $1.0354 million
Q.1608 The Principal Component Analysis is a practical framework utilized in the scope of Risk
Analysis and Management in Finance, enabling traders to better estimate risk and return on
their securities. It’s particularly useful because:
A. The sum of the variances of the first two PCs is usually quite close to the sum of
variances of all the rates
B. The sum of the variances of the first three PCs is usually quite close to the sum of
C. The sum of the variances of the last three PCs is usually quite close to the sum of
93
Q.1609 Which of the following statements is FALSE regarding the Principal Component (PC)
Analysis:
I. The PC Analysis provides a mechanism of empirical regularity for regression analysis.

II. The sum of the PCs’ variances equals the sum of the individual rates’ variances capturing the
volatility of the set’s interest rates.
III. The sum of the variances of the first two PCs is usually quite close to the sum of variances of
all the rates.
A. I only
B. I and II
C. III only
Q.1610 Principal Component (PC) Analysis is unique in scope and helps investors to achieve
maximum gain from trading of securities. Which of the following is correct with regard to PCs?
A. The PCs are uncorrelated with each other while individual interest rates are highly
correlated
B. The PCs are correlated with each other while individual interest rates are highly
uncorrelated
C. The PCs are poorly correlated with each other while individual interest rates are
highly correlated
D. The PCs are poorly uncorrelated with each other while individual interest rates are
highly uncorrelated
Q.1611 Which of the following statements is true regarding principal components (PCs)?
A. Each PC is chosen to have the maximum possible variance given all earlier PCs
B. Each PC is chosen to have the maximum possible variance given all later PCs
C. Each PC is chosen to have the minimum possible variance given all earlier PCs
D. Each PC is chosen to have the minimum possible variance given all later PCs
94
Q.1612 The financial markets comprise of different financial rates and the common classification
is in terms of time-frame, namely short-term and long-term financial rates. Which of the
following statements is TRUE regarding short-term and long-term rates associated with the
financial markets?
A. Long-term rates are more volatile than short-term rates
B. Short-term rates are more volatile than long-term rates
C. Both long-term and short-term rates are equally volatile
Q.1614 What makes the Principal Component Analysis (PCA) highly practical and doable in the
scope of hedging and risk metrics?
A. The PCA is very useful in the construction of empirically-based hedges for large
portfolios
B. The PCA is very useful in the construction of empirically-based hedges for small
portfolios
C. The PCA is very useful in the construction of theoretically-based hedges for large
portfolios
D. The PCA is very useful in the construction of theoretically based-hedges for small
portfolios
Q.1615 The butterfly trade is defined as a neutral strategy as it is a limited risk and limited profit
option. To hedge against market risks, butterfly traders can:
A. Short the wings and buy the security of intermediate maturity
B. Buy the wings and short the security of intermediate maturity
C. Implement either A or B as outlined above
D. None of the given practices can be implemented
95
Q.2846 Alvin Johnson is a trader and plans to short $230 million of the (nominal) 46⁄7s of 17th
February 2020 and purchase some amount of the TIPS 25⁄7 s of 17th January 2020 against that.
The yields and DVO1s of a TIPS and a nominal US Treasury as of 30th April 2015 are provided as
follows:
Bond Yield% DVO1
Tips 25⁄7 s of 17th January 2020 1.096 0.092
46⁄7 s of 17th February 2020 3.461 0.056
Compute the TIPS face amount that should be purchased for the trade to be hedged against the
interest rate levels.
A. $200 million
B. $275 million
C. $160 million
D. $140 million
96
Q.2847 A trader believes that the 5-year swap rate is far too high relative to the 2- and the 10-
year swap rates. She decides to receive in the 5-year and pay in the 10-year. The tables below
give the par swap rates and the DVO1s of the swaps of the relevant terms. Compute the 5-year
hedging ratio of the DVO1, by the 2- and the 10-year swap.
Par swap rates and DVO1s:

Term Rate% DVO1
2 1.064 0.0286
5 2.535 0.0547
10 3.187 0.0931
Principal components of the USD swap curve:

Term Level Slope Short Rate PC Vol
2 5.27 -3.18 0.68 6.48
5 6.76 -1.64 -0.48 7.13
10 6.46 0.17 -0.45 6.27
Compute the 5-year hedging ratio of the DVO1, by the 2- and the 10-year swap.
A. 55.3% and 66.5%
B. 54.3% and 65.7%
C. 54.8% and 60.0%
D. 52.8% and 66.5%
97
Q.2848 A trader plans to short $175 million of the 32⁄7s of 20th February 2019 and purchase
some amount of the TIPS 23⁄7 s of 20th January 2019 against that. Assume that the nominal yield
in the data changes by 1.036 basis points per basis-point change in the real yield. The yields and
DVO1s of a TIPS and a nominal US Treasury as of 30th April 2015 are provided as follows:
Bond DVO1
23⁄7 s of 20th January 2019 0.087
32⁄7s of 20th February 2019 0.066
Compute the TIPS face amount that should be purchased for the trade to be hedged against the
interest rate levels.
A. $137.5 million
B. $126.2 million
C. $160.4 million
D. $140.0 million
Q.2849 What is the role of regression analysis in bonds?
A. It is used to explain the value at risk of amounts invested in bonds
B. It explains the changes in the yield of one bond relative to the changes in yields of a
small number of other bonds
C. It is used for empirical description of the term structure of bonds
D. All the above
98
Reading 71: The Science of Term Structure Models
Q.1616 The market rate of a bond is considered to be equivalent to the price of that bond having
the same maturity. Securities with assumed prices are called underlying securities to distinguish
them from the:
A. Proprietarily rights priced by arbitrage arguments
B. Contingent claims priced by arbitrage arguments
C. Contingent rights priced by arbitrage arguments
D. Proprietarily claims priced by arbitrage arguments
Q.1617 Refer to the following binomial tree:
p = 12 ; 5.50%
5%
↗
↘
p = 12 ; 4.50%
The six-month rate is 5% today, which will be called date 0. On the next date six months from
now, which will be called date 1, there are two possible outcomes.
The 5.50% state is called the:
A. Higher state
B. Upper extreme state
C. Up-state
D. Maximum state
99
p = 12 ; 5.50%
5%
↗
↘
p = 12 ; 4.50%
now, which will be called date 1, there are two possible outcomes.
Given the current term structure of spot rates, trees for the prices of six-month and one-year
zero-coupon bonds can be computed. The price tree for $666 face value of the six-month zero
will approximately be:
A. 635
B. 650
C. 675
D. 680
100
p = 12 ; 5.50%
5%
↗
↘
p = 12 ; 4.50%
now, which will be called date 1, there are two possible outcomes, where the risk-neutral
probability of an increase or decrease in the 6-month spot rate is 10%.
Considering the above data, suppose you wanted to find the price of a call option, maturing in 6
months, of a $1,000 face value of a then six-month zero at $972. The right to buy the zero at
$972 would be worth:
A. $6
B. $976
C. $3.53
D. $978
Q.1620 We can price a security by means of arbitrage pricing and this is done by first searching
and valuing a portfolio which is a replica of the original one. In comparison, the derivative
context is complicated as its cash flows are dependent on the rates, and the portfolio replica is
required to duplicate the derivative security for any possible:
A. Inflation rate scenario
B. Call option scenario
C. Interest rate scenario
D. Sell option scenario
101
Q.1621 An analyst wants to determine the value of a call option, maturing in six months, to
purchase $1,000 face value of a then six-month zero at $975. To do so, he constructs a
replicating portfolio of six-month and one-ear zeros. The following spot rates apply:
Six-month spot rate = 5.0%

