FRM FRM Market Risk 2 — Questions and Answers
Question 1: What does a negative convexity in a mortgage-backed security (MBS) indicate?
- Prepayment risk causes the price to underperform when rates fall (Correct answer)
- The bond price rises faster than a comparable straight bond
- Duration increases as yields rise
- The security has no interest rate risk
Correct answer: Prepayment risk causes the price to underperform when rates fall
Negative convexity in MBS arises because borrowers prepay when rates fall, capping price appreciation and creating unfavorable price behavior for investors.
Question 2: Which volatility measure is derived from market prices of options rather than historical price data?
- Implied volatility (Correct answer)
- Historical volatility
- Realized volatility
- GARCH volatility
Correct answer: Implied volatility
Implied volatility is extracted from current option market prices using an option pricing model such as Black-Scholes.
Question 3: In stress testing, what is the purpose of a reverse stress test?
- To identify scenarios that would cause a firm to fail (Correct answer)
- To measure VaR under extreme market conditions
- To backtest a model against historical crises
- To estimate losses from a 1-in-100-year event
Correct answer: To identify scenarios that would cause a firm to fail
Reverse stress testing starts from an outcome—typically firm failure—and works backward to identify what scenarios could produce that outcome.
Question 4: What is the volatility smile phenomenon observed in equity options markets?
- Out-of-the-money puts and calls have higher implied volatility than at-the-money options (Correct answer)
- Implied volatility is constant across all strike prices
- At-the-money options always have the highest implied volatility
- Implied volatility declines monotonically as strike price increases
Correct answer: Out-of-the-money puts and calls have higher implied volatility than at-the-money options
The volatility smile shows that implied volatility is higher for deep OTM and ITM options relative to ATM, contradicting the Black-Scholes constant volatility assumption.
Question 5: What is the primary purpose of backtesting a VaR model?
- To compare VaR predictions against actual daily profit and loss outcomes (Correct answer)
- To stress test the model under hypothetical extreme scenarios
- To calibrate model parameters using Monte Carlo simulation
- To verify that VaR accurately measures expected losses
Correct answer: To compare VaR predictions against actual daily profit and loss outcomes
Backtesting counts how often actual losses exceed the VaR estimate, allowing regulators and risk managers to assess model accuracy.
Question 6: Which risk measure was recommended by the Basel Committee as a replacement for VaR in the Fundamental Review of the Trading Book (FRTB)?
- Expected Shortfall at 97.5% (Correct answer)
- VaR at 99.9%
- Stressed VaR at 95%
- Conditional Drawdown at Risk
Correct answer: Expected Shortfall at 97.5%
FRTB replaced 10-day 99% VaR with Expected Shortfall at 97.5% to better capture tail risk and reduce incentives for risk underestimation.
FRM FRM Market Risk 2
What does a negative convexity in a mortgage-backed security (MBS) indicate?