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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 61
A bank is using the IRB approach. For a corporate loan, PD = 2%, LGD = 45%, EAD = $10 million. The expected loss (EL) on the loan is:
Select an option first.
Correct answer: B — $90,000
Explanation: B is correct: EL = PD × LGD × EAD = 0.02 × 0.45 × $10,000,000 = $90,000. A is wrong — $9,000 = 0.02 × 0.45 × $1m. C is wrong — $900,000 would require PD = 20%. D is wrong — that is the full EAD.
Question 62
A bank has $500 million total assets, $450 million total liabilities, and $50 million equity. Its equity multiplier (financial leverage ratio) is:
Select an option first.
Correct answer: A — 10 times
Explanation: A is correct: equity multiplier = total assets / equity = $500m / $50m = 10 times. This is a measure of financial leverage. B is wrong — total liabilities / equity = 450/50 = 9 times (debt-to-equity, not equity multiplier). C is wrong — not 11. D is wrong — not 5.
Question 63
A repo is executed with a 2% haircut on $100 million of collateral. The cash borrowed is:
Select an option first.
Correct answer: B — $98 million
Explanation: B is correct: a 2% haircut means the lender will lend 98% of the collateral's market value. Cash borrowed = $100m × (1 − 0.02) = $98 million. A is wrong — the cash is less than collateral value, not more. C is wrong — without a haircut, $100m would be lent. D is wrong — $2m is the haircut amount, not the loan.
Question 64
A T-bill has a face value of $1,000, matures in 90 days, and is purchased at $985. The bank discount yield is:
Select an option first.
Correct answer: A — 6.0%
Explanation: A is correct: bank discount yield = (F − P) / F × (360/days) = ($1,000 − $985) / $1,000 × (360/90) = 0.015 × 4 = 6.0%. B is wrong — 6.09% is the money market yield (using purchase price). C is wrong — not supported. D is wrong — not supported.
Question 65
A bond has a modified duration of 7 and the portfolio manager wants to hedge against a 50 bps rise in yield. The bond has a market value of $10 million. The approximate dollar loss without hedging would be:
Select an option first.
Correct answer: A — $350,000
Explanation: A is correct: approximate price change = −Modified Duration × Δyield × Price = −7 × 0.005 × $10,000,000 = −$350,000. A rise of 50 bps on a 7-duration bond causes a ~$350,000 loss. B is wrong — that uses 1% yield change. C is wrong — would require 100 bps change. D is wrong — too small.
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Question 66
For a bank, 'economic capital' for a loan portfolio is best described as:
Select an option first.
Correct answer: B — The additional capital needed (above expected loss) to cover unexpected losses at a specified confidence level (e.g. 99.9%)
Explanation: B is correct: economic capital covers unexpected losses (UL) — losses above the expected level — at a chosen confidence level. Expected losses are covered by provisioning/pricing. Economic capital is: UL = VaR (at confidence level) − EL. A is wrong — regulatory capital uses standardised risk weights. C is wrong — historical averages are not the definition. D is wrong — market cap is an external measure.
Question 67
A bank runs a sensitivity analysis on its NII. Rate-sensitive assets total $300m with average yield 4%, rate-sensitive liabilities total $250m with average cost 2%. The current NII from these is:
Select an option first.
Correct answer: A — $7 million
Explanation: A is correct: NII = interest income − interest expense = ($300m × 4%) − ($250m × 2%) = $12m − $5m = $7 million. B is wrong — $5m is interest expense only. C is wrong — $12m is interest income only. D is wrong — not supported.
Question 68
The credit value adjustment (CVA) represents:
Select an option first.
Correct answer: A — A reduction in the value of an OTC derivative portfolio to account for the counterparty's default risk
Explanation: A is correct: CVA is the market-value adjustment applied to OTC derivative portfolios to account for the risk that the counterparty may default before the contract's maturity. CVA = Expected Exposure × Probability of Default × Loss Given Default (all discounted). It reduces the portfolio's value from the risk-free price. B is wrong — CVA specifically addresses counterparty credit risk. C is wrong — the regulatory capital charge is a separate concept. D is wrong — an improvement in credit quality would create a CVA gain, but CVA itself is the adjustment concept.
Question 69
The Basel III capital conservation buffer of 2.5% CET1 serves to:
Select an option first.
Correct answer: B — Provide an additional capital cushion above the minimum — if breached, automatic restrictions on dividends and bonuses apply to rebuild the buffer
Explanation: B is correct: the capital conservation buffer (CCB) of 2.5% CET1 sits above the minimum 4.5% CET1 requirement. If a bank's CET1 falls into the buffer zone (4.5% to 7%), it faces increasing restrictions on profit distributions (dividends, buybacks, bonuses) to conserve capital and rebuild the buffer. A is wrong — the buffer reduces, not increases, lending capacity during downturns. C is wrong — Tier 2 requirements are separate. D is wrong — deposit insurance is funded differently.