One-year spot rate = 5.30%
Six months from now (date 1), the six-month rate will be either 6.0% (the up state) or 4.0% (the
down state). Both outcomes are equally likely to occur. Determine the value of the call option.
A. $2
B. $5
C. $0.5
D. $1.02
Q.1622 You have been provided an interest rate tree to price the value of a one-year zero-coupon
bond and a call option on this bond. If the probability of an up-move increases suddenly, the
current value of a one-year zero should:
A. Decline and the value of the call option should decline as well.
B. Increase and the value of the call option should increase as well.
C. Increase and the value of the call option should decrease.
D. Decrease and the value of the call option should remain unchanged.
Q.1624 The risk penalty implicit in the call option price is inherited from the risk penalty of the
one-year zero, that is, from the premise that the price of the one-year zero is:
A. Greater than its expected discounted value
B. Less than its expected discounted value
C. Equal to its expected discounted value
D. Not related to its expected discounted value
102
Q.1625 It is a requirement of arbitrage pricing that the replica portfolio’s value must match the
option value in both ups and downs. One of the extraordinary aspects of this is that the
probabilities of moving down and up are:
A. Never encountered while calculating the arbitrage price
B. Always encountered while calculating the arbitrage price
C. Sometime encountered while calculating the arbitrage price
D. Partially encountered while calculating the arbitrage price
Q.1626 The Black-Scholes-Merton model is not appropriate to value derivatives on fixed-income

securities because:
A. It assumes there is no upper limit to the price of the underlying asset
B. It assumes bond price volatility is constant
C. It assumes the risk-free rate is constant
D. All of the above
Q.1627 An option, like a derivative, depends on the probabilities only through current bond
prices. If the probability of an up move suddenly increases, the current value of a one-year zero
would decline. If the replicating portfolio comprises of long one-year zeros, the value of the
option would:
A. Increase
B. Decline
C. Remain unchanged
D. Cannot say due to insufficient information
103
Q.1628 Risk-neutral pricing is a technique that modifies an assumed interest rate process so that
any contingent claim can be priced without having to construct and price its replicating portfolio.
It is an extremely efficient way to price many contingent claims under the same assumed rate
process because:
A. The original interest rate process has to be modified once or more than once, and this
modification only requires pricing the contingent claim(s) by arbitrage
B. The original interest rate process has to be modified only once, and this modification
only requires pricing the contingent claim(s) by arbitrage
C. The original interest rate process does not need to be modified, and there is no need to
price the contingent claim(s) by arbitrage
Q.1629 The price of a derivative in the real economy may be computed as the discounted value
under the risk-neutral probabilities. Which of the following statement about the price of an
option is correct?
A. The arbitrage price of the option equals its expected discounted value under the risk-
neutral probabilities
B. The price of a security that is priced by arbitrage depends on investors' risk

preferences
C. Investors in the imaginary economy penalize securities for risk and do not price
securities by expected discounted value
D. The price of an option does not necessarily need to be the same in the real and
imaginary economies
104
Q.1630 While performing arbitrage pricing in a multi-period setting, recombining trees are
considered to be economically reasonable. Consider the following tree diagrams and choose the
correct option:
I.
6.00%
5.50%
↗
↘
5.00%
↗ 5.00%
↘
4.50%
↗
↘
4.00%
II.
6.00%
5.50%
↗
↘
5.00%
↗ 4.95%
↘
4.50%
↗
↘
4.05%
A. (I) is a recombining tree while (II) is a no recombining tree
B. (I) is a non-recombining tree while (II) is a recombining tree
C. Both (I) and (II) are recombining trees
D. Both (I) and (II) are non-recombining trees
105
Q.1631 You are asked to price a particular derivative security having a $200 million face value of
a stylized constant-maturity treasury swap struck at 5%. It is a one-year CMT swap on the six-
month yield. 50 bps increments/decrements are anticipated. On date 2, the state 2, 1, and 0
payoffs will be:
A. $1 million, -$1 million and $0 respectively
B. -$1 million, $0 and $1 million respectively
C. -$1 million, $1 million and $0 respectively
D. $1 million, $0 and -$1 million respectively
Q.1632 An option-adjusted spread is a widely-used measure of the relative value of a security,

that is, of its market price relative to its model value. In addition, an option-adjusted spread can
be elaborated as spread which makes a security’s market price ______ the price of its
corresponding model when discounted values are computed at risk-neutral rates plus that
spread.
A. equal to
B. greater than
C. lesser than
Q.1633 The return of a security or its profit and loss (P&L) may be divided into a component due
to the passage of time, a component due to changes in the factor, and a component due to the
change in the option-adjusted spread (OAS). On the other hand, if securities are non-priced in
accordance with the model (securities have an OAS greater/lesser than zero), their relevant cash
flows are discounted at:
A. The short-term rate
B. The long-term rate
C. The short-term rate plus the OAS
D. The short-term rate minus the OAS
106
Q.1634 Usually, the time that elapses between dates of the tree is six months. However, we might
choose time steps smaller than six months because:
I. Decreasing the time step to a day, week, month or quarter assures that cash flows are
adequately close to pertinent data
II. Smaller steps result in a more realistic distribution of interest rates
A. I only
B. II only
C. All of the above
107
Q.2660 A constant maturity treasury (CMT) swap of face value $1 million is struck at 6%. The
swap pays 1,000,000 ((yCMT − 6%)/2) where yCMT is a semiannually compounded yield, of a
predetermined maturity, on the payment date. Given the following binomial tree, calculate the
value of the swap.
A. $678.22
B. $458.74
C. $798.12
D. $689.89
108
Q.2662 Which of the following is the term used to describe the process of valuing a bond using a
binomial interest rate tree?
A. Bootstrapping
B. Backward induction
C. Backtesting
D. Bootstrap historical simulation
Q.2850 All of the following statements are true about callable bonds as screened against
noncallable bonds, EXCEPT:
A. At low yields, reinvestment risk falls
B. Capital gains are capped as the yield falls
C. They have less price volatility
D. They have negative convexity
Q.2851 A $7 million face value of a stylized constant-maturity treasury (CMT) swap is struck at
7%. It is a one-year CMT swap on the six-month yield in 0.5% increments. Calculate the possible
payoffs of the CMT swap after 6 months and one year.
A. 6 months: $17,500 and -$17,500; One year: $35,000, 0 and -$35,000
B. 6 months: $35,000 and -$35,000; One year: $70,000, 0 and -$70,000
C. 6 months: $8,750 and -$8,750; One year: $17,000, 0 and -$17,000
109
Q.2852 Which of the following statements are correct about the option-adjusted spread and the
Z-spread for option embedded bonds?
I. For a callable bond, the OAS is less than the Z-spread

II. For a putable bond, the OAS is greater than the Z-spread.
A. I only
B. II only
C. Both I and II
110
Reading 72: The Evolution of Short Rates and the Shape of the Term
Structure
Q.1635 We can derive a risk-neutral process on the basis of the assumptions related to interest
rates and a term structure that is based on market price movements. As risk analysts, we can use
it for pricing fixed-income securities with the means of arbitrage. Which of the following
components of a term structure are directly determined by assumptions?
I. The level of the term structure

