FRM FRM Market Risk 3 — Questions and Answers
Question 1: What is basis risk in the context of hedging?
- The risk that the hedge instrument does not perfectly offset the exposure being hedged (Correct answer)
- The risk of a sudden change in the risk-free rate
- The risk that the underlying asset price moves against the hedger
- The risk of counterparty default on a derivatives contract
Correct answer: The risk that the hedge instrument does not perfectly offset the exposure being hedged
Basis risk arises when the price movements of the hedging instrument and the hedged exposure are not perfectly correlated.
Question 2: Under a normal distribution assumption, approximately what percentage of daily returns fall outside 2 standard deviations?
- 5% (Correct answer)
- 1%
- 10%
- 32%
Correct answer: 5%
Under the normal distribution, approximately 95% of observations fall within 2 standard deviations, leaving about 5% in the tails.
Question 3: What is the key difference between systematic risk and idiosyncratic risk?
- Systematic risk affects the entire market and cannot be diversified away, while idiosyncratic risk is firm-specific and can be diversified (Correct answer)
- Systematic risk can be eliminated through hedging while idiosyncratic risk cannot
- Systematic risk is measured by VaR while idiosyncratic risk is measured by ES
- Systematic risk relates to credit events while idiosyncratic risk relates to market movements
Correct answer: Systematic risk affects the entire market and cannot be diversified away, while idiosyncratic risk is firm-specific and can be diversified
Systematic risk is driven by broad market factors affecting all securities, while idiosyncratic risk is specific to an individual firm or asset and diminishes with diversification.
Question 4: Which model is commonly used to estimate time-varying volatility by weighting recent observations more heavily?
- EWMA (Exponentially Weighted Moving Average) (Correct answer)
- Historical Simulation
- Black-Scholes
- CAPM
Correct answer: EWMA (Exponentially Weighted Moving Average)
EWMA assigns exponentially declining weights to older observations, so recent returns have greater influence on the volatility estimate.
Question 5: What does a correlation of -1 between two assets imply for portfolio risk?
- The assets move in perfectly opposite directions, allowing complete risk elimination when combined in the right proportions (Correct answer)
- The portfolio risk equals the sum of individual asset risks
- The assets are unrelated so diversification provides no benefit
- The portfolio variance is the average of individual variances
Correct answer: The assets move in perfectly opposite directions, allowing complete risk elimination when combined in the right proportions
Perfect negative correlation means combining two assets in appropriate proportions can create a zero-risk portfolio by offsetting gains and losses.
Question 6: In the context of options, what does 'delta hedging' involve?
- Continuously rebalancing a position in the underlying asset to offset changes in option value (Correct answer)
- Purchasing options to hedge an existing equity portfolio
- Using options of different strikes to neutralize gamma exposure
- Selling options to collect premium and reduce delta
Correct answer: Continuously rebalancing a position in the underlying asset to offset changes in option value
Delta hedging involves taking an offsetting position in the underlying asset equal to the option's delta, which must be rebalanced as the delta changes.
FRM FRM Market Risk 3
What is basis risk in the context of hedging?