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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 31
An inverted yield curve occurs when:
Select an option first.
Correct answer: A — Short-term rates are higher than long-term rates
Explanation: A is correct: an inverted (downward-sloping) yield curve has short-term rates above long-term rates. This is unusual and often interpreted as a signal of an upcoming economic recession, as markets expect future rate cuts. B is wrong — that describes a normal (upward-sloping) yield curve. C is wrong — that is a flat yield curve. D is wrong — a parallel shift does not define inversion.
Question 32
Under the expectations theory of the yield curve, the long-term interest rate is:
Select an option first.
Correct answer: B — The geometric average of current and expected future short-term rates
Explanation: B is correct: the pure expectations theory (or unbiased expectations hypothesis) states that the long-term rate is determined by the market's expectation of future short-term rates — specifically, it is the geometric mean of the current short-term rate and expected future short-term rates. A is wrong — the liquidity preference theory adds a premium, but pure expectations does not. C is wrong — central bank policy influences short-term rates but not the whole curve. D is wrong — no fixed spread assumption is made.
Question 33
Duration measures a bond's sensitivity to:
Select an option first.
Correct answer: B — Interest rate changes — specifically, the percentage change in bond price for a 1% change in yield
Explanation: B is correct: duration (modified duration) measures the approximate percentage change in a bond's price in response to a 1 percentage point (100 bps) change in yield. Higher duration means greater price sensitivity. A is wrong — credit sensitivity is measured by credit spread duration. C is wrong — FX sensitivity is separate. D is wrong — equity price is unrelated to bond duration.
Question 34
A bond with a modified duration of 5 years will approximately:
Select an option first.
Correct answer: B — Decrease in price by 5% when interest rates rise by 1%
Explanation: B is correct: modified duration of 5 means a 1% (100 bps) increase in yield results in approximately a 5% decrease in price. Δ Price ≈ −Duration × Δ yield. A is wrong — duration does not measure maturity sensitivity. C is wrong — coupons are fixed. D is wrong — duration is not the same as maturity (though they are related).
Question 35
Convexity in bond pricing accounts for:
Select an option first.
Correct answer: A — The non-linear (curved) relationship between bond prices and yields — duration underestimates price increases and overestimates price decreases for large yield changes
Explanation: A is correct: because the price-yield relationship is convex (curved), duration provides only a linear approximation. Convexity corrects for this non-linearity: for a given yield decrease, the actual price increase exceeds the duration estimate; for a yield increase, the actual price decrease is less than estimated. A is correct. B is wrong — linear is duration. C is wrong — convexity is a rate sensitivity measure. D is wrong — that is the shape of the yield curve.
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Question 36
The Federal Reserve's open market operations primarily affect:
Select an option first.
Correct answer: B — Short-term interest rates by adding or removing reserves from the banking system through purchase or sale of government securities
Explanation: B is correct: open market operations (OMOs) involve the Fed buying or selling US Treasuries. Purchases inject reserves, reducing short-term rates (the fed funds rate); sales drain reserves, raising short-term rates. A is wrong — OMOs primarily target domestic interest rates. C is wrong — long-term yields are influenced indirectly (through expectations). D is wrong — equity dividends are unrelated to OMOs.
Question 37
The discount rate (at the Fed's discount window) differs from the federal funds rate in that:
Select an option first.
Correct answer: B — The discount rate is the rate at which banks borrow directly from the Federal Reserve (the lender of last resort), while the fed funds rate is the overnight rate on interbank lending of reserves
Explanation: B is correct: the discount rate is set by the Federal Reserve and applies to loans made directly to banks through the discount window (typically for short-term liquidity needs). The fed funds rate is determined by supply and demand for overnight reserve lending between banks (though the Fed targets it through OMOs). A is wrong — typically the discount rate is set above the fed funds rate as a penalty rate. C is wrong — the discount rate is for banks. D is wrong — the discount rate is set by the Fed.
Question 38
In the context of bank capital adequacy, 'risk-weighted assets' (RWA) are:
Select an option first.
Correct answer: B — Assets adjusted by regulatory risk weights reflecting their credit, market, and operational risk — used as the denominator in capital adequacy ratios
Explanation: B is correct: RWAs are calculated by multiplying each asset's balance sheet value by its applicable risk weight. For example, cash has a 0% weight; mortgages typically 35%; corporate loans 100%. Capital ratios (CET1, Tier 1, Total) are all expressed as percentages of RWA. A is wrong — risk weights vary by asset. C is wrong — RWAs include all balance sheet and off-balance sheet exposures. D is wrong — book value (not market value) is generally used.