II. The shape of the term structure
III. The duration of the term structure
A. I and II
B. II and III
C. I and III
D. I, II and III
Q.1636 You are asked to start with assumptions about the interest rate process and about the
risk premium demanded by the market for bearing interest rate risk and then derive the risk-
neutral process. This approach results in:
A. An arbitrage-free model
B. An equilibrium model
C. The matching of the initial term structure
D. The pricing of all fixed-income securities by arbitrage
111
Q.1637 One of the financial engineering models used in market analysis is known as the
arbitrage-free model. This model basically allocates prices to instruments such as derivatives in a
manner that makes it extremely difficult to create arbitrage opportunities. In the case of an
arbitrage-free model, an understanding of the relationships between the model assumptions and
the shape of the term structure is important to:
A. Make reasonable assumptions about the interest rate process and the risk premium
B. Comprehend the assumptions implied by the market through the observed term
structure
C. Calculate the marginal productivity of capital
D. Compare propensity to save and expected inflation
Q.1638 The 2-year spot rate, S2 is 9%, and the 1-year spot rate, S1 is 4%. What is the 1-year
forward rate?
A. 0.05
B. 0.048
C. 0.1024
D. 0.1424
Q.1639 As finance professionals, we know the definition of the term structure of interest rates as
“the relationship among bond yields or interest rates and different maturities or terms.” The
forecasts are useful in describing the shape and level of the term structure over ______ horizons
and the level of rates at ______ horizons. This carries significant implications when selecting term
structure models.
A. medium-term; short-term
B. long-term; short-term
C. long-term; medium-term
D. short-term; long-term
112
Q.1640 Convexity can make duration negative, since there are some securities, like few
mortgage-backed securities, that exhibit negative convexity. Assume that, other factors kept
constant, the value of convexity of the curve increases with maturity of its pricing function. The
securities with greater convexity perform better when:
A. Yields remain constant
B. Yields change a little
C. Yields change a lot
Q.1641 Convexity is the rate at which the duration changes along the price-yield curve. In the
case of no interest rate volatility, the yields are completely determined by forecasts. But when
volatility is taken into account, the yields are affected by the value of convexity. The value of
convexity increases with:
I. Volatility
II. Maturity
III. Yield
A. I only
B. I and II
C. I and III
D. I, II and III
Q.1642 Assume that the maturity of a pricing function affects the convexity of the curve. A bond
with greater convexity is less affected by interest rates than a bond with less convexity. Also,
bonds with greater convexity will have a higher price than bonds with a lower convexity,
regardless of whether interest rates rise or fall. Therefore, which of the following securities
perform worse when yields do not change by much?
A. 1-year T-bill; convexity = 0.0265
B. 5-year T-note; convexity = 0.5863
C. 10-year T-note; convexity = 1.5986
D. 10-year corporate bond; convexity = 1.3256
113
Q.1643 Under the assumption of risk-neutrality, the prices of subsequent-year zeroes may be
calculated using the rate tree shown below (p = 1/2).
0.844595
0.769067
↗
↘
0.751184
↗ 0.905797
↘
0.889587%
↗
↘
0.976563%
The expected return of the three-year zero over the next year is:
A. 0.062
B. 0.104
C. 0.128
D. 0.142
Q.1644 The convexity in a financial model refers to non-linearities. For very short terms and
realistic levels of volatility, the value of convexity is quite small. It has been proved that
convexity:
A. Increases bond yields in theory and in practice
B. Decreases bond yields in theory and in practice
C. Increases bond yields in theory but not in practice
D. Decreases bond yields in theory but not in practice
114
Q.1645 In one year, if the interest rate is 14%, then the price of a one-year zero will be 1/1.14 or
.877193. If the rate is 6%, then the price will be 1/1.06 or 0 .943396. Which of the following is
closest to the expected return of the two-year zero priced at 0.826035?
A. 0.095
B. 0.1
C. 0.102
D. 0.105
Q.1646 The Capital Asset Pricing Model can be considered as the foundation of all financial
domains in this subject area but it also has prime relevance for practical decision-making.
According to the model, assets whose returns are positively correlated with aggregate
consumption or wealth will earn:
A. A return equivalent to the rate of the GDP
B. A risk premium
C. The risk-free rate of return
D. A return equivalent to the rate of inflation
Q.1647 You acquire an asset that is negatively correlated with the economy. When investments
are negatively correlated we can use them in risk management for diversifying, or mitigating, the
risk exposures relevant to the portfolio. The holdings which exist in that asset allow you to
reduce your exposure to the economy. Therefore, that asset is said to have:
A. Zero risk premium
B. Positive risk premium
C. Negative risk premium
115
Q.1648 The bonds with interest rate risk earn a risk premium. The interest rates rise when
inflation and expected inflation rise. It is said that:
A. High inflation is correlated with good economic times
B. Uncertain inflation is correlated with good economic times
C. Measurable inflation is correlated with good economic times
D. Low inflation is correlated with good economic times
Q.1649 While exploring the “relationship among bond yields or interest rates and different
maturities or term,” we can use also the term ‘yield curve’ to denote the term structure of
interest rates. On average, over the past 75 years, the term structure of interest rates has sloped
upward. A term structure that, on average, slopes upward can only be explained by:
A. A positive risk premium
B. Assumptions about convexity
C. Expectations of interest rate
D. A negative risk premium
Q.2853 Investors value the current one-year interest rate at 11.316%. However, they also
forecast that for the following year, the one-year interest rate will be 13.457% and 15.658% for
the year that follows next. Calculate the two- and three-year spot rates, ρ(2) and ρ(3),
respectively.
A. 11.3% and 13.5%
B. 15.3% and 16.1%
C. 12.8% and 13.5%
D. 12.4% and 13.5%
116
Reading 73: The Art of Term Structure Models: Drift
Q.1650 We can determine the Continuously Compounded Interest Rate via the following simple
model when no drifting is considered and rates are normally distributed:
dr = σdw
In this equation, what do dr and dw indicate?
A. dr denotes the change in the time with the small change in interest rate measured
annually; dw indicates a normally distributed random variable
B. dr indicates the change in the rate over a small time interval, dt, measured in years;
dw indicates a normally distributed random variable with a mean of zero
C. dr indicates a normally distributed random variable with a mean of one ; dw denotes

the change in the rate over a small time interval, dt, measured in years
D. dr denotes the change in the time with the small change in interest rate measured
annually; dw indicates a partially normal distributed random variable with a mean of one
Q.1651 Suppose the current short-term interest rate is 7.18%, in a time interval of 3 months per
year (or 3/12 per year), with a volatility of 118 basis points per year. After a period of three
months, the random variable dw has a value of 0.18. What are the change in the short-term
interest rate and the short-term rate after 3 months?
A. 0.2124% is the change in the short-term rate; 7.3924% is the short-term rate after 3
months
B. 7.3924% is the change in the short-term rate; 0.2124% is the short-term rate after 3
months
C. 1.2924 % is the change in the short-term rate; 8.4724% is the short-term rate after 3
months
D. 8.4724% is the change in the short-term rate; 1.2924 % is the short-term rate after 3
months
117
Q.1652 Term structure models in which the terminal distribution of interest rates has a normal
distribution are commonly known as Gaussian or normal models. The limitation of these models
is that the short-term rate can become negative. Which of the following statements is true?
A. Negative short-term interest rate are very attractive for lenders because lenders will
have zero lending risk
B. Individuals will never lend money at negative rates; they would rather hold it and earn
a zero rate
C. Individuals will lend money at negative rates to help the borrowers in tough situations
and boost the economy
D. Negative short-term rates can neither affect borrowers nor lenders because, in the
long-term, the rates become positive
Q.1653 A popular method of overcoming the problem of negative interest rates is to construct
interest rate trees with the desired distribution and fix all negative rates to zero. When using this
method, rates in the original tree are considered as:
A. Volatile market rates while the adjusted interest rates in the tree are called the
interest expected rates of interest
B. Volatile market rates of interest while the adjusted interest rates in the tree are called
the shadow rates of interest
C. Short-term rate of interest while adjusted interest rates in the tree are called the
shadow rates of interest
D. Shadow rates of interest while the adjusted interest rates in the tree are called the
observed rates of interest
118
Q.1654 The simplest model of term structuring is Model 1. This model’s term structure is
downward sloping, because it has no drifts and the rates decline uniquely with term. The major
aspect of this model is the factor structure and the only factor of this model is the short-term
rate. Now, suppose this short-term rate increases by 20 basis points compounded semi-annually.
What will be the impact on the term structure?
A. Volatility will increase by 20 basis points because of an increase in the short-term rate
B. Convexity will increase by 20 basis points because of an increase in the short-term

