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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 91
What is the 'discount window' in central banking?
Select an option first.
Correct answer: A — A mechanism through which commercial banks borrow funds directly from the central bank, typically as a last resort, at the discount rate (usually above the fed funds target)
Explanation: A is correct: the discount window is the Federal Reserve's lending facility for commercial banks. Banks can borrow from the Fed at the discount rate (primary credit rate) to cover short-term reserve needs. It serves as a 'lender of last resort' function. A is correct. B is wrong — bond auctions use different mechanisms. C is wrong — foreign exchange is separate. D is wrong — reserve requirements are changed by regulatory action, not the discount window.
Question 92
The concept of 'lender of last resort' in central banking means:
Select an option first.
Correct answer: B — The central bank provides emergency liquidity to solvent but temporarily illiquid banks during financial crises, preventing systemic bank runs
Explanation: B is correct: the lender of last resort function (Bagehot's principle) holds that the central bank should lend freely to solvent institutions at a penalty rate against good collateral during periods of market stress, to prevent bank runs from turning solvent institutions insolvent. A is wrong — it is for banks, not all customers. C is wrong — penalties are a separate concept. D is wrong — the central bank's asset purchase programs are quantitative easing.
Question 93
A bank's provision for loan losses (allowance for credit losses) serves to:
Select an option first.
Correct answer: B — Create a balance sheet reserve (reducing net loans and equity) that reflects expected credit losses on the loan portfolio
Explanation: B is correct: loan loss provisions (or expected credit loss allowances under IFRS 9/CECL) reduce the carrying value of loans on the balance sheet to reflect their expected collectability. The provision expense also reduces net income and retained earnings. A is wrong — provisions reduce equity via the income statement. C is wrong — provisions reduce tax indirectly via lower profit. D is wrong — provisions are estimates, not guarantees.
Question 94
The 'carry trade' strategy in interest rate markets involves:
Select an option first.
Correct answer: B — Borrowing in a low-interest-rate currency and investing in a higher-interest-rate currency — profiting from the interest rate differential (carry) while bearing currency risk
Explanation: B is correct: the classic carry trade (e.g. borrow in Japanese yen at near-zero rates, invest in Australian dollars at higher rates) profits from the interest rate differential as long as the exchange rate does not move adversely. The risk is currency depreciation (or sudden risk-off events) wiping out the carry income. A is wrong — that describes a basis trade. C is wrong — that eliminates the rate differential benefit. D is wrong — that is a directional bet on yields.
Question 95
The overnight index swap (OIS) rate represents:
Select an option first.
Correct answer: B — The fixed rate exchanged for the compounded overnight rate (e.g. SOFR in USD, SONIA in GBP) — considered a proxy for the risk-free rate in derivatives pricing
Explanation: B is correct: an OIS is an interest rate swap where the fixed rate is exchanged for the geometric mean of the daily overnight reference rate over the swap term. Since the overnight rate is nearly risk-free and OIS involves minimal counterparty risk, the OIS rate is used as a proxy for the risk-free rate. A is wrong — bank deposit rate is not OIS. C is wrong — the Fed targets the fed funds rate but OIS is a market-determined swap rate. D is wrong — ISDA provides documentation, not rate setting.
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Question 96
LIBOR-OIS spread (historically) was significant because:
Select an option first.
Correct answer: B — It represented the premium of unsecured interbank lending over the expected overnight rate — during financial stress (e.g. 2008), this spread widened dramatically, indicating banking sector stress
Explanation: B is correct: the LIBOR-OIS spread measures banking sector health. LIBOR is an unsecured interbank lending rate (includes credit and liquidity risk). OIS is the compounded overnight rate (nearly risk-free). The spread between them widened from ~10 bps in normal times to over 350 bps in October 2008, signalling extreme stress in interbank lending markets. A is wrong — LIBOR is unsecured; repo rates represent secured lending. C is wrong — government bonds are not priced off LIBOR-OIS. D is wrong — LIBOR-OIS is not a regulatory tool.
