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Free FRM Financial Markets and Products Practice Questions & Answers
400 exam-style Financial Markets and Products questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 1
What is the primary distinction between retail banking and investment banking?
Select an option first.
Correct answer: B — Retail banks accept deposits and make loans to consumers and businesses; investment banks underwrite securities and advise on corporate transactions
Explanation: B is correct: retail (commercial) banking involves taking deposits from savers and extending credit to borrowers, profiting from the spread between lending and deposit rates. Investment banking assists corporations in raising capital through equity and debt issuance and provides advisory services for mergers and acquisitions. A is wrong — the descriptions are reversed. C is wrong — their functions are materially different. D is wrong — both can operate globally.
Question 2
Which type of bank risk arises when a bank's assets reprice at different times or rates than its liabilities?
Select an option first.
Correct answer: C — Interest rate risk (specifically repricing risk)
Explanation: C is correct: repricing risk (a form of interest rate risk) occurs when a bank's assets and liabilities mature or reprice at different times. For example, a bank that funds long-term fixed-rate mortgages with short-term deposits faces repricing risk when short-term rates rise. A is wrong — credit risk concerns borrower default. B is wrong — liquidity risk concerns the ability to meet cash obligations. D is wrong — operational risk concerns systems, processes and people failures.
Question 3
A bank's net interest margin (NIM) is calculated as:
Select an option first.
Correct answer: B — (Interest income − interest expense) / average earning assets
Explanation: B is correct: NIM = (interest income − interest expense) / average earning assets. It measures how efficiently a bank uses its interest-earning assets to generate profit from the spread between borrowing and lending rates. A is wrong — operating expenses are excluded from the NIM numerator. C is wrong — the denominator should be earning assets, not liabilities. D is wrong — that is return on equity.
Question 4
Under Basel III, Tier 1 capital primarily consists of:
Select an option first.
Correct answer: B — Common equity (paid-up shares and retained earnings) and additional Tier 1 instruments
Explanation: B is correct: Tier 1 capital is the highest quality regulatory capital and consists of Common Equity Tier 1 (CET1 — ordinary shares, retained earnings, other comprehensive income) and Additional Tier 1 instruments (contingent convertible bonds). A is wrong — subordinated debt is Tier 2 capital. C is wrong — central bank borrowings are not regulatory capital. D is wrong — loan loss reserves and DTAs have limited inclusion.
Question 5
The Basel III minimum Common Equity Tier 1 (CET1) ratio requirement is:
Select an option first.
Correct answer: B — 4.5% of risk-weighted assets (plus a conservation buffer of 2.5%)
Explanation: B is correct: Basel III requires CET1 of at least 4.5% of risk-weighted assets. Combined with the capital conservation buffer of 2.5%, banks must maintain at least 7% CET1 ratio to avoid restrictions on dividends and bonuses. A is wrong — 2% is too low. C is wrong — 8% is the total capital requirement (Tier 1 + Tier 2). D is wrong — Basel uses risk-weighted assets, not total assets.
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Question 6
What is the purpose of the leverage ratio under Basel III?
Select an option first.
Correct answer: B — To provide a non-risk-based backstop measure of capital adequacy, calculated as Tier 1 capital divided by total exposure
Explanation: B is correct: the leverage ratio is a simple, non-risk-based measure — Tier 1 capital divided by total exposures (on and off-balance sheet). The Basel III minimum is 3%. It acts as a backstop to prevent excessive leverage regardless of risk weights. A is wrong — profitability is measured by ROE, ROA etc. C is wrong — liquidity is measured by LCR and NSFR. D is wrong — provisioning is determined by expected credit loss models.
Question 7
The Liquidity Coverage Ratio (LCR) under Basel III requires banks to hold:
Select an option first.
Correct answer: A — High-quality liquid assets (HQLA) sufficient to cover net cash outflows for 30 days under a stress scenario
Explanation: A is correct: the LCR requires banks to maintain a stock of HQLA equal to or greater than 100% of their total net cash outflows over the next 30 calendar days under a severe stress scenario. A is correct. B is wrong — the ratio is based on net outflows under stress, not 10% of deposits. C is wrong — the LCR relates to liquidity, not capital. D is wrong — it is based on net outflows, not all liabilities.
Question 8
The Net Stable Funding Ratio (NSFR) measures:
Select an option first.