Question 70
The countercyclical capital buffer (CCyB) under Basel III is designed to:
Select an option first.
Correct answer: B — Build up capital during periods of excessive credit growth (up to 2.5% CET1), which can then be released during downturns
Explanation: B is correct: the CCyB is a macroprudential tool — regulators accumulate it (up to 2.5% of RWAs in additional CET1) when credit growth is excessive and systemic risk is building, then release it during downturns to allow banks to absorb losses and maintain lending. A is wrong — CCyB rises when credit is loose, not tight. C is wrong — it applies to all banks. D is wrong — the buffer reduces profitability only when activated.
Question 71
If a bank uses the Advanced IRB (A-IRB) approach rather than the Foundation IRB (F-IRB) approach, the key difference is:
Select an option first.
Correct answer: B — A-IRB allows banks to estimate all risk parameters (PD, LGD, EAD, M) internally; F-IRB only allows internal PD estimates while regulators set LGD and EAD
Explanation: B is correct: under F-IRB, banks estimate PD internally but use regulator-prescribed values for LGD (typically 45% for unsecured senior), EAD (100% for loans), and M. Under A-IRB, banks may estimate all four parameters internally, giving greater sensitivity to actual risk profiles but requiring more rigorous data and model validation. A is wrong — A-IRB uses own LGD; F-IRB uses regulatory LGD. C is wrong — F-IRB uses internal PD estimates. D is wrong — capital requirements differ.
Question 72
The 'debit valuation adjustment' (DVA) in derivatives pricing represents:
Select an option first.
Correct answer: A — An upward adjustment to a derivative's value reflecting the benefit the bank receives from its own credit risk — if the bank's creditworthiness deteriorates, the value of its liability (derivative owed to counterparty) decreases
Explanation: A is correct: DVA is the counterpart of CVA — it represents the benefit a bank receives from its own potential default. If the bank's credit quality deteriorates, the present value of what it owes to counterparties decreases. DVA is controversial because it implies a bank profits from its own credit deterioration. A is correct. B is wrong — DVA is about derivatives, not loans. C is wrong — downward adjustment to one's own liabilities is DVA; downward to asset value is CVA. D is wrong — not a clearing fee.
Question 73
In the context of Basel operational risk capital, the business indicator component (BIC) used in the standardised measurement approach (SMA) is based on:
Select an option first.
Correct answer: B — A combination of the bank's interest, services, and financial components — reflecting the scale of the bank's operations
Explanation: B is correct: the SMA (introduced in the Basel III final rules) uses a Business Indicator (BI) derived from three revenue components: interest, lease, and dividend component; services component; and financial component. The BI is then used with an internal loss multiplier to determine operational risk capital. A is wrong — total assets is not the direct measure. C is wrong — employees and IT are operational metrics but not the BI formula. D is wrong — historical losses are used through the internal loss multiplier.
Question 74
FRTB (Fundamental Review of the Trading Book) is a Basel initiative that:
Select an option first.
Correct answer: B — Revises the market risk capital framework with a clearer boundary between banking book and trading book, new sensitivity-based standardised approach, and requirements for IMA (internal model approach)
Explanation: B is correct: FRTB, finalised in 2019, is a comprehensive overhaul of market risk capital. Key changes include: clearer definition of the trading/banking book boundary; a new sensitivity-based approach (SBA) replacing the old standardised method; stricter approval process for the Internal Models Approach (IMA); expected shortfall (ES) replacing VaR as the risk measure; and desk-level model approval. A is wrong — FRTB is about market risk. C is wrong — IMA still exists under FRTB. D is wrong — IMA remains available but with stricter conditions.
Question 75
A stress test in a banking context differs from a VaR model in that:
Select an option first.
Correct answer: B — Stress tests examine specific severe but plausible scenarios (e.g. a 30% equity market crash) that may fall outside the confidence intervals of statistical VaR models — they are forward-looking and scenario-specific
Explanation: B is correct: VaR estimates losses at a specified confidence level based on historical or modelled distributions. Stress tests examine what happens under specific adverse scenarios (market shocks, economic recessions) that may be extreme or unprecedented — they capture tail risks that VaR may underestimate. B is correct. A is wrong — both can use historical or scenario-based approaches. C is wrong — VaR can be forward-looking; stress tests are scenario-based. D is wrong — both can apply to all risk types.
Question 76
The net stable funding ratio (NSFR) formula is ASF/RSF ≥ 100%. If a bank has $400bn ASF and $350bn RSF, the NSFR is approximately:
Select an option first.