rate
C. Rates will increase by 20 basis points because of an increase in the short-term rate
D. Maturity will increase by 20 basis points because of an increase in the short-term rate
Q.1655 Because of some limitations of Model 1(dr = σdw), another term structure model was
introduced and named as Model 2. The new model is written as:
dr = λ dt + s dw
Suppose r0 = 6.138%, λ = 0.239%, σ =1.20% and the realization of the random variable happens
to be 0.15 over a month. Given these values, find the drift of the rate and standard deviation per
month, respectively.
A. The drift of the rate is 0.239%, and the standard deviation is 0.18% per month
B. The drift of the rate is 0.239%; and standard deviation is 0.01992% per month
C. The drift of the rate is 0.01992%, and the standard deviation is 0.18% per month
D. The drift of the rate is 0.1992%, and the standard deviation is 0.18%% per month
119
Q.1656 Model 1 and model 2 are usually known as equilibrium term structure models because of
the zero or constant drifts respectively. On the other hand, the model which varies with time is
known as the time-dependent drift. In this model, the drift depends on time and may vary from
date to date. From your understanding, what does the time-dependent drift represent over a
period of time?
A. It represents some combination of the risk premium and some expected changes in the
short-term rate
B. It represents some changes in the market short-term rates over time
C. It represents expected changes in the volatility of short-term rates and market returns
over time
D. It only represents changes in the risk premium occurring over a period of time
Q.1657 Whenever any investor is buying or selling any financial instrument, it is of great
importance to match its price with changes in market prices. The same case applies to the choice
of the models for term structure - whether to use arbitrage-free or equilibrium models. What is
the most important use of arbitrage-free models?
A. Quoting the prices of securities that are not actively traded based on the prices of
more liquid securities
B. Quoting the prices of securities that are not actively traded based on time to maturity
C. Quoting the prices of securities that are not actively traded on the basis of the
economic and financial stability of the lending institute
D. Quoting the prices of securities that are not actively traded on the basis of prevailing
interest rate and swap rates
120
Q.1658 Arbitrage-free models are used by practitioners for many purposes which include:
valuing and hedging many derivative securities, using real based assumptions to value the
securities, etc. Why are arbitrage-free models considered potentially superior to other security
models?
A. These models are valuing the securities mainly based on time-dependent variables
B. These models are valuing the securities mainly based on economic and financial
reasoning
C. These models are valuing the securities mainly based on the volatility assumptions and
sophisticated techniques
D. These models are valuing the securities mainly based on parallel shift assumptions
Q.1659 A model matching market prices does not necessarily provide true values of the
securities and hedges for derivative securities. The practice of fitting models to market prices is
a good way to incorporate the interest rate behaviors into the model but such a model may have
some limitations and warnings too. What are the main limitations of these types of models?
I. In some cases, adding a time-dependent drift to a parallel shift model to match a set of market
prices will make the model unsuitable for the intended application.
II. Expectation and risk premium built into the volatile assumptions of the model are not true
indicators of the security.
III. In many cases, market prices of the security or instrument are not fair in the context of that
model.
IV. There are no limitations for these models because they incorporate market changes and
prices.
A. I and II
B. I and III
C. IV only
D. II and III
121
Q.1660 Mean reversion is the theory in finance which assumes that returns and prices will solely
get back to their mean or average values. This mean (or average value) can be determined based
on the historical average or average returns and prices of that industrial sector. Assuming that
the short-term rate is characterized by mean reversion, what will be the effect on the rate if: (I) it
is below long-term equilibrium; and (II) if it is above long-term equilibrium?
A. (I) The drift is positive, moving the rate up toward the long term value; (II) The drift is
negative, moving the rate down towards the long-term value
B. (I) The drift is negative, moving the rate down towards the long term value; (II) The
drift is positive, moving the rate up toward the long-term value
C. The drift is parallel based on parallel slope assumption and will behave irrespective of
changes in the long-term equilibrium
D. Short term rates will change with the changes in the economic and financial condition
of that industrial sector irrespective of the changes in long-term values
Q.1661 The risk-neutral dynamics of the Vasicek model can be written as:
dr = k(θ − r) dt + σ dw
Here, the constant θ represents the long term value or the central propensity of the short-term
rate in the risk-neutral process, while “k” represents the quickness of mean reversion. What will
happen if the difference between r and θ increases?
A. The greater the difference between r and θ, the greater the value of the short-term
rate
B. The greater the difference between r and θ, the greater the value of k
C. The greater the difference between r and θ, the greater the expected change in the-
short term rate towards θ
D. The greater the difference between r and θ, the greater the expected change in the
short-term rate towards r
122
Q.1662 Taking a numerical example which needs to be solved using the risk-neutral model of
term structuring, let k = 0.020,σ = 125 basis points per year, r∞ = 6.180%, λ = 0.227%, r =
5.212%.
Given these given values, find the expected change in the short-term rate and the standard
deviation over the next month?
A. A 36.084 basis point change in the short-term rate and a standard deviation of 1.70
basis points
B. A 1.70 basis points change in the short-term rate and a standard deviation of 36.08
basis points
C. A 2.053 basis points change in the short-term rate and a standard deviation of 36.08
basis points
D. A 035.04 basis point change in the short-term rate and a standard deviation of 1.54
basis points
Q.1663 Suppose we drew a graph showing the impact of the mean reversion on the terminal.
Risk-neutral distributions at different time horizons for the short-term rate would show the
impact of the mean reversion on the term structures. Which of the following observations would
we most likely make?
A. The mean of the short-term rate, as a function of the time horizon, would remain
constant or relatively constant on the term structure
B. The mean of the short-term rate, as a function of the time horizon, would increase
from the current value to its limiting value of θ
C. The mean of the short-term rate, as a function of the time horizon, will remain
constant from the current value to its limiting value of θ
D. The graph would show an increase in the mean of the short-term rate to match the
market volatility
123
Q.1664 The mean-reverting parameter is not a particularly intuitive way of describing how long
it takes for a factor to return to its long-term goal. A more intuitive way is the half-life.
Suppose the half-life of interest rate is 28.72. What does this indicate?
A. The interest rate factor takes 28.72 years to progress towards half of the distance
between its starting value and its goal
B. The interest rate factor takes half of 28.72 years to progress towards its goal
C. The interest rate factor, on a weighted average, takes 28.72 years to progress towards
its goal
D. The interest rate factor, on a weighted average, takes 57.44 years to progress towards
its goal
Q.1665 Using the Vasicek model, we can determine the standard deviation of the terminal
distribution of the short-term rate after T years.
Consider the following scenario:

A mean-reverting parameter has a value of 0.025 and volatility of 126 basis points. The short rate
in 10 years is normally distributed with an expected value of 7.4812%.
What is the standard deviation of the short rate in 10 years?
A. 343 basis points
B. 253 basis points
C. 243 basis points
D. 353 basis points
124
Q.1666 Financial institutions use mean-reverted as well as non-mean-reverted parameters to
match the par rates of securities with those of the market. Mean-reverted parameters can be
used to fit the model with observed term structures more accurately. After graphing the term
structures of mean-reverted as well as non-mean-reverted models, what would you expect?
A. The model with mean reversion and the one without mean reversion would result in
dramatically different term structures of volatility
B. The model with mean reversion and the one without mean reversion would result in
same term structures of volatility
C. Both models would be much more volatile and their patterns cannot be determined
through a small set of data
D. The model with mean reversion would give more accurate term structures than the
one without mean reversion
Q.1667 An FRM exam candidate draws a graph showing the volatilities of par rates with different
term structures including short-term as well as long-term term structures. Mean reversion and
volatility parameters are graphed against each other. The model generates a term structure of
volatility that is sloping downwards, as mean reversion lowers the volatility of long term par
rates.
From such a graph, we can conclude that:
A. The model matches the market at longer terms but understates the volatility for
shorter terms
B. The model matches the market at shorter terms but overstates the volatility for longer
terms
C. The model matches the market at longer terms but overstates the prices for shorter
terms
D. The model matches the market at longer terms but overstates the volatility for shorter
terms
125
Q.1668 An analyst draws a graph showing the effects of spot rates using the Vasicek model
having a 10-basis-points change in the factor. The graph interprets how the 10 basis point
change in short-term rate affects the spot rate curve. The model is graphed with mean reversion.
What would be the effect on long-term and short-term rates given an increase of 10 basis points
in the interest rate factor?
A. The short-term rates decrease by about 10 basis points but longer-term rates are less
impacted
B. The short-term rates increase by about 10 basis points but longer-term rates are less
impacted
C. The short-term rates increase by about 10 basis points but longer-term rates are
impacted by more than 10 basis points
D. The short-term rates, as well as long-term rates, increase by 10 basis points because
of the increase in volatility
Q.1669 Using whichever model for term structure, short-term rates are impacted by the changes
in economic and financial conditions of the markets. Long term-rates are less likely to be
impacted by shocks in the market but these incidents largely impact short term rates. Regardless
of the changes, the short-term change is assumed to arrive at long-term goals. Which of the
following is correct regarding short-lived and long-lived news?
A. The news is short-lived if it changes the market's view of the economy many years in
the future; it is long-lived if it changes the market's view of the economy in the near
future.
B. News is long-lived if it changes the market's view of the economy many years in the
future; it is short-lived if it changes the market's view of the economy in the near future.
C. Both types of news impact the economy in short term or long term irrespective of the
types of news.
D. Long-lived news impact long-term instruments and projects while short-lived news
only impact short-term instruments and securities.
126
Q.2661 Given the following data:
Current short-term interest rate: 1.5%

Long-run mean reverting level: 4%
Long-run true interest rate: 2%
Interest rate drift: 0.1%
Use the Vasicek model with mean reversion to determine the model’s mean-reverting parameter.
A. 0.040
B. 0.015
C. 0.022
D. 0.050
127
Q.2663 Given the following binomial tree for the six-month spot rate:
Calculate the expected discounted value of a one-year $1000 face value, zero-coupon bond.
A. $927.93
B. $971.82
C. $974.91
D. $951.13
128
Q.4013 Under Model 1 of short-term interest rates, the current value of the short-term rate is
5.26%, that volatility equals 115 basis points per year, and that the time interval under
1
consideration is one month or 12 years. Mathematically, r0 = 5.26%; σ = 1.15%; and dt = 1/12. A
1
month passes and the random variable dw, with its zero mean and its standard deviation of √ 12
or 0.2887, happens to take on a value of 0.25. Determine the short-term rate after one month.
A. 0.035
B. 0.025
C. 0.055
D. 0.002875
Q.4014 Under Model 2 of short-term interest rates, the current value of the short-term rate is
5.26%, that volatility equals 115 basis points per year, drift is 0.25%, and that the time interval
1
under consideration is one month or 12 years. Mathematically, r0 = 5.26%; σ = 1.15%; λ =
1
0.25%; and dt = 12 . A month passes and the random variable dw, with its zero mean and its
1
standard deviation of √ 12 or 0.2887, happens to take on a value of 0.25. Determine the short-
term rate after one month.
A. 5.5%
B. 5.5683%
C. 4.5212%
D. 0.3083%
Q.4015 Consider a Vasicek model with a reversion adjustment parameter of 0.05, annual
standard deviation of 130 basis points, a true long-term interest rate of 5%, a current interest
rate of 6.0%, and annual drift of 0.40%. Determine the forecasted change in the short term rate
for the next one-month period.
A. 0.0292%
B. 6%
C. 13%
D. 0.05%
129
Q.4016 Using Model 1, assume the current short-term interest rate is 3%, annual volatility is
100bps, and dw, a normally distributed random variable with mean 0 and standard deviation √dt,
has an expected value of zero. After one month, the realization of dw is -0.3. What is the change
in the spot rate and the new spot rate?
Change in spot New Spot Rate

