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QUESTION 1

Which of the following best describes 'risk' in a financial context?

A. The certainty of losing money on an investment
B. The possibility of an outcome deviating from what was expected
C. The guaranteed return on a risk-free asset
D. The interest rate set by a central bank

Correct answer: B — The possibility of an outcome deviating from what was expected

Explanation: Risk is fundamentally about uncertainty — the chance that actual outcomes differ from expected ones, in either direction. A is wrong because risk is not a certainty. C describes the opposite (no risk). D is a monetary policy tool, not a definition of risk.

QUESTION 2

Market risk arises primarily from:

A. A borrower's inability to repay a loan
B. Failures in a firm's internal processes or systems
C. Adverse movements in market prices such as interest rates, equity prices, or exchange rates
D. A company losing customers due to negative publicity

Correct answer: C — Adverse movements in market prices such as interest rates, equity prices, or exchange rates

Explanation: Market risk stems from price movements in financial markets. A describes credit risk. B describes operational risk. D describes reputational risk.

QUESTION 3

Liquidity risk can be divided into which two broad categories?

A. Credit risk and market risk
B. Funding liquidity risk and trading (market) liquidity risk
C. Systematic risk and idiosyncratic risk
D. Operational risk and strategic risk

Correct answer: B — Funding liquidity risk and trading (market) liquidity risk

Explanation: Funding liquidity risk is the inability to raise cash to meet obligations; trading liquidity risk is the inability to sell an asset without significant price impact. The other options mix up different risk categories entirely.

QUESTION 4

Operational risk is caused by:

A. A fall in the value of a held portfolio due to rising yields
B. A counterparty defaulting on a swap agreement
C. Failures in people, processes, systems, or external events
D. A firm being unable to refinance maturing debt

Correct answer: C — Failures in people, processes, systems, or external events

Explanation: Operational risk is defined by its sources: human error, process failure, system outages, and external events. A is market risk, B is credit risk, D is funding liquidity risk.

QUESTION 5

Reputational risk refers to:

A. The risk of rising raw material costs
B. The potential loss in value arising from damage to a firm's standing or public image
C. The risk that a competitor launches a superior product
D. The risk of regulatory fines for capital inadequacy

Correct answer: B — The potential loss in value arising from damage to a firm's standing or public image

Explanation: Reputational risk is about the loss of trust from customers, investors, or the public. A and C are business/strategic risks. D is regulatory/compliance risk, though it may interact with reputational risk.

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QUESTION 6

Strategic risk is most closely associated with:

A. Day-to-day process errors in the back office
B. Large, long-term business decisions that may turn out to be wrong
C. A sudden drop in the value of foreign currency holdings
D. A hacker breaching the firm's IT security

Correct answer: B — Large, long-term business decisions that may turn out to be wrong

Explanation: Strategic risk involves the possibility that major strategic decisions — such as entering a new market or acquiring a company — prove to be incorrect. A and D are operational risk; C is market (FX) risk.

QUESTION 7

Which of the following is an example of basis risk?

A. A firm borrows in euros but earns revenue in dollars
B. A hedge using a futures contract does not perfectly offset the underlying exposure because the two prices do not move in lockstep
C. A bank's borrower files for bankruptcy
D. A technology system crashes during peak trading hours

Correct answer: B — A hedge using a futures contract does not perfectly offset the underlying exposure because the two prices do not move in lockstep

Explanation: Basis risk arises when a hedging instrument and the item being hedged do not move perfectly together, leaving a residual (basis) risk. A is currency risk, C is credit risk, D is operational risk.

QUESTION 8

Which risk type is most relevant when a firm cannot sell a large position in a thinly traded bond without moving the market against itself?

A. Credit risk
B. Operational risk
C. Trading liquidity risk
D. Strategic risk

Correct answer: C — Trading liquidity risk

Explanation: Trading (market) liquidity risk is the inability to exit a position at a fair price because of insufficient market depth. The other options involve different risk drivers.

QUESTION 9

The term 'counterparty risk' is most closely related to:

A. Market risk
B. Liquidity risk
C. Credit risk
D. Reputational risk

Correct answer: C — Credit risk

Explanation: Counterparty risk is a form of credit risk — specifically the risk that the other party in a financial contract (e.g., a derivative) will default before the contract is settled.

QUESTION 10

Which of the following statements about systematic risk is correct?