Question 97
In the context of central bank reserve requirements, excess reserves are:
Select an option first.
Correct answer: B — Reserves held by banks above the regulatory minimum — banks can lend these in the federal funds market or hold them at the central bank
Explanation: B is correct: excess reserves = actual reserves held − required minimum reserves. Banks can lend excess reserves overnight in the fed funds market. Since 2008, the Fed has paid interest on excess reserves (IOER, now IORB), which sets a floor under the federal funds rate. B is correct. A is wrong — required reserves are mandatory; excess reserves are above the minimum. C is wrong — reserves are not lent to the government. D is wrong — reserves are held at the central bank.
Question 98
A bank's net interest margin (NIM) tends to narrow when:
Select an option first.
Correct answer: B — The yield curve flattens or inverts — banks that borrow short and lend long face compressed or negative spreads between lending and funding rates
Explanation: B is correct: banks profit from the positive spread between lending rates (long-term) and borrowing rates (short-term). When the yield curve flattens (short rates rise toward long rates) or inverts, this spread compresses, reducing NIM. A is wrong — a steep yield curve is beneficial for banks. C is wrong — reserve requirements affect liquidity, not NIM directly. D is wrong — higher volume on unchanged spreads increases NII.
Question 99
Credit ratings issued by agencies like S&P, Moody's, and Fitch:
Select an option first.
Correct answer: B — Provide an opinion on the relative creditworthiness of a bond issuer — the likelihood of timely payment of principal and interest
Explanation: B is correct: credit ratings are opinions (not guarantees) about the probability that an issuer will make scheduled debt payments. They provide a relative ranking of creditworthiness: AAA/Aaa (highest) to D/C (in default). Ratings are advisory, not legally binding, and have faced criticism for conflicts of interest (especially in structured finance). A is wrong — ratings are opinions, not guarantees. C is wrong — ratings are advisory. D is wrong — markets set rates; ratings influence them.
Question 100
The global financial crisis of 2007-2009 revealed several structural vulnerabilities. Which of the following was a key factor?
Select an option first.
Correct answer: B — Underestimation of correlation risk in structured credit products — diversified pools of mortgages exhibited highly correlated defaults during the nationwide housing decline
Explanation: B is correct: a central flaw in pre-crisis structured credit models was the underestimation of correlation between mortgage defaults. Models assumed geographic diversification would limit correlated defaults, but a nationwide housing price decline caused correlations to spike. This invalidated the ratings of AAA tranches of CDOs that relied on diversification. A is wrong — regulation was too lax. C is wrong — rates were low pre-crisis. D is wrong — excessive leverage was the problem.
Question 101
The Financial Stability Board (FSB) is responsible for:
Select an option first.
Correct answer: B — Coordinating international financial regulation to promote global financial stability — monitoring the financial system, identifying vulnerabilities, and making recommendations
Explanation: B is correct: the FSB (established in 2009 post-crisis) coordinates national financial authorities and international standard-setting bodies (Basel Committee, IOSCO, IAIS) to develop and promote robust regulatory, supervisory, and other financial sector policies. A is wrong — FSB does not set rates. C is wrong — FSB coordinates policy; national regulators supervise banks. D is wrong — IMF manages its own programs.
Question 102
Which of the following is a key difference between commercial banks and investment banks in their sources of risk?
Select an option first.
Correct answer: B — Commercial banks primarily bear credit risk from loans and deposit funding risk; investment banks primarily bear market risk from trading positions and underwriting
Explanation: B is correct: commercial banks' primary risks are credit risk (borrowers defaulting) and liquidity/funding risk (depositor withdrawals). Investment banks' primary risks are market risk (trading positions in securities) and execution risk (underwriting new issues). Both face operational risk. A is wrong — both types face multiple risks. C is wrong — risk profiles differ significantly. D is wrong — commercial banks typically hold larger credit risk from their loan portfolios.