I. 0.25% 2.25%
II. −3% 0.0%
III. 0.6% 3.6%
IV. −0.3% 2.7%
A. I
B. II
C. III
D. IV
Q.4017 The U.S. department of Transport has just announced an unexpected technological
breakthrough that will have a major bearing on the development of self-driving autonomous
vehicles. What is the most likely anticipated impact on a mean-reverting model of interest rates?
A. The economic information is long-lived with a low mean-reversion parameter.
B. The economic information is short-lived with a low mean-reversion parameter.
C. The economic information is long-lived with a high mean-reversion parameter.
D. The economic information is short-lived with a high mean-reversion parameter.
rate of 5.0%, and annual drift of 0.35%. Determine the expected rate in the model after 10 years:
A. 4.55%
B. 3.70%
C. 8.28%
D. 11.67%
130
rate of 5.0%, and annual drift of 0.4%. Determine the half-life of the model
A. 5.8
B. 26.0
C. 13.86
D. 14.50
131
Reading 74: The Art of Term Structure Models: Volatility and
Distribution
Q.1670 In the same way that we use a time-dependent drift to match the bond or swap rates, we
can also use time-dependent volatility functions to match option prices. These models focus on
the volatility of interest rates for term structure modeling. A simple time-dependent volatility
function can be written as:
dr = λ (t) dt + σ (t) dw
In this function, on which factor does the volatility of the short-rate depend?
A. The volatility of the short-term rate depends on the interest rate
B. The volatility of the short-term rate depends on the volatility of σ
C. The volatility of the short-term rate depends on time
D. The volatility of the short-term rate depends on changes in the market prices of
securities
Q.1671 Deterministic volatility functions and models are widely used by market makers to exploit
the benefits of interest rate options. Like in trading caplets, the value of caplets depends on the
distribution of short-rates at the time of expiration of these caplets. So, the flexibility of
deterministic functions can be used to match market prices of caplets with distinctive expiration
dates. At expiration, what does a caplet pay?
A. A caplet compensates the difference between the short rate and a strike, if positive
B. A caplet compensates the difference between the short rate and a strike, if negative
C. A caplet compensates the strike price at the time of expiration if the strike price
increases
D. A caplet compensates the short rate only irrespective of the strike price at the time of
expiration
132
Q.1672 Model 3 is similar to the Vasicek Model with mean reversion in many ways. For example,
if the time-dependent drift of model 3 matches the average path of rates of the Vasicek model,
then both modes result in similar terminal distributions. However, these models differ in many
ways. Which of the following statements are true with regard to the differences between these
two models?
I. Model 3 is a parallel shift model just like models without mean reversion.
II. Model 3 is a parallel shift model just like models with mean reversion.
III. The term structure of volatility is flat in Model 3, which is not the case with the Vasicek
Model.
IV. The term structure of volatility is curved in Model 3, which is not the case with the Vasicek
Model.
A. I and IV
B. II and III
C. I and III
D. II and IV
Q.1673 Models with time-dependent volatility and those models with time-dependent drift with
mean reversion can be used for different securities based on the features of the securities. For
example, if you want to find the price of a fixed income option, then a model with:
A. Time-dependent drift is suitable, but if you want to price and hedge fixed-income
securities, then a model with time-dependent volatility is preferable
B. Time-dependent volatility is suitable, but if you want to price and hedge fixed-income
securities, then a model with time-dependent drift is preferable.
C. Time-dependent volatility is suitable, but if you want to price and hedge fixed-income
securities, then a model with mean reversion is preferable.
D. Mean reversion is suitable, but if you want to price and hedge fixed-income securities,
then a model with time-dependent volatility is preferable.
133
Q.1674 Many models of short-term rates assume the annualized standard deviation of dr is
independent of the interest rate level. This makes the models irrelevant and inappropriate during
high inflation times and during periods of high-interest rates in the market. Therefore, a new CIR
is introduced:
dr = k (θ − r) dt + σ√rdw
Which of the following statements is correct regarding the CIR model above?
A. The standard deviation of dr is inversely proportional to the square root of the short
rate
B. The standard deviation of dr is directly proportional to the square root of dw
C. The standard deviation of dr is directly proportional to the square root of dt
D. The standard deviation of dr is directly proportional to the square root of the short
rate
Q.1675 The standard specification of the new CIR model is that the standard deviation of dr
(basis-point volatility) is proportional to the rate. In this model, σ is usually referred to as yield
volatility, and this specification leads to two different models: the Courtadon model and the
Lognormal model.
Keeping the two models in mind, which of the following statements is correct regarding the yield
volatility and the basis-point volatility?
A. The basis-point volatility is constant but the yield volatility equals σr and rises with the
level of the rate
B. The yield volatility is constant but the basis-point volatility equals σr and rises with the
level of the rate
C. The yield volatility as well as the basis-point volatility equal σr and both rise with the
level of the rate
D. The yeld volatility as well as the basis-point volatility equal σ and both decrease with
the level of the rate
134
Q.1676 The property of CIR model - that basis-points volatility equals zero when in situations
when short rate is zero - joined with the condition that drift is positive when the rate is zero,
together ensure that the short rate cannot move to negative values. In many aspects, this
property of the CIR model is an improvement over models with constant basis-point volatility.
Keeping this in mind, what is the problem of constant basis-point volatility with regards to
interest rates?
A. Models with constant basis-point volatility permit interest rates to become negative
B. Models with constant basis-point volatility permit interest rates to become positive
C. Models with constant basis-point volatility permit interest rates to change with market
changes in interest rates
D. Models with constant basis-point volatility permit interest rates to change with spot
rates
Q.1677 The choice of model mainly depends on the purpose at hand, that is, traders choose
model for term structure modeling on the basis of their purpose of buying or selling a security.
Which of the following statements are true if the traders opt for a constant volatility basis points
model?
I. The current economic environment is best with constant volatility.