Correct answer: A — 114% — comfortably above the minimum
Explanation: A is correct: NSFR = $400bn / $350bn = 114%. The Basel III minimum is 100%, so this bank comfortably meets the requirement. B is wrong — 87.5% = 350/400 (inverted). C is wrong — 114% meets, not fails, Basel III. D is wrong — not 88%.
Question 77
A bank's return on assets (ROA) is 1.2% and its equity multiplier is 12. Using the DuPont decomposition, its ROE is:
Select an option first.
Correct answer: A — 14.4%
Explanation: A is correct: ROE = ROA × equity multiplier = 1.2% × 12 = 14.4%. The equity multiplier (total assets / equity) captures financial leverage. B is wrong — 10% is not derived from these numbers. C is wrong — 0.1% is far too low. D is wrong — not 13.2%.
Question 78
Under TLAC (Total Loss-Absorbing Capacity), global systemically important banks (G-SIBs) must hold:
Select an option first.
Correct answer: B — A minimum of 16–18% of RWAs (rising to 18% by 2022) in loss-absorbing instruments that can be bailed in (written down or converted to equity) in resolution
Explanation: B is correct: TLAC requires G-SIBs to hold sufficient capital and debt that can be bailed in (written down or converted to equity) during resolution. The minimum is 16% of RWAs (rising to 18%), plus regulatory buffers. The purpose is to ensure orderly resolution without taxpayer bailouts. A is wrong — TLAC includes both capital and eligible debt. C is wrong — TLAC is about loss absorption, not liquidity. D is wrong — it is expressed as a percentage of RWAs.
Question 79
The 'loan-to-deposit ratio' (LDR) for a bank measures:
Select an option first.
Correct answer: B — The proportion of deposits used to fund loans — a higher ratio indicates more reliance on wholesale funding and less liquidity buffer
Explanation: B is correct: LDR = total loans / total deposits. A ratio above 100% means deposits alone cannot fund the loan book, requiring additional wholesale funding (more liquidity risk). A ratio below 100% suggests the bank has more liquidity and less reliance on wholesale markets. A is wrong — LDR is a funding/liquidity measure. C is wrong — that is the NIM or spread. D is wrong — it is a volume ratio, not a revenue ratio.
Question 80
In the context of bank regulation, the 'Volcker Rule' (part of Dodd-Frank in the US) prohibits banks from:
Select an option first.
Correct answer: B — Engaging in proprietary trading (trading for the bank's own account) and having ownership interests in hedge funds or private equity funds
Explanation: B is correct: the Volcker Rule (named after former Fed Chairman Paul Volcker) restricts US bank holding companies and their affiliates from engaging in short-term proprietary trading of financial instruments and from owning, sponsoring, or having certain relationships with hedge funds or private equity funds. The intent is to limit risk-taking with depositor funds. A is wrong — the Volcker Rule targets trading, not lending. C is wrong — deposit-taking is not restricted. D is wrong — underwriting for clients is a permitted 'market-making' activity.
Question 81
A reverse repo is a transaction in which the investor:
Select an option first.
Correct answer: A — Borrows securities and lends cash — effectively lending cash secured by the collateral received
Explanation: A is correct: from the perspective of the cash lender, the transaction is a reverse repo — the investor lends cash, receiving securities as collateral, with an agreement to return the securities when the cash is repaid at a higher price (the repo rate). From the cash borrower's perspective, it is a repo. A is correct. B is wrong — that describes a repo. C is wrong — that describes a calendar spread. D is wrong — reverse repos always involve cash exchange.
Question 82
The Dodd-Frank Wall Street Reform Act (2010) was primarily a response to:
Select an option first.
Correct answer: B — The 2007-2009 global financial crisis — it significantly reformed US financial regulation, including creation of the FSOC, CFPB, and central clearing mandates for standardised OTC derivatives
Explanation: B is correct: Dodd-Frank was enacted in response to the 2008 financial crisis. Key provisions include: Financial Stability Oversight Council (FSOC); Consumer Financial Protection Bureau (CFPB); Volcker Rule; mandatory central clearing for standardised OTC derivatives; enhanced resolution authority; and stress testing requirements. A is wrong — dot-com led to Sarbanes-Oxley (2002). C is wrong — the S&L crisis led to FIRREA (1989). D is wrong — Black Monday led to circuit breakers.
Question 83
The 'originate-to-hold' banking model compared to 'originate-to-distribute':
Select an option first.
