FRM FRM Market Risk 3

Question 1

What is basis risk in the context of hedging?

Accepted Answer

The risk that the hedge instrument does not perfectly offset the exposure being hedged

Answer

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?

Accepted Answer

5%

Answer

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?

Accepted Answer

Systematic risk affects the entire market and cannot be diversified away, while idiosyncratic risk is firm-specific and can be diversified

Answer

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?

Accepted Answer

EWMA (Exponentially Weighted Moving Average)

Answer

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?

Accepted Answer

The assets move in perfectly opposite directions, allowing complete risk elimination when combined in the right proportions

Answer

Perfect negative correlation means combining two assets in appropriate proportions can create a zero-risk portfolio by offsetting gains and losses.

FRM Practice Test

FRM Practice Test

FRM FRM Market Risk 3