FRM Review and Assessment 2 — Questions and Answers
Question 1: A risk assessment review finds a portfolio's 1-day 99% VaR is $2M. What does this figure represent?
- The maximum possible loss over one day
- The loss expected to be exceeded on only 1% of days (Correct answer)
- The average daily loss
- The guaranteed loss every day
Correct answer: The loss expected to be exceeded on only 1% of days
A 1-day 99% VaR of $2M means losses should exceed $2M on roughly 1% of trading days.
Question 2: During backtesting review, VaR breaches occur far more often than the model predicts. What is the most likely conclusion?
- The model overstates risk
- The model understates risk and underestimates VaR (Correct answer)
- The model is perfectly calibrated
- Backtesting is unnecessary
Correct answer: The model understates risk and underestimates VaR
Excessive breaches indicate the model underestimates risk and produces VaR figures that are too low.
Question 3: Which limitation of VaR does Expected Shortfall (ES) specifically address in a model review?
- It ignores volatility
- It says nothing about the size of losses beyond the VaR threshold (Correct answer)
- It cannot be computed historically
- It only works for equities
Correct answer: It says nothing about the size of losses beyond the VaR threshold
Expected Shortfall captures the average loss in the tail beyond VaR, which VaR itself does not quantify.
Question 4: An assessment of a bank's capital adequacy under Basel III focuses on which primary ratio?
- Loan-to-deposit ratio
- Common Equity Tier 1 (CET1) ratio (Correct answer)
- Price-to-earnings ratio
- Current ratio
Correct answer: Common Equity Tier 1 (CET1) ratio
Basel III emphasizes the CET1 capital ratio as the core measure of a bank's loss-absorbing capacity.
Question 5: A review of stress testing reveals scenarios only use historical events. What weakness should the assessor flag?
- It is too forward-looking
- It may miss plausible but unprecedented (hypothetical) shocks (Correct answer)
- It overestimates correlations
- It cannot use macro variables
Correct answer: It may miss plausible but unprecedented (hypothetical) shocks
Relying solely on historical scenarios can overlook severe but previously unobserved events.
Question 6: In assessing operational risk, which approach links capital to internal loss data and scenario analysis?
- Standardized Approach only
- Advanced Measurement Approach (AMA) (Correct answer)
- Market risk charge
- Duration matching
Correct answer: Advanced Measurement Approach (AMA)
The AMA uses internal loss data, external data, scenario analysis, and business environment factors to estimate operational risk capital.
Question 7: A model validation review checks for model risk. Which is a key source of model risk?
- Using audited financial statements
- Incorrect assumptions or implementation errors in the model (Correct answer)
- Holding adequate capital
- Diversifying the portfolio
Correct answer: Incorrect assumptions or implementation errors in the model
Model risk arises from flawed assumptions, data, or implementation that lead to inaccurate outputs.
FRM Review and Assessment 2
A risk assessment review finds a portfolio's 1-day 99% VaR is $2M.
What does this figure represent?