Question 103
The concept of 'duration matching' (immunisation) in asset-liability management (ALM) requires:
Select an option first.
Correct answer: B — The duration of assets to equal the duration of liabilities, so that changes in interest rates have equal effects on both sides, protecting the bank's equity value
Explanation: B is correct: immunisation through duration matching sets the duration of assets equal to the duration of liabilities. When rates change, the change in asset values approximately equals the change in liability values, leaving equity value (assets − liabilities) unchanged. A is wrong — matching maturities is not the same as duration matching. C and D are wrong — duration matching works with both fixed and floating instruments.
Question 104
A bank's 'core deposits' are:
Select an option first.
Correct answer: B — Stable, low-cost retail deposits (checking and savings accounts) that are unlikely to be withdrawn rapidly — they provide a stable, low-cost funding base
Explanation: B is correct: core deposits are retail deposits (transaction accounts, savings accounts, small CDs) characterised by low interest rate sensitivity, stable balances, and low withdrawal likelihood. They represent a valuable, low-cost, and stable funding source for banks. A is wrong — those are volatile, rate-sensitive deposits. C is wrong — wholesale funding is non-core. D is wrong — guarantee structures are separate.
Question 105
The concept of 'economic value of equity' (EVE) in interest rate risk management measures:
Select an option first.
Correct answer: B — The present value of all future asset cash flows minus the present value of all future liability cash flows — sensitive to long-term rate changes
Explanation: B is correct: EVE = PV(assets) − PV(liabilities). When interest rates change, the present values of both sides change, affecting EVE. EVE is a long-term (balance sheet) measure of interest rate risk. It is complementary to NII (earnings) sensitivity which is a short-term measure. A is wrong — market cap is the equity market value. C is wrong — book value uses historical costs. D is wrong — NII is a 12-month income measure.
Question 106
Under Basel III, the Internal Model Approach (IMA) for market risk capital allows banks to:
Select an option first.
Correct answer: B — Use their own internal risk models (VaR and stressed VaR) to calculate market risk capital, subject to regulatory approval and ongoing validation
Explanation: B is correct: the IMA allows qualifying banks to use internal VaR models to calculate regulatory market risk capital. The model must be validated by the regulator, meet quantitative standards (99% confidence, 10-day holding period), and pass backtesting requirements. Under FRTB, the IMA is replaced by an Expected Shortfall model. A is wrong — standardised approach is the alternative to IMA. C is wrong — market risk capital is still required. D is wrong — external ratings are used in the standardised credit risk approach.
Question 107
The 'flight to quality' phenomenon during financial crises refers to:
Select an option first.
Correct answer: A — Investors moving from low-quality to high-quality investments during stress — selling risky assets and buying safe assets like government bonds
Explanation: A is correct: during financial crises, investors sell risky assets (equities, corporate bonds, emerging market assets) and buy safe haven assets (US Treasuries, German Bunds, gold). This 'flight to quality' drives up safe asset prices (lower yields) while increasing spreads on risky assets. A is correct. B is wrong — banks typically tighten lending during stress (credit crunch). C is wrong — regulators may actually reduce requirements to stimulate lending. D is wrong — central banks typically cut rates in crisis.
Question 108
Expected Shortfall (ES), also known as Conditional VaR (CVaR), measures:
Select an option first.
Correct answer: B — The expected loss given that losses exceed the VaR threshold — i.e., the average of losses in the tail beyond the VaR confidence level
Explanation: B is correct: ES = E[Loss | Loss > VaR(α)], the average of all losses that exceed the VaR at confidence level α. For example, 97.5% ES is the average of the worst 2.5% of losses. ES is subadditive (unlike VaR) and was adopted under FRTB as it better captures tail risk. A is wrong — no finite maximum exists for most distributions. C is wrong — that is the probability level used in VaR. D is wrong — ES measures losses, not gains.
Question 109
When a central bank engages in quantitative easing (QE):
Select an option first.