A. It can be fully eliminated through diversification
B. It affects only individual securities, not the broader market
C. It represents market-wide risk that cannot be diversified away
D. It is the same as operational risk

Correct answer: C — It represents market-wide risk that cannot be diversified away

Explanation: Systematic (undiversifiable) risk affects the entire market — e.g., recession, interest rate changes. Idiosyncratic (firm-specific) risk can be diversified away, but systematic risk cannot. A and B are incorrect; D is a completely different risk category.

QUESTION 11

Idiosyncratic risk is best described as:

A. Risk common to all assets in a market
B. Risk unique to a specific company or asset that can be reduced through diversification
C. The risk of a government defaulting on its bonds
D. The risk arising from changes in the overall level of interest rates

Correct answer: B — Risk unique to a specific company or asset that can be reduced through diversification

Explanation: Idiosyncratic (unsystematic) risk is firm-specific and can be eliminated by holding a well-diversified portfolio. A describes systematic risk. C is sovereign credit risk. D is interest rate risk.

QUESTION 12

Settlement risk is best described as:

A. The risk that a firm's management makes poor strategic decisions
B. The risk that one party in a transaction delivers but the counterparty fails to deliver its side
C. The risk that commodity prices fall sharply
D. The risk of a cyberattack on a payment system

Correct answer: B — The risk that one party in a transaction delivers but the counterparty fails to deliver its side

Explanation: Settlement risk (also called Herstatt risk) arises when one leg of a transaction is completed but the other is not, leaving one party exposed. C is commodity/market risk; D is operational risk; A is strategic risk.

QUESTION 13

Which of the following best characterises 'model risk'?

A. The risk that a financial model produces incorrect outputs due to flawed assumptions or errors
B. The risk that a trading model is copied by competitors
C. The risk that a regulator changes the capital model requirements
D. The risk of hardware failure in a pricing system

Correct answer: A — The risk that a financial model produces incorrect outputs due to flawed assumptions or errors

Explanation: Model risk arises when models used for pricing, valuation, or risk measurement are built on wrong assumptions, use bad data, or are applied in inappropriate contexts. B is intellectual property risk; C is regulatory risk; D is operational/IT risk.

QUESTION 14

A firm's exposure to natural disasters and pandemics is an example of:

A. Credit risk
B. Operational risk arising from external events
C. Strategic risk
D. Market risk

Correct answer: B — Operational risk arising from external events

Explanation: External event risk — such as natural disasters, pandemics, or terrorist attacks — falls under operational risk. These events affect a firm's operations without being caused by financial market movements (market risk) or counterparty actions (credit risk).

QUESTION 15

Which risk category is most relevant when a government changes tax laws affecting all businesses in an economy?

A. Idiosyncratic risk
B. Liquidity risk
C. Systemic/regulatory risk (a form of systematic risk)
D. Settlement risk

Correct answer: C — Systemic/regulatory risk (a form of systematic risk)

Explanation: Changes in tax law affect all firms and represent a form of regulatory or systematic risk. It cannot be diversified away because it applies market-wide. A (idiosyncratic) is firm-specific; B and D are different categories.

QUESTION 16

Funding liquidity risk is most likely to materialise when:

A. A firm's equity price drops sharply
B. A firm cannot roll over or obtain sufficient short-term financing to meet its obligations
C. A firm's hedging instrument gains in value
D. A firm's supplier goes bankrupt

Correct answer: B — A firm cannot roll over or obtain sufficient short-term financing to meet its obligations

Explanation: Funding liquidity risk is the inability to access cash or credit to meet obligations as they fall due — classic during bank runs or credit crunches. A is market risk; C is actually a positive outcome; D is supply chain / operational risk.

QUESTION 17

Prepayment risk on a mortgage-backed security is an example of which broader risk type?

A. Operational risk
B. Market risk (specifically interest rate / optionality risk)
C. Reputational risk
D. Sovereign risk

Correct answer: B — Market risk (specifically interest rate / optionality risk)

Explanation: Prepayment risk — borrowers repaying mortgages early when rates fall — is a form of market risk driven by interest rate movements and embedded options. The other choices are unrelated risk categories.

QUESTION 18

Which of the following is an example of legal risk?

A. A lawsuit arising from a contract dispute that was not anticipated at deal inception
B. A decline in the credit rating of a corporate bond issuer
C. A sudden depreciation of the domestic currency
D. Failure of a server during a high-volume trading session

Correct answer: A — A lawsuit arising from a contract dispute that was not anticipated at deal inception

Explanation: Legal risk is the risk of loss from legal proceedings, unenforceability of contracts, or regulatory penalties. B is credit risk, C is FX/market risk, D is operational risk.