Question 39
A bank's ROE (return on equity) can be decomposed using the DuPont framework as:
Select an option first.
Correct answer: B — Net profit margin × Asset turnover × Financial leverage (equity multiplier)
Explanation: B is correct: DuPont decomposition: ROE = (Net income / Revenue) × (Revenue / Total assets) × (Total assets / Equity) = Net profit margin × Asset turnover × Equity multiplier. This shows ROE is driven by profitability, efficiency and leverage. A is wrong — not a standard DuPont formula. C is wrong — that is a yield measure on loans. D is wrong — that is an efficiency ratio.
Question 40
Counterparty credit risk in OTC derivative markets is the risk that:
Select an option first.
Correct answer: B — The counterparty to a derivative contract defaults before the contract settles, leaving the surviving party with a replacement cost
Explanation: B is correct: counterparty credit risk (CCR) is the risk that a counterparty defaults before a derivative contract's final settlement, and the replacement cost (the cost of entering a new contract at current market prices) represents a loss. CCR is distinct from loan credit risk because the exposure fluctuates with market movements. A is wrong — interest rate movement is market risk. C is wrong — exchange closure is operational/settlement risk. D is wrong — underlying illiquidity is market risk.
Question 41
Central counterparty (CCP) clearing for OTC derivatives reduces systemic risk by:
Select an option first.
Correct answer: B — Becoming the buyer to every seller and seller to every buyer, mutualising counterparty credit risk through margin requirements and a default fund
Explanation: B is correct: a CCP interposes itself between every trade — it is the counterparty to both the buyer and the seller. By collecting margin (initial and variation) and maintaining a mutualised default fund, a CCP reduces bilateral counterparty risk and the risk of cascading defaults. A is wrong — market risk remains. C is wrong — CCPs also clear standardised OTC contracts. D is wrong — leverage is not prohibited.
Question 42
Initial margin in derivatives markets serves to:
Select an option first.
Correct answer: B — Cover potential future exposure — the estimated worst-case loss during the time required to close out a defaulted position
Explanation: B is correct: initial margin (IM) is collected at the inception of a trade to cover potential future exposure (PFE) — the estimated maximum loss the CCP or counterparty might sustain if the other party defaults and positions must be closed out. IM is typically set at a confidence level (e.g. 99%) over a liquidation period. A is wrong — IM is held as risk collateral, not for income. C is wrong — IM is not for coupon payments. D is wrong — IM is a financial risk buffer.
Question 43
Variation margin in derivatives trading refers to:
Select an option first.
Correct answer: B — Daily (or intraday) cash settlements reflecting mark-to-market gains and losses on open positions
Explanation: B is correct: variation margin (VM) is the daily (or more frequent) cash flow that reflects the change in mark-to-market value of a position. When a position moves against the holder, VM is paid out; when it moves in favour, VM is received. VM ensures that losses are settled daily rather than accumulating. A is wrong — that describes initial margin. C is wrong — there is no penalty margin concept. D is wrong — VM applies to both futures and cleared OTC derivatives.
Question 44
Under the internal ratings-based (IRB) approach to credit risk in Basel, the key risk parameters used to calculate capital requirements are:
Select an option first.
Correct answer: B — Probability of default (PD), loss given default (LGD), exposure at default (EAD), and maturity (M)
Explanation: B is correct: the IRB approach uses four key parameters: PD (probability of borrower default), LGD (loss as a percentage of EAD in event of default), EAD (amount outstanding at time of default), and M (effective maturity). These feed into the Basel capital formula. A is wrong — PD alone is insufficient. C is wrong — IRB uses internal ratings, not just external agency ratings. D is wrong — CDS spreads are not used in IRB calculations.
Question 45
The 'originate-to-distribute' model in banking refers to:
Select an option first.
Correct answer: B — A bank originating loans, packaging them into securities, and distributing (selling) them to investors — reducing the bank's credit risk exposure
Explanation: B is correct: the originate-to-distribute (OTD) model involves banks originating loans, then securitising and selling them to investors rather than holding them on the balance sheet. While this allows banks to recycle capital and originate more loans, it can reduce incentives to carefully assess credit quality (as the bank bears no long-term risk). A is wrong — that is the originate-to-hold model. C is wrong — dividends are unrelated. D is wrong — OTD is not limited to high-quality loans.
