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FRM Part I study materials
FRM Part I study resources

FRM Part I practice questions

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Question 1Foundations of Risk Management

Which statement best captures the distinction between risk and uncertainty as used in risk management?

  1. Uncertainty is measurable, whereas risk by definition cannot be quantified.
  2. Risk applies only to losses already realized, while uncertainty applies only to future events.
  3. Risk is measurable uncertainty, whereas uncertainty involves outcomes whose probabilities cannot be quantified. Correct answer.
  4. Risk and uncertainty both require known probability distributions, so the two terms are interchangeable.

Explanation

The classic distinction treats risk as exposure to outcomes whose probabilities can be estimated, while uncertainty covers outcomes that cannot be assigned reliable probabilities. Risk management therefore focuses on quantifying and pricing measurable exposures.

Question 2Foundations of Risk Management

A bank lends to a corporate borrower and faces potential loss if the borrower defaults. This exposure is classified as:

  1. Operational risk
  2. Credit risk Correct answer.
  3. Market risk
  4. Liquidity risk

Explanation

Credit risk is the risk of loss because a counterparty or obligor fails to meet its contractual obligations. Default by a borrower is the textbook credit risk event.

Question 3Foundations of Risk Management

The Sharpe ratio measures performance as:

  1. Total return per unit of standard deviation
  2. Excess return per unit of systematic risk
  3. Excess return per unit of total risk Correct answer.
  4. Excess return per unit of tracking error

Explanation

The Sharpe ratio divides the portfolio's return in excess of the risk-free rate by the standard deviation of its returns, so it prices total variability rather than only the systematic component.

Question 4Foundations of Risk Management

In the capital asset pricing model, beta of an individual security represents:

  1. The risk-free rate plus the market risk premium
  2. The sensitivity of the security's returns to returns on the market portfolio Correct answer.
  3. The share of the security's variance that is diversifiable
  4. The security's standard deviation divided by the market's standard deviation

Explanation

Beta measures how much a security's returns co-move with the market portfolio, scaled by market variance. It captures only the systematic risk that cannot be diversified away.

Question 5Foundations of Risk Management

Value at risk at a given confidence level and horizon is best defined as:

  1. The maximum loss the portfolio could ever experience
  2. The average loss in the worst one percent of outcomes
  3. The loss threshold expected to be exceeded with probability equal to one minus the confidence level Correct answer.
  4. The loss realized on the worst historical day in the sample

Explanation

VaR is a quantile of the loss distribution: at confidence level c, losses exceed VaR with probability 1 − c over the stated horizon. It is a threshold, not a worst case.

Question 6Foundations of Risk Management

Which statement best describes enterprise risk management?

  1. It transfers all risks to insurers and counterparties.
  2. It manages risks on a firmwide, integrated basis and aggregates them at the level of the whole enterprise. Correct answer.
  3. It confines risk oversight to hedging market exposures with derivatives.
  4. It removes the need for a formal risk appetite statement.

Explanation

ERM takes a portfolio view, aggregating risks across business lines so that correlations and concentrations are visible to senior management and the board. It complements rather than replaces hedging or insurance.

Question 7Foundations of Risk Management

Which of the following is a core principle of the GARP Code of Conduct?

  1. Members may trade on confidential client information provided the trades are subsequently reported.
  2. Members need only comply with local law, regardless of professional standards.
  3. Members must act with integrity and put client interests and the profession's integrity first. Correct answer.
  4. Members must place the interests of their employer ahead of those of their clients at all times.

Explanation

The code requires integrity, competence, and the primacy of client interests and the profession's reputation over personal gain. Legal compliance is a floor, not a substitute for ethical conduct.

Question 8Foundations of Risk Management

Under the Basel definition, operational risk is the risk of loss arising from:

  1. A counterparty failing to meet its obligations
  2. Inability to meet obligations as they come due
  3. Inadequate or failed internal processes, people, and systems, or external events Correct answer.
  4. Adverse movements in market prices and rates

Explanation

The Basel definition covers process, people, and systems failures plus external events, and explicitly includes legal risk while excluding strategic and reputational risk.

