FRM Review and Assessment 3 — Questions and Answers
Question 1: When assessing credit risk, what does Expected Loss (EL) equal?
- PD only
- PD × LGD × EAD (Correct answer)
- LGD minus EAD
- EAD divided by PD
Correct answer: PD × LGD × EAD
Expected Loss is the product of Probability of Default, Loss Given Default, and Exposure at Default.
Question 2: A review of a duration-based hedge finds it fails for large rate moves. What property explains this?
- Convexity, the curvature of the price-yield relationship (Correct answer)
- Linearity of bond prices
- Constant duration
- Zero coupon assumption
Correct answer: Convexity, the curvature of the price-yield relationship
Duration is a linear approximation; convexity captures the curvature that matters for large yield changes.
Question 3: In assessing liquidity risk, the Liquidity Coverage Ratio (LCR) ensures a bank can survive how long under stress?
- 30 days (Correct answer)
- 1 year
- 5 years
- 90 days
Correct answer: 30 days
The LCR requires enough high-quality liquid assets to cover net cash outflows over a 30-day stress period.
Question 4: A risk committee reviews a trade with high gamma. What does high gamma imply about hedging?
- The delta hedge needs frequent rebalancing (Correct answer)
- No hedging is required
- The position has no directional risk
- Vega is zero
Correct answer: The delta hedge needs frequent rebalancing
High gamma means delta changes rapidly with the underlying, requiring frequent rebalancing of the hedge.
Question 5: An assessment of correlation assumptions during a crisis should account for which phenomenon?
- Correlations tend toward zero in crises
- Correlations often rise toward 1 in crises (correlation breakdown) (Correct answer)
- Correlations are always stable
- Correlations become negative
Correct answer: Correlations often rise toward 1 in crises (correlation breakdown)
In stress periods, asset correlations frequently spike, reducing diversification benefits when they are needed most.
Question 6: Reviewing a Sharpe ratio comparison, which adjustment improves assessment when returns are non-normal?
- Ignore skewness and kurtosis
- Consider downside-risk measures like the Sortino ratio (Correct answer)
- Use only nominal returns
- Remove the risk-free rate
Correct answer: Consider downside-risk measures like the Sortino ratio
The Sortino ratio penalizes only downside volatility, better reflecting risk when return distributions are skewed.
Question 7: A model review notes the use of historical simulation for VaR. What is its main drawback?
- It assumes returns are normally distributed
- It assumes the future resembles the chosen historical window (Correct answer)
- It requires a covariance matrix
- It cannot handle options
Correct answer: It assumes the future resembles the chosen historical window
Historical simulation assumes past observed returns are representative of future risk, which may not hold.
FRM Review and Assessment 3
When assessing credit risk, what does Expected Loss (EL) equal?