FRM FRM Market Risk 2

Question 1

What does a negative convexity in a mortgage-backed security (MBS) indicate?

Accepted Answer

Prepayment risk causes the price to underperform when rates fall

Answer

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?

Accepted Answer

Implied volatility

Answer

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?

Accepted Answer

To identify scenarios that would cause a firm to fail

Answer

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?

Accepted Answer

Out-of-the-money puts and calls have higher implied volatility than at-the-money options

Answer

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?

Accepted Answer

To compare VaR predictions against actual daily profit and loss outcomes

Answer

Backtesting counts how often actual losses exceed the VaR estimate, allowing regulators and risk managers to assess model accuracy.

FRM Practice Test

FRM Practice Test

FRM FRM Market Risk 2