II. The current economic environment is very unstable and changes immediately with small
changes in investors’ perception.
III. The negative rates have a minor impact on the valuing of the security under consideration.
IV. The negative rates have a major impact on the valuing of the security under consideration.
A. I and IV
B. I and III
C. II and III
D. II and IV
135
Q.1678 A model was constructed to estimate the dynamics for a lognormal model with
deterministic drift. The function of the model (time-dependent) is:
d[ln(r)] = α(t)dt + σdw
In this equation, the short rate has a lognormal distribution.
Considering this equation, what will be the distribution of a random variable if its natural
logarithm has a normal distribution?
A. The random variable will be having a lognormal distribution if its natural logarithm
has a normal distribution
B. The random variable will be having a normal distribution if its natural logarithm has a
normal distribution
C. The random variable will be having a standard normal distribution if its natural
logarithm has a normal distribution
D. The random variable will be having an exponential distribution if its natural logarithm
has a normal distribution
Q.1679 A lognormal model with mean reversion is called the Black-Karasinski model. This model
allows the volatility, mean reversion and short rate’s central tendency to depend on time. These
features make this model arbitrage-free. This model shows that the natural logarithm of the
short rate is normally distributed.
What does this model allow the user to do which is not allowed in other models?
A. A user can use or remove as much time dependence as desired
B. A user can change the distributions as desired in any situation
C. A user can change the price of the securities under consideration when needed
D. A user does not have any extra privilege under this model
136
Q.1680 A lognormal model with mean reversion allows certain factors to depend on time, making
it an arbitrage-free model. This model allows the user to make use of time dependence as desired
for the purpose at hand. The dynamics of the model can be written as:
d [ln(r)] = k(t) [lnθ(t) − ln(r)] dt + σ(t)dw
This equation assumes that the natural logarithm of short rates follows a time-dependent version
of the Vasicek model. Keeping this concept in mind, what is the distribution of natural logarithm
short rates in this equation?
A. The lognormal distribution
B. The normal distribution
C. The standard normal distribution
D. The Bernoulli distribution
Q.1681 Time-dependent volatility functions or models are widely used by financial institutions
because of their flexible features. These models can be used to fit many option prices. A simple
volatility function suggests that the volatility of short rates depends on time. What does σ (1) =
1.25% and σ (2) = 1.28% represent in that equation?
A. The volatility of the short rate in 6 months is 125 basis points while the volatility of the
short rate one year is 128 basis points per year
B. The volatility of the short rate in one year is 128 basis points while the volatility of the
short rate in two years is 125 basis points per year
C. The volatility of the short rate in one year is 125 basis points while the volatility of the
short rate intwo years is 128 basis points per year
D. The time-dependence of the short rate in one year is 125 basis points while the time-
dependence of the short rate in two years is 128 basis points per year
137
Q.1682 A special case of the time-dependent volatility function is Model 3. Model 3 illustrates the
features of time-dependent volatility through the following equation:
dr = λ(t)dt + σe-αtdw
This equation represents the behaviour of the short rate volatility. Which of the following
statements is true about the short rate volatility?
A. The volatility of the short rate starts at the constant σ, and then exponentially
decreases to zero
B. The volatility of the short rate ends at the constant λ, and then exponentially
decreases to zero
C. The volatility of the short rate starts at the constant σ, and then exponentially
increases from zero to infinite
D. The volatility of the short rate starts at the constant λ, and then decreases to zero
Q.1683 The choice of term structure depends on the purpose at hand. For instance, if the
purpose of the model is to price or hedge fixed-income securities/options, then the mean
reversion model is preferred because many users disagree with the time-dependent volatility
model’s argument that markets have a forecast of short term volatility in the distant future.
Which modification in the new model addresses this objection?
A. Assuming that volatility depends on time in the near future and then settles at a
constant
B. Assuming that the short rate depends on time in the near future and then settles at a
constant
C. Assuming that the volatility depends on time in the distant future and then settles at
an increasing rate
D. Assuming that volatility depends on time in the near future and then settles at a
decreasing rate
138
Q.1684 Which of the following statements is true about mean-reverting models?
A. They exhibit an upward-sloping factor structure and term structure of volatility which
capture the interest rate behavior movement much better compared to parallel shift
models
B. They exhibit a downward-sloping factor structure and term structure of volatility and
are as good at capturing interest rate behavior as parallel shift models
C. They exhibit a downward-sloping factor structure and term structure of volatility and
capture interest rate behavior better than parallel shift models.
D. They exhibit upward-sloping factor structure and term structure of volatility and
capture interest rate behavior better than parallel shift models
Q.1685 In the past, many models studied assumed that the basis-point volatility of the short rate
was independent of the level of the short rate, but in certain scenarios, this assumption went
wrong, making the models inappropriate for use (for instance, during times of high inflation).
This argument led to a more specific model that considers basis point volatility of the short rate
as an increasing function.
Which of the following equations truly represents the dynamics of that model?
A. dr = k(λ - r)dt + σ√rdw
B. dr = k(θ - r)dt + σ√rdw
C. dr = k(θ - r)dt + σ√dw
D. dr = k(θ - λ)dt + σ√rdw
139
Q.1686 Models are always continually improved to make them more suitable in the face of
changing economic conditions. Many models with constant basis-point volatility allow interest
rates to become negative, which is not economically possible and appropriate.
Which property of model CIR guarantees that the short rate cannot become negative?
A. The property that the basis-point volatility equals zero in case the short rate is zero,
joined with the condition that the drift is negative when the rate is zero, guarantees that
the short rate cannot become negative
B. The property that the basis-point volatility equals a constant in case the short rate is
zero, joined with the condition that the drift is positive when the rate is positive,
guarantees that the short rate cannot become negative
C. The property that the basis-point volatility equals a constant in case the short rate is
zero, joined with the condition that the drift is zero when the rate is zero, guarantees that
D. The property that the basis-point volatility equals zero in case the short rate is zero,
joined with the condition that the drift is positive when the rate is zero, guarantees that
Q.2858 James Greenberg, an analyst at HSBC, is employing the Cox-Ingersoll-Ross (CIR) model
for the short-term rate process.
His assumptions include:
The time-step is monthly, dt = 1/12, today's initial rate, r(0) = 2.11%, the annual basis point
volatility, sigma = 3.17%, the long-run rate, theta = 7.64%, the strength of reversion, k = 0.57.
For the first month, dw = 0.160. What is the short-rate in the first month under this CIR process,
r(1/12)?
A. -3.006%
B. -1.336%
C. 2.446%
D. 3.006%
140
Q.2859 What is the implication of basis-point volatility being equal to zero should the short rate
be zero in conjunction with the condition that a zero rate implies a positive drift?
A. The long rate will always be positive
B. The short rate will always be non-negative
C. The long and the short rate will always be equal
141
Reading 75: Volatility Smiles
Q.1705 The Black-Scholes-Merton model is known in the field of Financial Risk Management for
depicting the variance of prices of instruments over a period of time. It is being used by traders
today but with a little variation from the method originally applied by Black, Scholes, and Merton
and this difference is because of:
I. The allowance of the factor of stability to be used for pricing as an option to be dependent on
its strike-price
II. The allowance of the factor of volatility to be used for pricing as an option to be dependent on
its strike-price
III. The allowance of the factor of volatility to be used for pricing as an option to be dependent on
its time to maturity
A. Both I and II
B. Both II and III
C. Both I and III
Q.1706 The term "volatility smile" carries significant value in the scope of Financial Risk
Management, and is used traders in equity and foreign currency markets. Which of the following
statements gives the correct definition of a volatility smile?
A. The plot of volatility (implied) of financial markets determining prices of options
B. The plot of volatility (implied) of an option with a defined life span acting as a function
of its strike price
C. The plot of volatility (implied) of an option with an infinite life span acting as a
function of its stated price
142
Q.1707 The term "volatility smile" is a pictorial representation of an option’s implied volatility
and it is being used by the traders as a pricing tool for their financial securities. Which of the
following statement is correct about volatility smiles?
A. The volatility smile for European call-options with a certain maturity and strike price is
the same as that for European put-options with the same maturity and strike price
B. The volatility smile for European call-options with a certain maturity and strike price is
different from that for European put-options with the same maturity and strike price
C. The volatility smile for European call-options with a shorter maturity and same strike
price is the same as that for European put-options with a longer maturity and the same
strike price
Q.1708 The value of a foreign currency is $0.55. The risk-free interest rate is 4% and 8% per
year in the U.S. and in the foreign country, respectively. The market price of a European call
option on the foreign currency with a maturity of 1 year and a strike price of $0.57 is $0.0325.
The implied volatility of the call is 14.5%. For there to be no arbitrage, the equation of the put-
call parity relationship is to be applied with q equal to the foreign risk-free rate. What is the
value of a put option according to the put-call parity?
A. 0.0725
B. 0.0724
C. 0.0419
D. 0.0687
143
Q.1709 Which of the following statements stands TRUE for the following equation depicting the
put-call parity relationship in regard to the Black-Scholes-Merton model?
PBS - Pmkt = CBS - Cmkt
I. BS in the equation reflects the inclusion of the Black-Scholes-Merton model

II. c and p represent the European call and put prices, respectively
III. There is a no-arbitrage argument reflected in the equation
IV. The dollar pricing error when pricing a European option is the same when using the Black-
Scholes-Merton model provided the option carries the same strike price and time to maturity
A. Both I and II
B. Both II and III
C. All of the above
Q.1710 After reading the following scenario, pick the statement which CORRECTLY depicts it.
Suppose that the implied volatility of a put option = 25% meaning that PBS = Pmkt when volatility
of 25% is being applied in the Black-Scholes-Merton model. From the following equation, PBS -
Pmkt = CBS - Cmkt, then CBS = Cmkt when this volatility is used. The implied volatility of the call is
also 25%.
A. This scenario shows that the implied volatility of a European call option is always the
same as the implied volatility of a European put option when the two have the same
strike prices and maturity dates
B. This scenario shows that the implied volatility of a European call option is always the
different as the implied volatility of a European put option when the two have the same
C. This scenario shows that the implied volatility of a European call option is always the
same as the implied volatility of a European put option when the two have different strike
prices and maturity dates
D. This scenario shows that the implied volatility of a European call option is always the
same as the implied volatility of an American put option when the two have the same
144
Q.1711 When it comes to making a decision regarding trading using the Black-Scholes-Merton
model, assumptions must be made regarding the distribution of exchange rates. But at the same
time, the lognormal assumption is deemed as not a right choice for exchange rates, and it’s
advisable to buy deep-out-of-the money call and put options on a variety of different currencies
and wait. This suggestion is supported by the following reasons:
I. The chosen options will be relatively inexpensive