Correct answer: B — Aligns lender incentives with loan quality — the originating bank retains the credit risk and has strong incentives to assess creditworthiness carefully
Explanation: B is correct: in the originate-to-hold model, the bank keeps the loan on its balance sheet until maturity. Since the bank bears the credit risk, it has strong incentives to carefully underwrite loans. This contrasts with originate-to-distribute where the bank sells or securitises loans, potentially weakening underwriting standards. A is wrong — the positions are reversed. C is wrong — lower volume but better quality. D is wrong — defaults still occur.
Question 84
A bank's 'tier 2' capital under Basel III includes:
Select an option first.
Correct answer: B — Subordinated debt with minimum 5-year original maturity, general loan loss provisions (up to 1.25% of RWA), and certain other hybrid instruments
Explanation: B is correct: Tier 2 capital provides a secondary layer of loss absorption. It includes: subordinated debt (original maturity ≥ 5 years); general provisions/allowances (limited to 1.25% of RWA under standardised approach); and certain other qualifying instruments. A is wrong — that is CET1. C is wrong — central bank borrowings are liabilities. D is wrong — off-balance-sheet items are risk exposures.
Question 85
A bank executes a 'sell and buyback' transaction (sale and repurchase agreement). Economically, this is most similar to:
Select an option first.
Correct answer: B — A secured borrowing (repo) — the bank raises cash against securities with an obligation to repurchase
Explanation: B is correct: a sell-and-buyback is economically identical to a repo — the bank sells securities for cash and agrees to repurchase them at a higher price. Although structured as two separate sale contracts (rather than a single repo agreement), the economic substance is a secured borrowing. A is wrong — the obligation to repurchase distinguishes it from a permanent sale. C is wrong — it is secured by the securities. D is wrong — no derivative element.
Question 86
The money market is characterised by instruments with:
Select an option first.
Correct answer: B — Original maturities of one year or less — highly liquid, low-risk instruments used for short-term funding
Explanation: B is correct: the money market covers short-term debt instruments with maturities up to one year (T-bills, commercial paper, CDs, repos, Fed funds, Eurodollars). These instruments are highly liquid and low risk, used by corporations, banks, and governments for short-term cash management. A is wrong — long-dated instruments are capital market products. C is wrong — money market instruments are short-term and often discount-based. D is wrong — money market instruments are debt, not equity-like.
Question 87
The interbank lending market serves primarily to:
Select an option first.
Correct answer: B — Allow banks to manage short-term reserve positions — banks with excess reserves lend to those with deficits, typically overnight
Explanation: B is correct: the interbank market allows banks to manage their reserve positions daily. A bank with more reserves than required can lend overnight to one with a shortfall. The federal funds market (US) is a prime example. B is correct. A is wrong — interbank lending is short-term. C is wrong — this is wholesale, not retail. D is wrong — central banks implement policy through open market operations, not by directly participating in interbank markets.
Question 88
A 'bankers' acceptance' (BA) is:
Select an option first.
Correct answer: B — A time draft (short-term obligation) drawn on and accepted by a commercial bank — the bank guarantees payment, making it a liquid, low-risk money market instrument
Explanation: B is correct: a BA is created when a buyer draws a time draft on their bank requesting deferred payment for a trade transaction. The bank 'accepts' (guarantees) the draft, making it a bankable instrument that can be traded in secondary markets. BAs are used in international trade finance. A is wrong — BAs are short-term. C is wrong — that is a loan approval. D is wrong — that is a central bank swap line.
Question 89
The money market yield convention typically uses:
Select an option first.
Correct answer: B — Actual days / 360 (for instruments like CDs and commercial paper in the US) or actual days / 365 (for T-bills in the UK)
Explanation: B is correct: money market instruments use actual day counts. US instruments like CDs, BAs, and Eurodollars use actual/360; US T-bills use actual/360 for the discount yield but actual/365 for bond-equivalent yield. UK gilts and UK T-bills use actual/365. B captures the key conventions. A is wrong — 30/360 is used for some bond markets. C is wrong — 252 trading days is used for equity volatility. D is wrong — money market uses simple (not compound) interest.
Question 90
Under Basel III, the minimum total capital ratio (CET1 + Additional Tier 1 + Tier 2) is:
Select an option first.
Correct answer: B — 8% of risk-weighted assets (plus the 2.5% conservation buffer = 10.5% total minimum including buffer)
Explanation: B is correct: the minimum total capital ratio under Basel III is 8% of RWAs (4.5% CET1 + 1.5% AT1 + 2% Tier 2). Including the capital conservation buffer of 2.5% CET1, the effective minimum CET1 is 7% and total capital requirement is 10.5%. A is wrong — 6% is the minimum Tier 1 ratio. C is wrong — 12% is not a standard Basel threshold. D is wrong — 4.5% is just the CET1 minimum.
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