FRM Part I flashcards

32 cards. Read the term and the definition here. The deck at the top of this page is optional.

Sharpe ratio

Excess portfolio return over the risk-free rate divided by the portfolio's standard deviation; it measures reward per unit of total risk.

CAPM beta

Covariance of the asset return with the market return divided by the variance of the market return; it measures the asset's systematic risk exposure.

Jensen's alpha

Actual portfolio return minus the return required by CAPM given the portfolio beta; a positive value indicates outperformance after adjusting for systematic risk.

Security market line

Graph of expected return against beta under the CAPM; assets plotting above the line offer excess risk-adjusted return, those below are overvalued.

Efficient frontier

Set of portfolios offering the highest expected return for each level of volatility; it is the upper portion of the minimum-variance frontier.

Risk appetite

The amount and type of risk an organization is willing to accept in pursuit of its objectives, set by senior management and constrained by capital and regulation.

Moral hazard

Risk-taking distortion that arises when one party takes more risk because another party bears the consequences, as with deposit insurance or debt financing.

Basel three pillars

The Basel framework's three components: minimum capital requirements, a supervisory review process, and market discipline enforced through public disclosure.

Bayes' theorem

Rule for updating a prior probability with new evidence: the posterior equals likelihood times prior divided by the unconditional probability of the evidence.

Central limit theorem

For large samples the distribution of the sample mean approaches normality with mean mu and standard error sigma over root n, whatever the population distribution.

Unbiased estimator

An estimator whose expected value equals the true population parameter; the sample variance with divisor n minus one is unbiased for population variance.

Type I error

Rejecting a null hypothesis that is actually true; its probability equals the significance level alpha chosen for the test.

R-squared

Proportion of the total variation in the dependent variable explained by the regression; it equals explained sum of squares divided by total sum of squares.

Heteroskedasticity

Condition in which regression residual variance is not constant across observations; coefficients remain unbiased but ordinary standard errors are invalid.

Autocorrelation

Correlation between a time series and its own lagged values; in regression residuals it biases standard errors and is often corrected with Newey-West estimators.

Covariance stationarity

Property of a time series whose mean, variance and autocovariances are constant over time; required for valid inference from an AR(1) model.

Put-call parity

For European options on a non-dividend-paying stock, a call plus the present value of the strike equals a put plus the stock price.

Forward price formula

F0 equals S0 times e raised to (r minus q) times T, where r is the risk-free rate and q the dividend or convenience yield.

Marking to market

Daily settlement of gains and losses on futures through the margin account; this daily cash flow is the key difference between futures and forwards.

Interest rate swap

Agreement to exchange fixed for floating interest payments on a notional principal; it can be valued as a portfolio of forward rate agreements.

Interest rate parity

Covered parity states that the forward rate divided by the spot rate equals the ratio of domestic to foreign interest rate factors for the same maturity.

Intrinsic value

For a call, the maximum of stock price minus strike and zero; for a put, the maximum of strike minus stock price and zero.

Delta

Sensitivity of an option price to a one-unit change in the underlying price; call delta lies between zero and one, put delta between minus one and zero.

Credit default swap

Contract in which the protection buyer pays a periodic spread and the seller compensates for the loss given default on a reference obligation.

Value at risk

The loss threshold expected to be exceeded with a specified small probability over a given horizon, such as 1% over one day.

Expected shortfall

Average loss conditional on the loss exceeding the VaR level; it is a coherent measure that reflects the severity of tail losses.

Modified duration

Macaulay duration divided by one plus the yield per period; it approximates the percentage bond price change for a small change in yield.

DV01

Dollar change in a bond's value for a one basis point rise in yield; computed as modified duration times price times 0.0001.

Convexity adjustment

Second-order correction to duration-based price change: one half times convexity times the squared yield change, multiplied by the bond price.

Risk-neutral probability

In a binomial tree, p equals (e^(rT) minus d) over (u minus d); using it makes the discounted expected payoff equal the option price.

EWMA volatility

Variance forecast equal to a weighted average of the previous forecast and the latest squared return, with decay parameter lambda typically near 0.94.

Merton model

Model treating equity as a European call on firm assets with strike equal to debt face value; default occurs when asset value falls below debt.