Correct answer: A — The ratio of available stable funding to required stable funding over a one-year horizon
Explanation: A is correct: the NSFR = available stable funding (ASF) / required stable funding (RSF) ≥ 100%. It promotes medium-to-long-term resilience by ensuring banks fund their activities with sufficiently stable sources over a one-year period. B is wrong — that is a different liquidity measure. C is wrong — NSFR is about structural funding, not short-term capacity. D is wrong — NSFR is not a capital ratio.
Question 9
Deposit insurance creates a moral hazard problem because:
Select an option first.
Correct answer: B — Depositors have less incentive to monitor bank risk-taking since their deposits are protected, encouraging banks to take excessive risks
Explanation: B is correct: deposit insurance protects depositors from losses, so they have little incentive to monitor or discipline their bank's risk-taking. Banks may therefore take on excessive risk, knowing that depositors will not withdraw funds in response to riskier strategies — this is the moral hazard problem. A is wrong — deposit insurance can reduce funding costs but does not directly reduce profits. C is wrong — deposit insurance tends to reduce deposit costs (through greater depositor confidence). D is wrong — bank failures still occur even with deposit insurance.
Question 10
In a repurchase agreement (repo), the seller of securities agrees to:
Select an option first.
Correct answer: B — Sell securities to a buyer and simultaneously agree to repurchase them at a specified future date and price
Explanation: B is correct: a repo is a secured borrowing. The seller (borrower of cash) sells securities and simultaneously agrees to buy them back at a predetermined price and date. The difference between the sale price and the repurchase price represents the interest (repo rate). A is wrong — the repurchase is obligatory under the agreement. C is wrong — repos are collateralised borrowing with a firm obligation to repay. D is wrong — the seller retains the right (and obligation) to repurchase.
Question 11
The repo rate in a repurchase agreement represents:
Select an option first.
Correct answer: B — The annualised interest cost of the cash borrowing over the repo term
Explanation: B is correct: the repo rate is the implicit interest rate charged on the cash lent, calculated from the difference between the selling price and the repurchase price, annualised over the term of the repo. A is wrong — dividends are a separate cash flow from the security. C is wrong — the haircut is a risk adjustment to collateral value. D is wrong — margin calls are triggered by collateral value changes.
Question 12
A haircut in a repo transaction refers to:
Select an option first.
Correct answer: B — The percentage reduction applied to the market value of collateral to determine the maximum loan amount
Explanation: B is correct: the haircut is the difference between the market value of the collateral and the loan amount. For example, a 5% haircut means a bond worth $100 supports only $95 of borrowing. It provides a cushion for the lender against falls in collateral value. A is wrong — there is no specific 'penalty haircut'. C is wrong — repos do not have management fees. D is wrong — that is the bid-ask spread.
Question 13
Federal funds are:
Select an option first.
Correct answer: B — Reserve balances that US commercial banks lend to each other overnight
Explanation: B is correct: federal funds are overnight reserve balances held at Federal Reserve Banks. Commercial banks with excess reserves can lend these to banks with reserve deficiencies overnight. The interest rate charged is the federal funds rate. A is wrong — the Fed lends to banks through the discount window. C is wrong — federal funds are interbank, not government grants. D is wrong — the Fed issues no bonds.
Question 14
LIBOR (London Interbank Offered Rate) historically represented:
Select an option first.
Correct answer: B — The average rate at which major banks could borrow unsecured funds in the London interbank market for various maturities and currencies
Explanation: B is correct: LIBOR was a benchmark representing the average interest rate at which a panel of major international banks could borrow unsecured funds from each other in the London money market, for various currencies and maturities (overnight to 12 months). It has largely been replaced by risk-free rates (SOFR in the US, SONIA in the UK). A is wrong — the Bank of England's rate is the Bank Rate (base rate). C is wrong — LIBOR included a credit spread; risk-free rates do not. D is wrong — LIBOR is market-determined, not set by regulators.
Question 15
SOFR (Secured Overnight Financing Rate) differs from LIBOR in that SOFR is:
Select an option first.
Correct answer: B — A transaction-based overnight rate derived from Treasury repo market transactions, making it essentially risk-free
Explanation: B is correct: SOFR is based on actual transactions in the US Treasury repurchase (repo) market — it reflects the cost of borrowing cash overnight collateralised by US Treasuries. Being secured and based on observed transactions, it is considered nearly risk-free and manipulation-resistant. A is wrong — SOFR is transaction-based and secured; LIBOR was unsecured. C is wrong — SOFR is determined by the New York Fed from market transactions. D is wrong — SOFR has no credit premium since it is secured.