Question 9Foundations of Risk Management

The risk-free rate is 4%, the expected market return is 10%, and a stock has a beta of 1.3. According to the CAPM, the stock's expected return is closest to:

  1. 7.8%
  2. 11.8% Correct answer.
  3. 12.4%
  4. 13.0%

Explanation

The security market line gives E(R) = Rf + beta x (E(Rm) − Rf) = 4% + 1.3 x 6% = 11.8%. The market risk premium is scaled by beta, not applied in full.

Question 10Foundations of Risk Management

A portfolio returned 14% over the year. The risk-free rate was 3%, the market return was 11%, and the portfolio's beta is 1.2. Jensen's alpha is closest to:

  1. 2.6%
  2. 1.4% Correct answer.
  3. −1.4%
  4. 3.0%

Explanation

Alpha is the return in excess of the CAPM prediction: required return = 3% + 1.2 x (11% − 3%) = 12.6%, so alpha = 14% − 12.6% = 1.4%. Positive alpha indicates outperformance after adjusting for systematic risk.

Question 11Foundations of Risk Management

A portfolio is one component added to a large, already well-diversified fund, so only its contribution to the fund's systematic risk matters. The most appropriate risk-adjusted performance measure is one based on:

  1. Total risk, as in the Sharpe ratio
  2. Systematic risk, as in the Treynor ratio Correct answer.
  3. Downside deviation, as in the Sortino ratio
  4. Tracking error, as in the information ratio

Explanation

When a portfolio is held inside a diversified fund, its unsystematic risk is eliminated at the fund level, so performance should be judged against beta. Treynor and Jensen's alpha use systematic risk for exactly this reason.

Question 12Foundations of Risk Management

Which statement about the arbitrage pricing theory is accurate?

  1. It identifies the exact set of macroeconomic factors that price every asset.
  2. It relies on the absence of arbitrage and permits multiple unspecified systematic factors. Correct answer.
  3. It assumes all investors optimize a mean-variance objective.
  4. It requires asset returns to be normally distributed.

Explanation

APT derives a linear factor structure from no-arbitrage conditions rather than from utility maximization, and it leaves the identity and number of factors to empirical work. Normality is not required.

Question 13Foundations of Risk Management

A portfolio returned 12% while its benchmark returned 10%, and the standard deviation of the active return was 5%. The information ratio is closest to:

  1. 2.50
  2. 0.40 Correct answer.
  3. 0.04
  4. 0.20

Explanation

The information ratio equals active return divided by tracking error: (12% − 10%) / 5% = 0.40. It measures how much excess return is earned per unit of active risk.

Question 14Foundations of Risk Management

Which statement best defines an organization's risk appetite?

  1. The maximum loss the firm could absorb before insolvency
  2. The amount and type of risk the firm is willing to accept in pursuing its objectives Correct answer.
  3. The total economic capital the firm has raised from shareholders
  4. The range of outcomes the firm regards as acceptable variation around its targets

Explanation

Risk appetite is the quantum of risk the board is willing to accept in pursuit of strategy, expressed in qualitative and quantitative terms. It differs from risk capacity, which is the maximum risk the firm could bear.

Question 15Foundations of Risk Management

The near-collapse of Long-Term Capital Management is most often cited as evidence of which risk management failure?

  1. A rogue trader hid unauthorized futures positions in a secret account.
  2. The fund held no positions in developed government bond markets.
  3. Regulators revoked its banking licence after a money-laundering investigation.
  4. Heavy leverage on concentrated convergence trades left it unable to meet margin calls when spreads diverged. Correct answer.