Question 46
What does the term 'net interest income' (NII) represent for a bank?
Select an option first.
Correct answer: B — The difference between interest earned on assets (loans, securities) and interest paid on liabilities (deposits, borrowings)
Explanation: B is correct: NII = interest income (from loans, bonds, etc.) minus interest expense (on deposits, debt, etc.). It is the primary revenue line for retail banks and reflects the benefit of maturity transformation. A is wrong — that is non-interest income. C is wrong — that is net income. D is wrong — NII encompasses all earning assets.
Question 47
A bank with a positive repricing gap (assets reprice faster than liabilities) benefits when:
Select an option first.
Correct answer: B — Interest rates rise — the faster repricing of assets means interest income rises more quickly than interest expense
Explanation: B is correct: a positive repricing gap means the bank's rate-sensitive assets exceed its rate-sensitive liabilities. When rates rise, asset yields increase before deposit/funding costs rise, expanding the NII. Conversely, a rate decline hurts a positive-gap bank. A is wrong — rate falls hurt a positive-gap bank. C is wrong — a flat curve affects the shape of earnings, not specifically the gap position. D is wrong — credit spreads affect credit risk, not repricing.
Question 48
Under Basel III, the systemic capital surcharge (G-SIB buffer) for globally systemically important banks requires additional:
Select an option first.
Correct answer: B — Common Equity Tier 1 capital (1% to 3.5% of RWA depending on the bank's systemic importance bucket)
Explanation: B is correct: the G-SIB buffer requires additional CET1 capital above the minimum requirements, ranging from 1% to 3.5% of RWA depending on which of five systemic importance buckets the bank falls into. This surcharge is designed to ensure the most systemically important banks have extra loss-absorbing capacity. A is wrong — Tier 2 capital does not satisfy the G-SIB buffer. C is wrong — it is a capital (not liquidity) requirement. D is wrong — it applies broadly, not just to operational risk.
Question 49
A bank's 'non-performing loans' (NPLs) are loans where:
Select an option first.
Correct answer: B — The borrower has stopped making scheduled payments for a defined period (typically 90+ days past due) or where full repayment is in doubt
Explanation: B is correct: NPLs are loans where the borrower is significantly in arrears (typically 90+ days overdue) or where the full repayment of principal and interest is in doubt. They are a key indicator of a bank's credit quality. A is wrong — high income is not NPL. C is wrong — rate reductions are not NPLs. D is wrong — prepayment means early repayment in full, which is not an NPL.
Question 50
The term structure of interest rates can be derived from the prices of:
Select an option first.
Correct answer: B — Zero-coupon bonds (strips) — each maturing at a different date provides a pure discount factor for that maturity
Explanation: B is correct: zero-coupon bonds directly provide the discount factors for each maturity — since they pay no coupons, the price reflects only the present value of the face value at maturity. Bootstrapping from coupon bond prices also derives the zero curve. A is wrong — corporate bonds include credit spreads that obscure the pure time value component. C is wrong — floating rate notes reflect only current short-term rates. D is wrong — equity dividends are not fixed income instruments.
Question 51
Forward rates implied by the yield curve represent:
Select an option first.
Correct answer: B — The market's implied future interest rates for specific periods, derived from current spot rates
Explanation: B is correct: forward rates are implied by the current spot yield curve. For example, the 1-year rate one year from now can be derived from the 1-year and 2-year spot rates. Forward rates represent the no-arbitrage rate implied by today's yield curve. A is wrong — spot rates are today's yields. C is wrong — forward rates are market-implied, not central bank forecasts. D is wrong — actual forward loan rates may differ from market-implied forward rates.
Question 52
Calculating the spot rate from coupon bonds requires a process called:
Select an option first.
Correct answer: B — Bootstrapping — extracting zero-coupon rates sequentially from coupon bond prices
Explanation: B is correct: bootstrapping extracts zero-coupon rates (spot rates) from the prices of coupon-paying bonds. Starting with the shortest maturity, you solve for the discount rate, then use that to find the next rate, sequentially building the zero curve. A is wrong — interpolation estimates values between known points. C is wrong — duration matching is a hedging technique. D is wrong — convexity adjustment is a pricing correction.
Question 53
In the context of interest rate risk, the 'dollar duration' of a bond position is:
Select an option first.
