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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 121
The 'net stable funding ratio' (NSFR) was introduced in Basel III to address:
Select an option first.
Correct answer: B — Structural liquidity risk — ensuring banks fund longer-term assets with stable funding sources over a 1-year horizon
Explanation: B is correct: the NSFR addresses structural (long-term) liquidity risk by requiring banks to match the maturity profile of their funding with the tenor of their assets over a 1-year horizon. It complements the LCR (which covers 30-day stress). ASF (available stable funding) must be ≥ RSF (required stable funding). A is wrong — overnight lending is covered by the LCR. C and D are wrong — NSFR is specifically about structural liquidity.
Question 122
A 'credit line' or 'committed credit facility' creates which type of risk for a bank?
Select an option first.
Correct answer: B — A contingent credit exposure — off-balance sheet but potentially on-balance-sheet if the borrower draws it; subject to a credit conversion factor (CCF) to calculate RWA
Explanation: B is correct: committed credit lines are off-balance-sheet until drawn, but they represent potential future credit exposure. Basel applies a credit conversion factor (CCF, typically 20-100% depending on the facility type and maturity) to convert the undrawn portion to a credit equivalent for RWA calculation. A is wrong — not all undrawn amounts are 100% included. C is wrong — undrawn committed facilities do require capital. D is wrong — credit risk arises when drawn.
Question 123
Which of the following best describes a 'Globally Systemically Important Bank' (G-SIB)?
Select an option first.
Correct answer: B — A bank identified by the FSB and national regulators as posing significant systemic risk to the global financial system, based on size, interconnectedness, substitutability, complexity, and cross-jurisdictional activity
Explanation: B is correct: G-SIBs are identified annually using an indicator-based methodology assessing: size (total exposures); global interconnectedness; substitutability/financial infrastructure; complexity; and cross-jurisdictional activity. G-SIBs face additional capital surcharges (1-3.5% CET1) and enhanced supervision. A is wrong — total assets alone is not the test. C is wrong — geographic scope is only one factor. D is wrong — credit rating is not the criterion.
Question 124
The 'macroprudential' approach to financial regulation differs from 'microprudential' regulation in that:
Select an option first.
Correct answer: B — Macroprudential focuses on system-wide financial stability and limiting systemic risk; microprudential focuses on the safety and soundness of individual institutions
Explanation: B is correct: microprudential regulation (traditional banking regulation) focuses on ensuring each individual bank is safe and sound. Macroprudential regulation (post-2008 focus) focuses on the stability of the financial system as a whole — addressing systemic risk, procyclicality, interconnectedness, and too-big-to-fail. Tools include: CCyB, systemic surcharges, LTV caps, and leverage ratio. A is wrong — the descriptions are reversed. C is wrong — they differ substantially. D is wrong — macroprudential applies to all systemically important institutions.
Question 125
The Minsky moment refers to:
Select an option first.
Correct answer: B — The sudden collapse in asset prices following a prolonged period of speculation funded by debt — named after Hyman Minsky's financial instability hypothesis
Explanation: B is correct: Hyman Minsky's financial instability hypothesis describes how stability breeds instability — prolonged stability encourages excessive risk-taking and leverage. The 'Minsky moment' is the sudden, sharp asset price collapse triggered when highly leveraged investors must sell assets to service debt, initiating a cascading deleveraging process. The 2007-2008 crisis is often described as a Minsky moment. A is wrong — not regulatory. B is correct. C is wrong — insolvency is more specific. D is wrong — the business cycle is broader.
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Question 126
The money multiplier concept explains that:
Select an option first.
Correct answer: A — The total stock of broad money is greater than the monetary base because banks create deposits through lending
Explanation: A is correct: the money multiplier (m = 1/reserve requirement) shows that an increase in base money (central bank money) leads to a larger increase in broad money supply through the lending process. For example, with a 10% reserve requirement, $1 of base money can support up to $10 of deposits. A is correct. B is wrong — central banks control base money; commercial banks create broad money. C is wrong — banks are central to credit money creation. D is wrong — no such relationship.
Question 127
Under Basel's Pillar 2 (Supervisory Review Process), banks are required to:
Select an option first.
Correct answer: B — Conduct their own internal capital adequacy assessment processes (ICAAP) and demonstrate to supervisors that they hold capital sufficient for all risks — including those not covered by Pillar 1
Explanation: B is correct: Pillar 2 requires banks to conduct ICAAP (Internal Capital Adequacy Assessment Process) to assess all risks (including those not in Pillar 1 like concentration risk, pension risk, strategic risk) and ensure adequate capital. Supervisors review the ICAAP and can impose additional capital requirements (Pillar 2 add-ons). A is wrong — Pillar 2 goes beyond Pillar 1. C is wrong — Pillar 3 covers public disclosure. D is wrong — ICAAP uses the bank's own assessment.
Question 128
The concept of 'contagion' in financial markets refers to:
Select an option first.
Correct answer: B — The transmission of financial distress from one institution or market to others — through direct credit linkages, fire sales, confidence effects, or funding market freezes
Explanation: B is correct: financial contagion describes how distress spreads: (1) direct linkages — interbank lending, CDS exposures; (2) fire sales — forced selling depresses prices, harming others; (3) information contagion — runs on similar institutions; (4) funding contagion — money market funds and repo markets freeze. The 2008 crisis showed rapid global contagion. A is wrong — strategy copying is herding, not contagion. C is wrong — profitability decline is secular. D is wrong — accounting harmonisation is separate.
Question 129
A bond's 'dirty price' versus 'clean price' difference represents:
Select an option first.