Explanation

LTCM's positions were large relative to market liquidity and financed with extreme leverage, so a divergence of spreads triggered margin calls it could not fund. The episode illustrates liquidity, leverage, and concentration risk interacting.

Question 16Foundations of Risk Management

The collapse of Barings Bank is most commonly cited as evidence of which control failure?

  1. Absence of a documented risk appetite statement
  2. Failure to separate trading from settlement and reporting duties Correct answer.
  3. Failure to hedge interest-rate exposure on government bonds
  4. Inadequate capital relative to the size of its loan book

Explanation

The trader responsible for the losses also controlled the back office, letting him book losses in a suspense account that went undetected. Segregation of front, back, and reporting functions is the standard safeguard against this.

Question 17Foundations of Risk Management

Model risk is best described as the risk of loss from:

  1. Decisions based on inaccurate or misapplied model outputs Correct answer.
  2. Hardware failure that prevents a model from running
  3. Unavailability of historical data for backtesting
  4. A competitor replicating the firm's proprietary pricing model

Explanation

Model risk arises from errors in model design, implementation, calibration, or use, and grows with reliance on models for valuation and decisions. Validation, backtesting, and independent review are the standard mitigants.

Question 18Foundations of Risk Management

Compared with VaR at a 99% confidence level, scenario stress testing is better suited to:

  1. Providing a single probabilistic summary of portfolio risk
  2. Quantifying losses under severe but plausible events beyond the historical distribution Correct answer.
  3. Replacing the backtesting of internal models
  4. Estimating expected returns for capital budgeting

Explanation

Stress tests impose extreme but plausible shocks to identify loss magnitudes that a daily VaR at 99% would largely ignore. They complement VaR by exploring tail scenarios and non-linear exposures.

Question 19Foundations of Risk Management

Which situation best illustrates an agency problem in a financial firm's risk taking?

  1. The risk committee reviews limits quarterly and reports to the board.
  2. The bank sets aside capital to cover unexpected losses.
  3. The firm hedges its currency exposure with forward contracts.
  4. A trader paid on annual reported profit takes large tail risks that pay off in most years. Correct answer.

Explanation

Agency problems arise when an employee's incentives diverge from the owners' interests, here through compensation that rewards short-run reported profit while tail losses fall on shareholders. Deferred equity, clawbacks, and risk-adjusted bonuses are typical mitigants.

Question 20Foundations of Risk Management

The slope of the security market line equals:

  1. The market risk premium, E(Rm) − Rf Correct answer.
  2. The standard deviation of market returns
  3. The risk-free rate of interest
  4. The beta of the market portfolio

Explanation

The security market line plots expected return against beta; its intercept is the risk-free rate and its slope is the excess return on the market. A steeper slope means investors demand more compensation per unit of systematic risk.

Question 21Foundations of Risk Management

Portfolio A has an expected return of 15% and a beta of 1.5; Portfolio B has an expected return of 11% and a beta of 0.8. The risk-free rate is 3% and the market return is 9%. Using the Treynor ratio, which portfolio performed better and why?

  1. A, because its raw return is 4 percentage points higher
  2. B, with a Treynor ratio of 0.10 versus 0.08 for A Correct answer.
  3. B, with a Treynor ratio of 0.13 versus 0.10 for A
  4. A, with a Treynor ratio of 0.08 versus 0.06 for B

Explanation

Treynor divides excess return by beta: A gives (15% − 3%) / 1.5 = 0.08 and B gives (11% − 3%) / 0.8 = 0.10. B earns more excess return per unit of systematic risk despite the lower raw return.

Question 22Foundations of Risk Management

Which statement about the limitations of VaR is most accurate?

  1. VaR equals the average loss in the tail of the distribution.
  2. VaR is subadditive for every return distribution, so diversification benefits are always captured.
  3. A 99% VaR guarantees no loss can exceed the threshold.
  4. It ignores loss severity beyond the threshold and can fail subadditivity for non-elliptical distributions. Correct answer.