II. Many of the chosen options will close in the money than the prediction of lognormal-model
III. On average, the payoffs’ present value will be more than the options’ cost
A. Both I and II
B. Both I and III
C. All of the above
Q.1713 In practice, exchange rates do not work on the condition of lognormal distribution as the
exchange rate’s volatility is far from constant, and there are frequent jumps. Which of the
following statements stands FALSE for this scenario?
A. Extreme outcomes are expected as a result of the impact of the variable volatility and
jumps
B. The effect of the variable volatility and jumps are independent of the maturity of
options
C. When the maturity of options increases, the volatility smile becomes less pronounced
145
Q.1714 It is often stated that the volatility smile (the relationship between implied volatility and
strike price K, dependent on the asset’s current price) is calculated as the relationship between
the implied volatility and K/S0 rather than as the relationship between the implied volatility and
K. Which of the following statements depicts the reason behind this calculation?
I. The lowest point of the volatility smile is usually close to the current exchange rate
II. When the exchange rate decreases, the volatility smile tends to move to the left and when the
exchange rate increases, the volatility smile tends to move to the right
III. When the equity price increases, the volatility skew tends to move to the right and when the
equity price decreases, it tends to move to the left
A. I and II
B. III only
C. All of the above
Q.1715 Which of the following holds true for equity options smiles?
I. Leverage is identified as one of the main reasons for the smile in equity options
II. It is said that when a company's equity declines in terms of value, the company's leverage
then increases making equity riskier, and its volatility increases
III. It is said that when a company's equity increases in terms of value, the company's leverage
then decreases making equity less risky, and its volatility decreases
A. Both I and II
B. Both I and III
C. None of the above
D. All of the above
146
Q.1716 Traders use volatility smiles to allow for non-log-normality when trading call and put
options. Which of the following statements stands TRUE about volatility smiles for equity
options?
I. A volatility smile depicts the relationship between the option’s implied volatility and the
option’s strike price
II. Volatility smiles for equity options are drawn as downward slopes on graphs
III. Volatility smiles show that out-of-the-money calls tend to have higher implied volatility as
compared to in-the-money calls
IV. Volatility smiles show that in-the-money puts tend to have higher implied volatility as
compared to out-of-the-money puts
A. I and II
B. III and IV
C. All of the above
Q.1717 Volatility surfaces (the implied volatility as a function of strike price and time to maturity)
are used as pricing tools by traders when dealing with options. Which of the following
statements defines volatility surface CORRECTLY?
A. When volatility smiles and volatility term structures are combined, they produce a
volatility surface
B. When volatility frowns and volatility term structures are combined, they produce a
volatility surface
C. When volatility smiles and volatility slopes are combined, they produce a volatility
surface
147
Q.2860 A foreign currency is valued at $1.73. The foreign currency has a European call option
market price of 0.135 and a strike price of $1.60. In the US, the risk-free interest rate is 7% per
annum and 16% per annum in the foreign country. Determine the price of a European put option
with a 1-year maturity for the foreign currency.
A. $0.254
B. $0.153
C. $0.548
D. $0.004
Q.2862 Suppose that a small-cap stock is priced at $0.6560. Suppose further that the European
call and put options computed by Black-Scholes-Merton model are $0.0249 and $0.0501
respectively. Compute the market price of a FEB $0.75 call option if the market price of a FEB
$0.75 put option is $0.0317.
A. $0.0065
B. $0.0025
C. $0.0337
D. $0.0654
Q.2863 Which of the following condition are necessary for an asset price to have a lognormal
distribution?
I. The asset should have a varying volatility

II. The price of the asset should change smoothly with no jumps
III. The volatility of the asset should be constant
A. I and II
B. I and III
C. II and III
D. All of the above
148
Reading 76: Fundamental Review of the Trading Book
Q.2362 What’s the number of days of stressed market conditions required for the calculation of
the stressed VaR?
A. 90
B. 150
C. 250
D. 360
Q.2363 In May 2012, the Basel Committee on Banking Supervision issued a consultative
document referred to as the Fundamental Review of the Trading Book (FRTB). FRTB requires the
changes to market variables (referred to as shocks) to be the changes that would take place (in
stressed market conditions) over certain periods of time, referred to as liquidity horizons. The
following are acceptable time frames, EXCEPT:
A. 10 days
B. 20 days
C. 60 days
D. 140 days
Q.2364 The December 2014 consultative document by the Basel Committee defined an approach
for implementing varying liquidity horizons in which market variables were divided into
categories. What is the criterion used to place the variables into categories?
A. Length of time horizons
B. Severity of change
C. Size of market
D. Type of product
149
Q.2365 Banks sometimes find it difficult to search for past stressed periods using all market
variables because of a shortage of historical data for some of the variables. The Fundamental
Review of Trading Book (FRTB) allows the stressed period calculations to be based on a subset of
market variables and the results scaled up by the ratio of the expected shortfall for a number of
recent months. What’s the exact number of months as defined by the FRTB?
A. 1
B. 3
C. 6
D. 12
Q.2366 In May 2012, the Basel Committee on Banking Supervision issued a consultative
document referred to as the Fundamental Review of the Trading Book (FRTB). According to
FRTB, there are several categories of market variables. Which of the following is NOT one of
them?
A. Equity risk
B. Commodity risk
C. Volatility risk
D. Foreign exchange risk
Q.2367 The Fundamental Review of Trading Book (FRTB) proposes back-testing be done using a
VaR measure calculated over a certain horizon and the most recent 12 months of data. What’s
the exact time horizon used?
A. Thirty-day horizon
B. Seven-day horizon
C. Two-day horizon
D. One-day horizon
150
Q.2368 Which of the following presents FRTB's (Fundamental Review of the Trading Book)
proposed change during the measurement of market risk capital?
A. VaR at 99% confidence
B. VaR at 99.99% confidence
C. Expected shortfall with a 97.5% confidence level
D. Expected shortfall with a 99% confidence level
Q.2369 The Fundamental Review of Trading Book (FRTB), among other things, defines the type
of instruments which should be put either in the trading or the banking book. Which instruments
are marked-to-market?
A. Instruments in the trading book
B. Instruments in the banking book
C. Instruments in both the banking and the trading books
Q.2370 According to the Fundamental Review of Trading Book (FRTB), the instruments in the
trading book are subject to:
A. Credit risk capital
B. Market risk capital
C. Operational risk capital
D. Both credit and market risk capital
151
Q.2371 Basel II.5 introduced the incremental risk charge (IRC), while the Fundamental Review
of Trading Book (FRTB) provides a modification of the IRC by recognizing that for instruments
dependent on the credit risk of a particular company, two types of risk can be identified. These
are:
A. Downgrade risk and jump-to-default risk
B. Downgrade risk and credit spread risk
C. Credit spread risk and jump-to-default risk
D. Credit spread risk and liquidity risk
Q.2998 Billow Bank has sometimes been finding it difficult to search for past stressed periods
using all market variables. This fact can be attributed to a shortage of historical data for some of
the variables. How does the Fundamental Review of Trading Book (FRTB) deal with this
challenge?
A. The FRTB can allow the stressed period computations to be based on a subset of
market variables and the results scaled up by the ratio of the expected shortfall for the
latest 12 months using all variables to the expected shortfall for the latest 12 months
using the subset of the market variables.
B. An intervention at an early stage by supervisors should prevent capital from falling

below the necessary minimum levels to support a particular bank’s risk characteristics,
and a rapid remedial action should be required in case capital is not maintained or
resorted
C. The bank should possess a process for assessing the its overall capital adequacy
relative its strategy for capital level maintenance and risk profile
D. All the above
152
Q.2999 Which of the following reasons best explains why the Fundamental Review of the Trading
Book (FRTB) proposes that back-testing should be done by applying a VaR measure computed
over a one-day horizon and the latest 12 months of data?
A. This is due to the difficulty in directly backtesting a 10-day expected shortfall and
impossible to back-test stressed VaR or stressed ES
B. The events of a contractual default, acceptable remedies, and opportunities for a

default to be cured, should be well defined in the FRTB. Therefore, termination rights
should also be included in agreements
C. The reasonability of the proposed limitations compared to the institution’s risks in case
of performance failure by the service provider should be ascertained by the senior
management and the Board of Directors in the institution
Q.4020 In January 2016, the Basel Committee on Banking Supervision (BCBS) issued a revised
framework for Market risk Capital Requirements in part informed by the mass failure of banks
following the 2007-2009 financial crisis. That framework has been widely referred to as the
Fundamental Review of the Trading Book (FRTB). Compared to Basel I and Basel II.5, each of the
following is true about the FRTB EXCEPT which is false?
A. Under Basel I and Basel II.5, market risk capital calculations were based on value at
risk (VaR) with a 99.0% confidence level, but the FRTB requires calculations based on
expected shortfall (ES) with a 97.5% confidence level
B. Under Basel I regulations, banks were required to calculate market risk capital based
on a value at risk calculated for a 10-day horizon with a 99% confidence interval
C. Under Basel II.5, banks had to add a stressed VaR measure to the current value at
risk, both calculated based on a 10-day horizon.
D. Under Basel I and II.5 market risk capital was based on a 10-day time horizon, but the
FRTB uses five different horizons (10, 20, 40, 60, and 120 days) depending on the
liquidity of the market variable
153
Q.4021 In the past, a lack of a clear distinction between the regulatory banking book and the
trading book created an opportunity for regulatory arbitrage. The FRTB attempts to make the
distinction between the trading book and the banking book clearer and less subjective. Which of
the following is FALSE with regard to the FRTB's treatment of the boundary between the two
books?
A. The FRTB establishes a more objective boundary between the regulatory banking and
trading book and severely restricts subsequent movement between the books unless
under extraordinary circumstances
B. Under FRTB, there must be a sincere intent to trade if an asset has to be included in
the trading book
C. FRTB subjects the trading book and banking book to the same set of capital
requirements so as to mitigate regulatory arbitrage
D. In an attempt to further mitigate regulatory arbitrage, FRTB distinguishes two types of