QUESTION 19

Sovereign risk refers to:

A. The risk that a corporation's largest shareholder sells its stake
B. The risk that a national government defaults on its debt or changes rules affecting foreign investors
C. The risk of commodity price volatility affecting a manufacturing firm
D. The risk of a firm's employee committing fraud

Correct answer: B — The risk that a national government defaults on its debt or changes rules affecting foreign investors

Explanation: Sovereign risk involves the possibility that a government entity fails to meet its financial obligations or takes actions (e.g., capital controls, expropriation) that harm investors. The other options describe equity, commodity, and operational risks.

QUESTION 20

Which statement about the relationship between risk and return is most accurate?

A. Higher risk always leads to higher actual returns
B. Investors should demand higher expected returns as compensation for bearing higher risk
C. Risk and return are completely unrelated in efficient markets
D. Risk-free assets always generate the highest returns

Correct answer: B — Investors should demand higher expected returns as compensation for bearing higher risk

Explanation: The fundamental principle is that rational investors require higher expected (not guaranteed) returns for bearing greater risk. A confuses expected with actual returns. C contradicts the risk-return tradeoff. D is incorrect — risk-free assets have the lowest expected returns.

QUESTION 21

The term 'tail risk' refers to:

A. The risk of small, frequent losses
B. The risk of extreme outcomes that occur in the tails of a probability distribution
C. The risk that the final instalment of a loan is not repaid
D. The risk at the end of a product's life cycle

Correct answer: B — The risk of extreme outcomes that occur in the tails of a probability distribution

Explanation: Tail risk refers to the low-probability, high-severity events at the extremes of a return distribution. Managing tail risk is critical because normal distribution assumptions often underestimate these events. A and D are incorrect; C is a credit risk variant.

QUESTION 22

Which of the following best describes 'rollover risk'?

A. The risk that a physically settled futures contract leads to commodity delivery
B. The risk that a borrower cannot refinance maturing debt on acceptable terms
C. The risk that a portfolio manager misreads a market trend
D. The risk of changes in the slope of the yield curve

Correct answer: B — The risk that a borrower cannot refinance maturing debt on acceptable terms

Explanation: Rollover risk (a type of funding liquidity risk) is the danger that when short-term debt matures, it cannot be refinanced — either at all or only at prohibitively high rates. A is a futures mechanics issue, C is a judgment/strategy issue, D is yield curve risk.

QUESTION 23

Which of the following best describes 'concentration risk'?

A. The risk of holding too many different types of assets
B. The risk of being overexposed to a single borrower, sector, region, or asset class
C. The risk of a portfolio being too diversified to outperform benchmarks
D. The risk of a merger creating operational inefficiencies

Correct answer: B — The risk of being overexposed to a single borrower, sector, region, or asset class

Explanation: Concentration risk arises from lack of diversification — excessive exposure to one entity, sector, or geography. The others misrepresent the concept; over-diversification is not typically classified as a risk, and merger issues relate to operational/strategic risk.

QUESTION 24

A bank that relies heavily on short-term wholesale funding to support long-term assets is most exposed to:

A. Reputational risk
B. Model risk
C. Funding liquidity and maturity mismatch risk
D. Credit concentration risk

Correct answer: C — Funding liquidity and maturity mismatch risk

Explanation: Funding long-term assets with short-term liabilities creates a maturity mismatch. If wholesale markets freeze, the bank cannot roll over funding — the core of the 2008 crisis for many institutions. The other options are different risk types.

QUESTION 25

Which of the following distinguishes market risk from credit risk?

A. Market risk is driven by counterparty behaviour; credit risk is driven by price movements
B. Market risk arises from price changes in financial markets; credit risk arises from failure to pay obligations
C. Market risk only applies to equity; credit risk only applies to bonds
D. Market risk can be hedged; credit risk cannot

Correct answer: B — Market risk arises from price changes in financial markets; credit risk arises from failure to pay obligations

Explanation: Market risk = price/rate movements; credit risk = default or deterioration in counterparty creditworthiness. A reverses the definitions. C is too narrow — market risk applies to rates, FX, commodities, etc. D is incorrect — credit risk can also be hedged via credit derivatives.

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