Explanation

VaR is a quantile and says nothing about how large losses are once the threshold is breached; for non-elliptical distributions it may also violate subadditivity. These gaps motivate expected shortfall and tail-risk measures.

Question 23Foundations of Risk Management

Which factor makes the CAPM most difficult to test empirically?

  1. The risk-free rate does not exist in any economy.
  2. The true market portfolio of all risky assets is unobservable, so tests must use proxies. Correct answer.
  3. The model assumes investors prefer lower returns for identical risk.
  4. Beta cannot be estimated from historical returns.

Explanation

The market portfolio should contain every risky asset, including human capital and private holdings, which cannot be observed. Tests therefore rely on equity indices as proxies, introducing measurement error into both beta and the market premium.

Question 24Foundations of Risk Management

A bank funds long-dated illiquid loans with short-term wholesale deposits. Depositors suddenly withdraw, forcing the bank to sell loans at deep discounts. Which description is most accurate?

  1. This is market risk, because asset prices moved during the episode.
  2. This illustrates a failure of diversification within the loan book.
  3. This is an operational risk event caused by a failed internal process.
  4. A funding liquidity shock transmitted into market liquidity risk through fire sales. Correct answer.

Explanation

The inability to roll over short-term funding is funding liquidity risk, which becomes market liquidity risk when forced sales depress prices. The maturity mismatch converts a liability-side shock into realized asset-side losses.

Question 25Foundations of Risk Management

Which statement best describes risk budgeting within an enterprise risk management framework?

  1. It assigns every business unit an identical risk limit regardless of strategy.
  2. It allocates the firm's risk capacity across business units using measures such as economic capital. Correct answer.
  3. It sets the annual accounting budget for the risk control department.
  4. It replaces limit setting with a single firmwide VaR number.

Explanation

Risk budgeting decomposes aggregate risk appetite into allocated limits per business unit or strategy, usually in economic capital or VaR terms. It links capital consumption to expected return and supports risk-adjusted performance measurement.

Question 26Foundations of Risk Management

Which type of risk refers to the potential for loss when a counterparty fails to make a promised payment or otherwise honor a contractual obligation?

  1. Operational risk
  2. Liquidity risk
  3. Credit risk Correct answer.
  4. Market risk

Explanation

Credit risk arises from the possibility that a borrower or counterparty defaults or deteriorates in credit quality, so the promised cash flows are not received in full or on time. It applies to loans, bonds, derivatives receivables and any other contractual claim.

Question 27Foundations of Risk Management

Which component of a single stock's total risk can be reduced to near zero by holding a large, well-diversified portfolio?

  1. Unsystematic risk Correct answer.
  2. Interest rate risk
  3. Market risk
  4. Systematic risk

Explanation

Unsystematic (firm-specific) risk reflects events peculiar to one company or industry, and the offsetting effects of many such independent exposures drive it toward zero as holdings increase. What remains is systematic risk, which is common to all securities and cannot be diversified away.

Question 28Foundations of Risk Management

A portfolio earned 13% over the year with a standard deviation of 16%, and the risk-free rate was 5%. What is the portfolio's Sharpe ratio, rounded to two decimals?

  1. 0.50 Correct answer.
  2. 1.13
  3. 0.81
  4. 0.19

Explanation

The Sharpe ratio equals the excess return over the risk-free rate divided by the standard deviation of returns: (13% - 5%) / 16% = 0.50. It measures reward per unit of total risk taken.

Question 29Foundations of Risk Management

If the covariance between a stock's returns and the market portfolio's returns equals the variance of the market portfolio, the stock's beta is:

  1. 1.0 Correct answer.
  2. 0.0
  3. 0.5
  4. 2.0

Explanation

Beta is defined as the covariance of the asset with the market divided by the variance of the market, so when the two quantities are equal the ratio is one. A beta of one means the asset carries average market sensitivity.