Question 16
A certificate of deposit (CD) is:
Select an option first.
Correct answer: B — A fixed-term bank deposit that pays interest, typically negotiable in secondary markets for large-denomination CDs
Explanation: B is correct: a CD is a time deposit with a fixed maturity date and fixed or floating interest rate. Large-denomination CDs (e.g. $1 million+) are typically negotiable — they can be sold in the secondary market before maturity. A is wrong — that describes a share certificate. C is wrong — CDs are bank products, not government guarantee certificates. D is wrong — CDs are not derivatives.
Question 17
Treasury bills (T-bills) are primarily characterised by:
Select an option first.
Correct answer: B — Short maturities (up to 52 weeks), issued at a discount to face value, with the return coming from price appreciation to face value at maturity
Explanation: B is correct: T-bills are short-term government securities (typically 4, 13, 26 or 52 weeks) issued at a discount and redeemed at face value. They pay no coupon — the entire return comes from the discount. A is wrong — T-bills are short-term; T-bonds are long-term. C is wrong — T-bills are discount instruments, not floating rate. D is wrong — T-bills are not callable.
Question 18
The discount yield on a T-bill is calculated as:
Select an option first.
Correct answer: B — (Face value − Purchase price) / Face value × (360 / days to maturity)
Explanation: B is correct: the bank discount yield (used for T-bills in the US) = (Face − Price) / Face × (360 / days to maturity). This uses face value in the denominator and a 360-day year. A is wrong — the denominator is face value, not purchase price (that would give a money market yield). C is wrong — T-bills have no coupon. D is wrong — the formula is annualised by dividing 360 by days, not multiplying.
Question 19
Commercial paper is a short-term debt instrument typically issued by:
Select an option first.
Correct answer: B — Large, creditworthy corporations and financial institutions to fund short-term working capital needs
Explanation: B is correct: commercial paper (CP) is unsecured, short-term promissory notes issued by high-credit-quality corporations and financial institutions, typically with maturities of 1 to 270 days. It is issued at a discount. A is wrong — governments use T-bills. C is wrong — CP requires high credit quality. D is wrong — central banks use open market operations, not CP.
Question 20
Eurodollars are:
Select an option first.
Correct answer: B — US dollar-denominated deposits held in banks outside the United States
Explanation: B is correct: Eurodollars are US dollar deposits held at banks outside the United States (or in International Banking Facilities within the US). They are important in the international money market and historically served as the basis for LIBOR. A is wrong — Eurodollars are USD-denominated, not EUR. C is wrong — ECB manages euro reserves. D is wrong — those would be Eurobonds.
Question 21
A bank's economic capital differs from its regulatory capital in that economic capital:
Select an option first.
Correct answer: B — Is the bank's own internal estimate of capital needed to support its risk profile with a specified confidence level
Explanation: B is correct: economic capital is the bank's internally calculated estimate of capital required to remain solvent given its actual risk exposures, typically at a high confidence level (e.g. 99.9%). Regulatory capital is determined by regulatory rules (Basel framework) using standardised or internal model approaches. A is wrong — regulatory capital uses regulator-prescribed methods. C is wrong — the relationship varies by institution. D is wrong — credit risk is a major component of economic capital.
Question 22
In securitisation, the 'special purpose vehicle' (SPV) serves to:
Select an option first.
Correct answer: B — Hold the pool of underlying assets and issue securities backed by those assets, isolating them from the originating bank's balance sheet
Explanation: B is correct: the SPV is a legally separate entity that purchases the assets (e.g. mortgages, auto loans) from the originator and issues asset-backed securities (ABS) to investors. By holding the assets in the SPV, they are bankruptcy-remote from the originator — investors have recourse to the asset pool, not the originator. A is wrong — the SPV is not an investment manager. C is wrong — credit enhancement is a separate structural feature. D is wrong — the underwriter distributes the securities.
Question 23
What is an initial public offering (IPO)?
Select an option first.
Correct answer: A — The first sale of a company's shares to the public through a stock exchange
Explanation: A is correct: an IPO is the process by which a private company first offers shares to the public, typically through a stock exchange. This allows the company to raise capital and provides liquidity to existing shareholders. B is wrong — that is a share buyback. C is wrong — that is debt issuance. D is wrong — a private placement is not public; an IPO is public by definition.
