FRM FRM 3 — Questions and Answers
Question 1: What is the primary purpose of netting agreements in counterparty credit risk management?
- To increase gross exposure
- To offset positive and negative exposures with a counterparty (Correct answer)
- To eliminate market risk
- To avoid posting collateral entirely
Correct answer: To offset positive and negative exposures with a counterparty
Netting reduces credit exposure by offsetting amounts owed in both directions with the same counterparty.
Question 2: The Liquidity Coverage Ratio (LCR) requires banks to hold high-quality liquid assets sufficient to cover net cash outflows over what stress horizon?
- 7 days
- 30 days (Correct answer)
- 90 days
- 1 year
Correct answer: 30 days
The LCR is calibrated to a 30-day stressed liquidity scenario.
Question 3: Which of the following best describes wrong-way risk?
- Exposure rises as counterparty credit quality deteriorates (Correct answer)
- Exposure falls as default probability rises
- Risk that is fully hedged
- Risk independent of the counterparty
Correct answer: Exposure rises as counterparty credit quality deteriorates
Wrong-way risk occurs when exposure to a counterparty increases just as that counterparty becomes more likely to default.
Question 4: In the Capital Asset Pricing Model, beta measures:
- Total risk of an asset
- Idiosyncratic risk only
- Systematic risk relative to the market (Correct answer)
- The risk-free rate
Correct answer: Systematic risk relative to the market
Beta captures an asset's sensitivity to market movements, representing systematic (non-diversifiable) risk.
Question 5: A trader uses historical simulation to compute VaR. A key limitation of this approach is that it:
- Requires assuming a normal distribution
- Assumes the future will resemble the historical sample period (Correct answer)
- Cannot handle nonlinear instruments
- Ignores actual price history
Correct answer: Assumes the future will resemble the historical sample period
Historical simulation assumes past return patterns will repeat, so it may miss risks absent from the sample.
Question 6: Which measure evaluates portfolio return per unit of total risk (standard deviation)?
- Treynor ratio
- Sharpe ratio (Correct answer)
- Jensen's alpha
- Information ratio
Correct answer: Sharpe ratio
The Sharpe ratio divides excess return by total volatility (standard deviation).
Question 7: Stress testing differs from VaR primarily because it:
- Always uses a 99% confidence level
- Examines impacts of specific extreme or hypothetical scenarios (Correct answer)
- Relies only on the normal distribution
- Measures only daily losses
Correct answer: Examines impacts of specific extreme or hypothetical scenarios
Stress testing assesses portfolio impacts under defined extreme scenarios rather than statistical confidence thresholds.
FRM FRM 3
What is the primary purpose of netting agreements in counterparty credit risk management?