Question 30Foundations of Risk Management

In the three lines of defense model of risk governance, which party provides independent assurance to the board on how well risk management and controls are working?

  1. The risk management function
  2. Business line management
  3. The external regulator
  4. Internal audit Correct answer.

Explanation

The first line is the business, which owns and manages risk day to day; the second line is the risk and compliance function, which sets frameworks and monitors; the third line is internal audit, which independently assures the board. Independence from the risk-taking activities is what makes the third line effective.

Question 31Foundations of Risk Management

A risk register is best described as:

  1. a record of the firm's historical loss events only
  2. a schedule of regulatory capital charges by business unit
  3. a hierarchy of trading limits approved by the board
  4. a structured inventory of identified risks with owners, assessments and mitigation actions Correct answer.

Explanation

A risk register is the central tool that documents each identified risk, assigns an accountable owner, records likelihood and impact assessments, and tracks the mitigation or control actions. It is a live management document rather than a static list.

Question 32Foundations of Risk Management

Which performance measure divides a portfolio's excess return by its beta?

  1. Sortino ratio
  2. Treynor ratio Correct answer.
  3. Information ratio
  4. Sharpe ratio

Explanation

The Treynor ratio uses beta, a measure of systematic risk, in the denominator, which makes it suited to portfolios held inside a diversified fund. The Sharpe ratio uses total standard deviation and the Sortino ratio uses downside deviation.

Question 33Foundations of Risk Management

In mean-variance portfolio theory, the efficient frontier is:

  1. every feasible portfolio, including those that offer an inferior risk-return tradeoff
  2. the set with the lowest variance regardless of the expected return offered
  3. the single portfolio holding the highest-return asset available
  4. the highest expected return attainable for each level of risk Correct answer.

Explanation

The efficient frontier contains the portfolios that dominate all others: for any given level of risk it offers the maximum expected return, and for any given return it offers the minimum risk. Portfolios below the frontier are inefficient because a better combination exists.

Question 34Foundations of Risk Management

A stock plots above the security market line. Which interpretation is most appropriate?

  1. It earns less than CAPM requires for its beta, so it appears overpriced.
  2. It has a beta above 1.0 and therefore earns more than the market.
  3. It earns more than CAPM requires for its beta, so it appears underpriced. Correct answer.
  4. It lies on the efficient frontier and must be held by every investor.

Explanation

The security market line gives the return CAPM requires for a given beta; a point above the line means the expected return exceeds that requirement, producing a positive alpha. Investors would bid for such an asset until its price rises and the expected return falls back to the line.

Question 35Foundations of Risk Management

The Fama-French three-factor model extends the market factor with which two additional factors?

  1. momentum and liquidity
  2. inflation surprises and industrial production growth
  3. default premium and term premium
  4. size and book-to-market value Correct answer.

Explanation

Fama and French added a size factor (small-cap minus large-cap returns, SMB) and a value factor (high minus low book-to-market, HML) to the market excess return. These factors capture return patterns that the single-factor CAPM leaves unexplained.

Question 36Foundations of Risk Management

Which statement best describes expected shortfall at the 95% confidence level?

  1. The 5% probability loss scaled up by the portfolio's volatility.
  2. The average loss in the worst 5% of outcomes. Correct answer.
  3. The maximum loss the portfolio can suffer on 95% of trading days.
  4. The loss that is exceeded on exactly 5% of trading days.

Explanation

Expected shortfall is a conditional average: it measures the mean loss given that the loss is in the tail beyond the confidence level, here the worst 5% of outcomes. Unlike VaR it describes the size of losses beyond the threshold, which is why it is a coherent risk measure.

Question 37Foundations of Risk Management

A bank backtests a 99% one-day VaR over 250 trading days and records 12 exceptions. Which conclusion is most appropriate?