credit risk exposure to a company: credit spread risk and jump-to-default risk
Q.4022 Which of the following is not a component of the standardized approach to calculating
regulatory capital for banks under market risk measurement and management.
A. A risk charge calculated using a risk sensitivity approach
B. A residual risk add-on
C. A default risk charge
D. Insolvency risk charge
154
Q.4023 Bank of Baroda has the following taken the following positions:
$100 million in a corporate bond with credit quality of A
$40 million credit default swap but protection on the same issuer
Determine the default risk charge. Assumptions:
There’s zero profit/loss on each exposure, and
The LGD for senior debt is 75%.
Single A credits have a risk weight of 3%
A. $1.50m
B. $2.20m
C. $1.05m
D. $3.30m
Q.4024 Which of the following entities should apply the simplified standardized approach while
calculating their market risk capital?
A. Large systematically important banks (SIBs)
B. Small banks with a low concentration of trading book activity
C. Central banks
D. Banks heavily invested in securitized assets
155
Q.4025 Under FRTB, the term liquidity horizon represents "the time required to sell a financial
instrument or hedge all its material risks, in a stressed market, without materially affecting
market prices." All of the following liquidity horizons have been proposed by the Basel
Committee under the FRTB framework EXCEPT:
A. 10 days
B. 30-days
C. 60 days
D. 120 days
Q.4026 Under Basel I regulations, banks were required to calculate market risk capital based on
a calculated for a horizon with a confidence interval.
A. Value at risk; 250-day; 99.5%
B. Value at risk; 10-day; 99%
C. Expected shortfall; 10-day; 99.9%
D. Expected shortfall; 10-day; 95%
Q.4027 Under the standardized approach, the capital requirement is the simple sum of three
components: risk charges under the sensitivities based method, a default risk charge, and a
residual risk add-on. Which of the following is not a risk class as defined under the sensitivities-
based method.
A. General interest rate risk
B. Foreign exchange risk
C. Commodity risk
D. Funding risk
156
Q.4028 Under FRTB, the term liquidity horizon refers to:
A. The time taken to find a willing buyer for a security or commodity
B. The time taken to successfully execute a sale transaction that guarantees a minimum
level of profit
C. The time it takes to buy a security or commodity
D. The time required to sell a security in a stressed market, without materially affecting
market prices
Q.4029 One of the issues extensively addressed in FRTB has much to do with regulatory
modifications with respect to the trading book and banking book. Which of the following is a
major reason behind these modifications?
A. Internal fraud
B. Default risk
C. Interest rate risk
D. Regulatory arbitrage
Q.4030 To allocate an asset to the trading book, FRTB proposes two major conditions:
I. bank must be able to trade the asset, and physically manage the associated risks of the
underlying asset on the trading desk.
II. asset must be traded on an exchange
III. The day-to-day price fluctuations must affect the bank’s equity position and pose a risk to
bank solvency.
IV. There must be significant default risk on the part of the obligor
A. I and IV
B. II and III
C. I and III
D. IIV only
157
Q.4031 Which of the following approaches should banks use to compute capital with respect to
assets held under a securitization business model?
A. Internal models approach
B. Standardized approach
C. Advanced measurement approach
D. Revised internal models approach
Q.4032 Richard Glen, FRM, is evaluating market capital requirements for Exim Bank. He starts
by comparing the trading desk’s 1-day static value-at-risk measure (calibrated to the most recent
12 months’ data, equally weighted) at both the 97.5th percentile and the 99th percentile, using
two years of current observations of the desk’s one-day P&L. The desk experiences 13 exceptions
at the 99th percentile and 32 exceptions at the 97.5th percentile. Based on the results, which of
the following models should Exim bank use to determine its capital needs going forward?
A. Internal models approach
B. Standardized approach
C. Advanced measurement approach
D. Revised internal models approach
Q.4033 A bond portfolio, currently worth $500 million in assets, has a probability of default of
3%. An analyst evaluates the risk of the portfolio using a 95% value at risk (VaR) and a 95%
expected shortfall (ES). Which of the following is correct?
A. The VaR shows no loss while the expected shortfall shows a $500 million loss.
B. Both measures will show the same result.
C. The VaR shows no loss while the expected shortfall shows a $300 million loss.
D. The VaR shows a loss of $300 million while the expected shortfall shows no loss.
158
Q.4034 During a workshop set up by a banking regulator regarding market capital calculations,
an intern makes the following statements regarding the differences between Basel I, Basel II. 5,
and the Fundamental Review of the Trading Book (FRTB). Which statement is incorrect?
A. Both Basel I and Basel II. 5 require calculation of VaR with a 99% confidence interval.
B. FRTB requires the calculation of expected shortfall with a 97.5% confidence interval.
C. FRTB requires adding a stressed VaR measure to complement the expected shortfall
calculation.
D. The 10-day time horizon for market risk capital proposed under Basel I incorporates a
recent period of time, which typically ranges from one to four years.
Q.4035 Which of the following risks is specifically recognized by the incremental risk
charge(IRC)?
A. Jump to default risk
B. Interest rate risk
C. Foreign exchange risk
D. Equity price risk
159

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What are some of the methods used to calculate VaR?

What are some of the methods used to calculate VaR?

What is the difference between geometric and arithmetic returns?

What is the difference between geometric and arithmetic returns?

FRM

Questions - Market Risk Measurement and Management

Last Updated: Dec 19, 2020

Estimating Market Risk Measures: An Introduction and

Which of the above-mentioned points is/are correct?

A. Only Point I is correct

B. Only Point II is correct

C. Both I and II are correct

D. Neither I nor II is correct

A. Historical Simulation (HS)

C. Abnormally Distributed Profits/Losses

D. Normally Distributed Arithmetic Returns

A. The ES can be estimated as an average-tail-VaR because it's actually the probability-

B. The ES can be estimated with the help of a 'closed-form' solution

C. A 'closed-form' solution is more preferable than the average-tail-VaR because the

D. The average-tail-VaR is more preferable method to estimate the Expected Shortfall

C. The ES stays constant

D. The ES moves but not in a consistent manner

C. Weights appropriate to risk exposure being estimated

D. None of the above.

A. Ability to assign weights accurately

B. Ability to calculate exponential value accurately

C. Ability to estimate quantiles

D. Ability to approximate risk exposure

A. f(q), sample size n and p

B. p, standard error s and variance of q

C. sample size n, p and square root of error

D. variance of q, sample size n and f(q)

I. The weighs to assign, and

A. Only Point I is incorrect

B. Only Point II is incorrect

C. Both I and II are incorrect

D. Neither I nor II is incorrect

What is the 95% lognormal VAR for this portfolio?

Value of the portfolio USD 1 million

A. Normal distribution: $495,000; Lognormal distribution: $460,000

B. Normal distribution: $460,000; Lognormal distribution: $495,000

C. Normal distribution: $432,500; Lognormal distribution: $351,000

D. Normal distribution: $499,000; Lognormal distribution: $432,500

A. The 95% VaR is 32.289 and the 99% VaR is 51.4932

B. The 95% VaR is 36.495 and the 99% VaR is 51.556

C. The 95% VaR is 55.236 and the 99% VaR is 36.49551

D. The 95% VaR is 36.225 and the 99% VaR is 41.586

A. The 95% VaR is 2.3658 and the 99% VaR is 3.6588

B. The 95% VaR is 1.4542 and the 99% VaR is 0.0652

C. The 95% VaR is 0.6742 and the 99% VaR is 3.00896

D. The 95% VaR is 0.21015 and the 99% VaR is 0.93882

A. The 95% VaR is 0.8951 and the 99% VaR is 0.2351

B. The 95% VaR is 0.88526 and the 99% VaR is 0.56898

C. The 95% VaR is 0.3522 and the 99% VaR is 0.4762

D. The 95% VaR is 0.8951 and the 99% VaR is 0.56898

D. None of the above

A. VaR (P1) > VaR (P2)

B. VaR (P1) < VaR (P2)

C. VaR (P1) = VaR (P2)