Correct answer: B — It purchases longer-term assets (government bonds, MBS) to inject liquidity, lower long-term yields, and stimulate the economy when short-term rates are already near zero
Explanation: B is correct: QE involves the central bank creating reserves to purchase longer-term securities (T-bonds, agency MBS), increasing their prices and lowering their yields. This stimulates borrowing and investment when conventional rate cuts are constrained by the zero lower bound. A is wrong — QE buys (not sells) bonds. C is wrong — reserve requirements are a separate tool. D is wrong — the discount window is for liquidity support to individual banks.
Question 110
The Procyclicality problem in banking refers to:
Select an option first.
Correct answer: A — Banks increasing capital during economic downturns to meet requirements, which exacerbates the downturn by reducing lending
Explanation: A is correct: procyclicality is a major concern in bank regulation. During downturns, loan losses increase → banks need more capital → banks reduce lending → economic downturn worsens. Conversely, during booms, low losses → excess capital → aggressive lending → asset bubbles. Basel III introduced the countercyclical buffer to address this. A is correct. B is wrong — banks are typically less profitable in downturns. C is wrong — that is standard monetary policy. D is wrong — that is normal economic behaviour.
Question 111
Risk-weighted assets (RWA) under Basel are calculated using risk weights that vary by:
Select an option first.
Correct answer: B — The type and credit quality of the exposure — cash (0%), OECD government bonds (0-20%), residential mortgages (35-75%), corporate loans (75-150% under standardised approach)
Explanation: B is correct: risk weights under the Basel standardised approach vary by asset class and credit quality. For example: cash = 0%; OECD governments = 0-20%; rated corporates = 20-150% (depending on rating); unrated = 100%; certain equities = 250%+. B correctly describes the variation. A is wrong — asset type, not bank size, determines weights. C is wrong — geographic location is not the primary determinant. D is wrong — maturity affects credit conversion factors but not risk weights directly.
Question 112
The 'systemic risk' of a financial institution is best measured by:
Select an option first.
Correct answer: B — Its contribution to the system-wide risk — measured by metrics like CoVaR (conditional VaR), marginal expected shortfall, or SRISK
Explanation: B is correct: systemic risk measures (like CoVaR developed by Adrian and Brunnermeier, or SRISK by Engle and Brownlees) capture how much a firm's distress contributes to system-wide distress, or how much the financial system suffers conditional on the firm being in distress. These go beyond firm-level metrics. A is wrong — ROE is a profitability measure. C is wrong — leverage is a risk indicator but not a systemic risk measure. D is wrong — CDS spreads measure individual credit risk.
Question 113
The minimum reserve requirement is a monetary policy tool that:
Select an option first.
Correct answer: B — Requires banks to hold a minimum fraction of deposits as reserves at the central bank — reducing this fraction frees reserves for lending
Explanation: B is correct: the reserve requirement (where still used) sets the minimum fraction of deposits banks must hold as reserves. Lowering the ratio creates excess reserves, potentially increasing lending capacity and money supply. However, many central banks (including the Fed since March 2020) have set reserve requirements at zero. A is wrong — long-term rates are influenced by other mechanisms. C is wrong — usury laws address maximum lending rates. D is wrong — capital adequacy is a separate requirement.
Question 114
A bank uses interest rate derivatives to hedge its exposure to rising rates. This is an example of:
Select an option first.
Correct answer: B — Hedging — using derivatives to offset existing interest rate risk on the balance sheet
Explanation: B is correct: when a bank hedges its interest rate risk (e.g. using interest rate swaps to convert floating-rate liabilities to fixed, or vice versa), it is using derivatives for risk management purposes — offsetting existing balance sheet risks. A is wrong — hedging reduces risk; speculation takes on additional risk. C is wrong — arbitrage exploits mispricings. D is wrong — market making involves taking positions as a principal for clients.
Question 115
The Securities and Exchange Commission (SEC) in the US primarily regulates:
Select an option first.