  1. This is consistent with a well-calibrated model, since 12 is close to the 2.5 exceptions expected.
  2. The model is too conservative, since it predicted more exceptions than were observed.
  3. The result is inconclusive because VaR backtests require at least 1,000 observations.
  4. The model appears to underestimate risk, because 12 exceptions greatly exceeds the expected 2.5. Correct answer.

Explanation

At 99% over 250 days, a correctly calibrated model should generate about 1% of observations, or 2.5 exceptions. Twelve exceptions imply a loss frequency near 4.8%, so the model understates the risk it is meant to capture and would be rejected in standard tests.

Question 38Foundations of Risk Management

Under Basel III, the minimum Common Equity Tier 1 capital ratio, before any capital buffers, is:

  1. 2.0%
  2. 6.0%
  3. 8.0%
  4. 4.5% Correct answer.

Explanation

Basel III sets a 4.5% minimum for Common Equity Tier 1 relative to risk-weighted assets, with Tier 1 capital at 6.0% and total capital at 8.0%. The capital conservation and countercyclical buffers are added on top of these minimums.

Question 39Foundations of Risk Management

The Liquidity Coverage Ratio requires a bank to hold:

  1. capital equal to the undrawn portion of committed credit lines
  2. stable funding matched to the maturity of its assets over one year
  3. high-quality liquid assets covering 30-day stressed net outflows Correct answer.
  4. cash reserves equal to 100% of its demand deposits

Explanation

The LCR is a short-horizon stress metric: the stock of unencumbered high-quality liquid assets must at least equal net cash outflows estimated under a 30-day stress scenario. It targets the run-off risk of wholesale and retail funding.

Question 40Foundations of Risk Management

Which activity is the board of directors' most appropriate role in a firm's risk management framework?

  1. Approving individual trades that exceed a desk-level limit
  2. Calculating and reporting the firm's daily VaR
  3. Auditing the accuracy of the firm's financial statements
  4. Setting risk appetite and overseeing management's adherence to it Correct answer.

Explanation

The board sets the tone at the top by defining risk appetite and the governance structure, then monitors whether senior management keeps risk within those boundaries. Transaction-level decisions and measurement work are delegated to management and control functions.

Question 41Foundations of Risk Management

A stress-testing programme at a bank should be designed primarily to:

  1. replace VaR, which becomes unreliable in stressed markets
  2. produce a probability-weighted estimate of next year's expected loss
  3. test the effect of severe but plausible scenarios on capital Correct answer.
  4. calibrate trading limits to volatility observed in normal markets

Explanation

Stress tests apply coherent, severe but plausible scenarios, such as a sharp rate shock or a funding freeze, and trace their effect on earnings, liquidity and capital. They complement probabilistic measures by exposing vulnerabilities to events that historical data may not contain.

Question 42Foundations of Risk Management

Two assets have returns with a correlation of exactly +1.0. Combining them into a portfolio:

  1. eliminates all unsystematic risk if the weights are equal
  2. produces a zero-variance portfolio when short selling is permitted
  3. reduces variance below the weighted average of the individual variances
  4. yields no diversification benefit relative to the weighted average risk Correct answer.

Explanation

With perfect positive correlation the portfolio standard deviation equals the weighted average of the components' standard deviations, so risk falls only through the averaging of weights, not through offsetting movements. Diversification benefit requires correlation below +1.

Question 43Foundations of Risk Management

Which assumption underlies the capital asset pricing model?

  1. Borrowing at the risk-free rate is restricted to institutional investors
  2. Transaction costs and taxes differ across investor classes
  3. Investors care about skewness and kurtosis as well as mean and variance
  4. All investors have identical expectations about asset returns Correct answer.

Explanation

CAPM assumes homogeneous expectations, so every investor uses the same expected returns, variances and covariances and therefore holds the same risky portfolio. Combined with unlimited risk-free borrowing and lending, this generates the capital market line and the beta-pricing relation.