Correct answer: B — The change in dollar value of the position for a 1 basis point change in yield (often called DV01 or PVBP)
Explanation: B is correct: dollar duration (or DV01 — dollar value of one basis point, also called PVBP — price value of a basis point) measures the absolute dollar change in the price of a bond position for a 1 bps change in yield. DV01 = Modified Duration × Bond Price × 0.0001. A is wrong — dollar duration is about price sensitivity. C is wrong — that is a different calculation. D is wrong — bond price is just the price.
Question 54
A 'callable bond' gives the issuer the right to:
Select an option first.
Correct answer: B — Redeem the bond before maturity at a specified call price, typically at a premium to par
Explanation: B is correct: a callable bond gives the issuer (not the holder) the right to redeem (call) the bond before its scheduled maturity, usually at a call price that includes a premium over par. Issuers typically call bonds when interest rates fall, allowing them to refinance at lower rates. A is wrong — that describes a puttable bond (holder's right to sell back). C is wrong — that describes a convertible bond. D is wrong — maturity extension is not a call feature.
Question 55
What is 'credit spread' in bond markets?
Select an option first.
Correct answer: B — The additional yield (over a benchmark risk-free rate like a Treasury) that investors demand as compensation for the credit risk of a bond
Explanation: B is correct: the credit spread is the yield premium a credit risky bond pays above the risk-free benchmark (e.g. Treasury bond) of the same maturity, compensating investors for default risk, liquidity risk, and other risks associated with the issuer. A is wrong — that is the difference between coupon and yield. C is wrong — that is the bid-ask spread. D is wrong — comparing coupons, not yields to a benchmark.
Question 56
'Mark-to-market' (MTM) accounting for a financial asset means:
Select an option first.
Correct answer: B — Valuing the asset at its current market value on each reporting date, with changes recognised in income or equity
Explanation: B is correct: mark-to-market (or fair value accounting) requires financial assets to be recorded at current market prices. Unrealised gains/losses are recognised in the income statement (for trading assets) or other comprehensive income (for AFS assets under IFRS/GAAP). A is wrong — that is historical cost accounting. C is wrong — amortisation is for fixed assets. D is wrong — MTM applies to principal value, not just income.
Question 57
The 'too big to fail' (TBTF) problem refers to:
Select an option first.
Correct answer: B — The implicit government guarantee that very large, systemically important banks will be bailed out to prevent financial system collapse, which distorts risk-taking incentives
Explanation: B is correct: TBTF describes the perception that governments will bail out systemically important financial institutions to prevent widespread economic damage. This implicit guarantee gives large banks a funding cost advantage and reduces market discipline, as creditors know they will be protected. A is wrong — TBTF is about bail-out expectations, not acquisition. C is wrong — size caps are a separate regulatory proposal. D is wrong — TBTF banks generally have better market access.
Question 58
A bank with $100 million in rate-sensitive assets and $80 million in rate-sensitive liabilities has a repricing gap of $20 million. If interest rates rise by 50 basis points, the approximate change in net interest income (NII) is:
Select an option first.
Correct answer: B — +$100,000 (gain) — positive gap benefits from rate rises
Explanation: B is correct: change in NII = repricing gap × change in rate = $20,000,000 × 0.005 = $100,000. A positive gap means more assets reprice upward than liabilities, so a rate rise increases NII by $100,000. A is wrong — a positive gap benefits from rate rises. C is wrong — the calculation uses the gap, not the liability amount. D is wrong — not $400,000.
Question 59
The Basel leverage ratio = Tier 1 capital / total exposure. If a bank has Tier 1 capital of $5 billion and total assets plus off-balance-sheet exposures of $80 billion, the leverage ratio is:
Select an option first.
Correct answer: B — 6.25%
Explanation: B is correct: leverage ratio = $5bn / $80bn = 6.25%. The Basel III minimum is 3%, so this bank exceeds the requirement. A is wrong — 4% = 5/125. C is wrong — 8% is not derived from these numbers. D is wrong — not 16%.
Question 60
A bank calculates its liquidity coverage ratio (LCR). It holds $200 million of HQLA and expects $180 million of net cash outflows over the next 30 days under stress. Its LCR is:
Select an option first.
Correct answer: A — 111% — meets the 100% minimum requirement
Explanation: A is correct: LCR = HQLA / net cash outflows = $200m / $180m = 111%. This exceeds the minimum 100% requirement. B is wrong — 111% is above 100%. C is wrong — 200% is not derived. D is wrong — not 180%.
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