Correct answer: B — The issuance of securities (stocks, bonds) and the activities of broker-dealers, exchanges, and investment advisers — protecting investors
Explanation: B is correct: the SEC enforces federal securities laws in the US, regulating: public company disclosure; broker-dealers; investment companies; investment advisers; securities exchanges; and insider trading. A is wrong — commercial banks are regulated by the OCC, Fed, and FDIC. C is wrong — state insurance commissioners and NAIC regulate insurance. D is wrong — the Federal Reserve sets monetary policy.
Question 116
Credit derivatives differ from traditional credit insurance because:
Select an option first.
Correct answer: B — Credit derivatives are tradeable financial instruments that can be bought and sold in secondary markets, separating credit risk transfer from the underlying lending relationship
Explanation: B is correct: credit derivatives (CDS, CLNs, CDOs) are standardised or customisable financial contracts that can be traded independently of the underlying credit exposure. Unlike insurance, they do not require an insurable interest — investors can buy CDS as a 'naked' short on credit without owning the underlying bond. A is wrong — CDS can be cash settled. C is wrong — credit derivatives are wholesale instruments. D is wrong — CDS pays based on a credit event, not the buyer's actual loss.
Question 117
A 'stress period' for capital adequacy purposes in the Basel framework:
Select an option first.
Correct answer: B — Is a period of significant financial and economic distress used to calibrate stressed risk measures — for example, the period of the 2007-2009 financial crisis is commonly used
Explanation: B is correct: the Basel framework requires that banks use data from stressed market conditions to calibrate their internal capital models. For example, stressed VaR (pre-FRTB) required banks to identify the 12-month period of significant financial stress most relevant to their portfolio. Basel III specifies using a stressed observation period for certain requirements. A is wrong — stress periods are adverse conditions. C is wrong — regulators define the stressed period criteria. D is wrong — confidence levels vary by measure.
Question 118
Under IAS 39/IFRS 9, financial assets are classified into categories that determine measurement. Under IFRS 9, the primary categories are:
Select an option first.
Correct answer: B — Amortised cost, fair value through other comprehensive income (FVTOCI), and fair value through profit or loss (FVTPL)
Explanation: B is correct: IFRS 9 replaced IAS 39 and classifies financial assets based on the business model for managing assets and the cash flow characteristics: (1) amortised cost (hold-to-collect SPPI); (2) FVTOCI (hold-to-collect-and-sell SPPI, or equity instruments by election); (3) FVTPL (default or by designation). A is wrong — AFS and HTM are IAS 39 categories. C is wrong — trading/investment is US GAAP terminology. D is wrong — replacement cost is not used for financial instruments.
Question 119
The concept of 'bail-in' in bank resolution refers to:
Select an option first.
Correct answer: B — Writing down bank creditors' claims and/or converting them to equity to absorb losses — enabling resolution without taxpayer funds
Explanation: B is correct: bail-in is the resolution tool where losses are imposed on shareholders and then creditors (in order of priority) by writing down their claims or converting them to equity. This is distinct from bail-out (taxpayer-funded rescue). Bail-in is embedded in frameworks like the EU's BRRD and the US TLAC requirement. A is wrong — that is a bail-out. C is wrong — that is a purchase and assumption transaction. D is wrong — that is lender of last resort.
Question 120
Asset-liability management (ALM) in a bank focuses on:
Select an option first.
Correct answer: B — Managing the structure of assets and liabilities to optimise the risk-return trade-off — balancing profitability (NIM), liquidity, and interest rate risk
Explanation: B is correct: ALM involves coordinating the bank's balance sheet to manage: interest rate risk (how rate changes affect NIM and EVE); liquidity risk (funding stability and contingency planning); and capital management. The ALCO (Asset-Liability Committee) typically oversees ALM. A is wrong — trading is a separate function. C is wrong — tax management is separate. D is wrong — loan pricing is part of credit management.
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