Question 44Foundations of Risk Management

A loan has a 3% probability of default and a 40% loss given default. What is the expected loss as a percentage of the exposure?

  1. 4.3%
  2. 1.2% Correct answer.
  3. 3.0%
  4. 0.4%

Explanation

Expected loss equals probability of default multiplied by loss given default, here 3% × 40% = 1.2% of exposure. Loss given default already incorporates the recovery rate, so no further adjustment is needed.

Question 45Foundations of Risk Management

A business unit generates $18 million of profit after all costs and absorbs $120 million of economic capital. Under a RAROC framework, its risk-adjusted return on capital is:

  1. 15.0% Correct answer.
  2. 18.0%
  3. 6.7%
  4. 12.0%

Explanation

RAROC divides risk-adjusted profit by the economic capital required to support the activity: $18m / $120m = 15%. Comparing this figure with a hurdle rate tells management whether the activity creates value after charging for the risk it consumes.

Question 46Foundations of Risk Management

For which situation is the Sharpe ratio the most appropriate performance measure?

  1. Assessing a portfolio whose returns are highly skewed with fat tails
  2. Ranking managers of sub-portfolios inside a large diversified fund
  3. Evaluating a portfolio that is the investor's entire wealth Correct answer.
  4. Comparing funds with identical total volatility but different betas

Explanation

The Sharpe ratio charges the portfolio for its total risk, so it fits when the portfolio is the investor's whole holding and no diversification outside it exists. When a portfolio is one slice of a diversified fund, only systematic risk is relevant and a beta-based measure is preferred.

Question 47Foundations of Risk Management

An investor borrows at the risk-free rate and doubles the size of an investment in the market portfolio. How does the Sharpe ratio of this leveraged position compare with that of the unlevered market portfolio?

  1. It is doubled because both expected return and beta double
  2. Unchanged: excess return and volatility scale in equal proportion Correct answer.
  3. It rises, but less than proportionally, as borrowing costs increase
  4. It is halved because leverage doubles total risk

Explanation

Leverage at the risk-free rate moves the position along the capital market line, multiplying both the excess return and the standard deviation by the same factor. Their ratio, the Sharpe ratio, is therefore unchanged, which is why every point on the capital market line has the same reward-to-risk ratio.

Question 48Foundations of Risk Management

In the Basel market risk backtesting framework, a bank reports 6 exceptions in 250 trading days against a 99% VaR. The bank is placed in:

  1. the red zone, requiring supervisory action
  2. the green zone, since exceptions below 10 are acceptable
  3. the yellow zone, with an increased capital multiplier Correct answer.
  4. the green zone, with no capital add-on

Explanation

The Basel traffic-light approach classifies 0 to 4 exceptions as green, 5 to 9 as yellow and 10 or more as red. Six exceptions fall in the yellow zone, which triggers a higher multiplication factor applied to the VaR-based capital charge.

Question 49Foundations of Risk Management

Two divisions of a firm have standalone 99% one-year VaRs of $60 million and $80 million. The VaR of the combined portfolio is $110 million. What is the diversification benefit?

  1. $30 million Correct answer.
  2. $140 million
  3. $110 million
  4. $20 million

Explanation

If the risks were perfectly additive the firm would need $140 million of capital, but imperfect correlation means only $110 million is required. The diversification benefit is the difference, $140 million minus $110 million, equal to $30 million.

Question 50Foundations of Risk Management

The countercyclical capital buffer under Basel III is designed primarily to:

  1. ensure sufficient liquid assets to survive a 30-day run
  2. limit a bank's leverage to a fixed multiple of Tier 1 capital
  3. build capital in good times so it can be released during a downturn Correct answer.
  4. require banks to hold a fixed minimum of CET1 at all times

Explanation

The countercyclical buffer is set by national authorities and rises when credit growth signals overheating, then is released in a downturn. This macroprudential tool dampens procyclicality by restraining lending in booms and absorbing losses in stress.