Question 24
A firm commitment underwriting arrangement means the investment bank:
Select an option first.
Correct answer: B — Purchases the entire issue from the issuer at a fixed price and bears the risk of reselling to investors
Explanation: B is correct: in a firm commitment underwriting, the investment bank buys all the securities from the issuer at a guaranteed price (bearing inventory risk) and attempts to resell them to investors at a higher price. The spread between the two prices is the underwriting discount. A is wrong — that describes a best-efforts arrangement. C is wrong — that is a bridge finance arrangement. D is wrong — advisory-only is separate from underwriting.
Question 25
A 'Dutch auction' for a new share issuance works as follows:
Select an option first.
Correct answer: B — Investors submit bids (price and quantity); the clearing price is set at the lowest price that allocates all shares, and all winning bidders pay that single clearing price
Explanation: B is correct: in a Dutch auction (used by Google for its 2004 IPO, for example), all investors submit price-quantity bids. The offer price is set at the lowest price at which all shares can be sold (the market-clearing price), and all successful bidders pay that single price regardless of their bid. A is wrong — the clearing price is where supply meets demand, not the lowest bid. C is wrong — the Dutch auction price is market-determined. D is wrong — uniform pricing is used.
Question 26
A bank that transforms short-term deposits into long-term loans is engaged in:
Select an option first.
Correct answer: A — Maturity transformation — a core banking function that creates both liquidity risk and interest rate risk
Explanation: A is correct: maturity transformation is the process of accepting short-term deposits (liabilities) and making long-term loans (assets). This creates a maturity mismatch — the classic banking function — but also exposes the bank to liquidity risk (if deposits are withdrawn suddenly) and interest rate risk (if short-term rates rise above the fixed rates on long-term loans). B is wrong — the mismatch creates, not eliminates, risk. C is wrong — there is substantial risk involved. D is wrong — maturity transformation is legitimate and core to banking.
Question 27
A bank uses a standardised approach for credit risk capital calculation. Under Basel, the risk weight for a corporate loan rated AA− is typically:
Select an option first.
Correct answer: C — 100% — the standard corporate loan weight under the standardised approach
Explanation: C is correct: under the Basel standardised approach, most unrated or investment-grade corporate exposures receive a 100% risk weight (before any external rating adjustments). Under the revised standardised approach, AA-rated corporates may get a 20% risk weight, but the default corporate weight is 100%. A is wrong — 0% is for OECD government obligations. B is wrong — 20% applies to certain highly-rated banks. D is wrong — 150% applies to sub-investment grade exposures.
Question 28
The shadow banking system refers to:
Select an option first.
Correct answer: B — Financial intermediaries that perform bank-like functions (maturity transformation, leverage, liquidity creation) outside the traditional regulated banking sector
Explanation: B is correct: the shadow banking system encompasses entities like money market funds, hedge funds, SIVs (structured investment vehicles), and non-bank mortgage lenders that perform bank-like functions — lending, maturity transformation, leverage — but are not subject to the same regulatory oversight as banks. A is wrong — shadow banking operates in plain sight but with lighter regulation. C is wrong — tax havens are separate. D is wrong — after-hours trading is unrelated.
Question 29
A basis point (bps) in interest rate markets equals:
Select an option first.
Correct answer: B — 0.01% (1/100th of 1%)
Explanation: B is correct: one basis point equals 0.01% or 0.0001 in decimal form. So 100 bps = 1%. This unit is widely used to express small changes in interest rates, bond yields, and spreads. A is wrong — 1% = 100 bps, not 1 bps. C is wrong — 0.1% = 10 bps. D is wrong — 0.001% = 0.1 bps.
Question 30
The yield curve typically shows the relationship between:
Select an option first.
Correct answer: B — Interest rates (yields) and maturity for bonds of the same credit quality (typically government bonds)
Explanation: B is correct: the yield curve plots the yields of bonds of the same credit quality (usually government bonds) against their maturities — from short-term (overnight) to long-term (30 years). It shows the term structure of interest rates. A is wrong — that would be a credit spread analysis. C is wrong — yield curves apply to fixed income, not equities. D is wrong — the yield curve is about yields vs maturities, not prices vs coupons.
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