Correct answer: B — Accrued interest — dirty price includes accrued interest since last coupon; clean price excludes it and is the conventionally quoted price
Explanation: B is correct: clean price = dirty price − accrued interest. Bonds are conventionally quoted at the clean price, but settlement occurs at the dirty price (full price). Between coupon dates, accrued interest accumulates from the last coupon date, reflecting the portion of the next coupon earned by the seller. A is wrong — bid-ask spread is a different concept. C is wrong — no credit adjustment is involved. D is wrong — premium/discount is about the clean price relative to par.
Question 130
A credit default swap (CDS) is typically quoted in terms of:
Select an option first.
Correct answer: B — The annual premium (in basis points) paid by the protection buyer to the protection seller, expressed as a percentage of the notional amount
Explanation: B is correct: CDS is quoted as an annual spread in basis points. For example, a 200 bps CDS means the protection buyer pays 200 bps/year × notional principal to the protection seller. Payments are typically quarterly. A is wrong — the spread is in bps, not a dollar amount. C is wrong — recovery rate affects value but is separate from the quoted spread. D is wrong — PD is derived from the spread, not the quoted input.
Question 131
The 'term premium' in long-term interest rates represents:
Select an option first.
Correct answer: B — The additional compensation investors demand for holding long-term bonds rather than rolling over short-term investments — reflecting uncertainty about future rates
Explanation: B is correct: the term (or liquidity) premium is the excess yield on long-term bonds above the expected return from rolling short-term bonds. It compensates for: interest rate uncertainty over long holding periods; inflation uncertainty; liquidity risk; and supply-demand imbalances. The term premium explains why the yield curve is typically upward sloping. A is wrong — inflation breakeven is different. C is wrong — credit spread is separate. D is wrong — swap spread is separate.
Question 132
Under IFRS 9, the Expected Credit Loss (ECL) model requires banks to:
Select an option first.
Correct answer: B — Recognise expected losses based on a forward-looking assessment — Stage 1 (12-month ECL), Stage 2 (lifetime ECL for significant credit deterioration), Stage 3 (lifetime ECL, credit-impaired)
Explanation: B is correct: the IFRS 9 ECL model (replacing the IAS 39 incurred loss model) is forward-looking. Stage 1: performing loans — 12-month ECL provision. Stage 2: loans with significant credit deterioration — lifetime ECL. Stage 3: credit-impaired — lifetime ECL (similar to the 'default' concept). The model is intended to recognise credit losses earlier than the incurred loss model. A is wrong — IFRS 9 replaced the incurred loss model. C is wrong — IFRS 9 requires internal forward-looking assessments. D is wrong — ECL is assessed at each reporting date.
Question 133
A 'prime brokerage' relationship in financial services involves:
Select an option first.
Correct answer: B — An investment bank providing integrated services to hedge funds — custody, securities lending, financing (leverage), clearing, and reporting
Explanation: B is correct: prime brokers are typically large investment banks that provide a suite of services to hedge funds and other sophisticated investors: securities lending (for short selling), margin financing (leverage), clearing and settlement, custody, and portfolio reporting. Prime brokerage became systemically important as it concentrated hedge fund exposures with a few large banks. A is wrong — basic services are retail/commercial banking. C is wrong — credit cards are retail products. D is wrong — primary dealerships are distinct.
Question 134
The 'shadow rate' concept in interest rate modelling refers to:
Select an option first.
Correct answer: B — A theoretical rate that can be negative in models that impose a zero lower bound — the shadow rate represents the rate that would prevail without the non-negativity constraint
Explanation: B is correct: when the nominal interest rate is constrained at or near zero (zero lower bound), short-rate models can be extended using a shadow rate — the theoretical rate that could go negative, with the actual rate being the maximum of the shadow rate and zero (or a small floor). Wu and Xia developed a shadow rate model to estimate the effective monetary policy stance when rates hit the ZLB. A is wrong — no secret rates exist. C is wrong — shadow banking is a separate concept. D is wrong — shadow rates are used in current modelling.
Question 135
The relationship between bond price and yield can be summarised as:
Select an option first.
Correct answer: B — Bond price and yield move inversely — when yields rise, prices fall; when yields fall, prices rise
Explanation: B is correct: the fundamental inverse relationship: bond price = PV of all future cash flows. As the discount rate (yield) rises, PV of cash flows falls → price falls. As yield falls, PV rises → price rises. This is the foundational concept of fixed income. A is wrong — the relationship is inverse. C is wrong — price is directly determined by yield. D is wrong — the relationship is non-linear (convex).
Question 136
Securitisation involves 'credit tranching'. The role of over-collateralisation (OC) in a securitisation structure is:
Select an option first.
Correct answer: B — To provide a cushion: the face value of the collateral pool exceeds the face value of all issued securities — the excess protects senior note holders from losses
Explanation: B is correct: over-collateralisation means the pool of assets is larger (in face value) than the securities issued against it. The excess acts as a first-loss buffer — if some loans default, the losses are absorbed before affecting any noteholders. OC is one of several credit enhancement mechanisms (along with excess spread, subordination, and reserve accounts). A is wrong — OC does not affect the number of tranches. C is wrong — OC is a structural (not government) enhancement. D is wrong — OC reduces risk, not coupon.
Question 137
In the context of bank regulation, 'Pillar 3' of Basel III requires:
Select an option first.
Correct answer: B — Market discipline through public disclosure — banks must disclose their risk profiles, capital adequacy, and risk management practices to enable market participants to assess their financial condition
Explanation: B is correct: Pillar 3 uses market discipline by requiring banks to disclose qualitative and quantitative information about their capital structure, risk exposures, risk measurement approaches, and capital adequacy. This enables counterparties, investors, and analysts to assess the bank's risk profile. A is wrong — that is the countercyclical buffer (Pillar 1). C is wrong — that is Pillar 2 (ICAAP). D is wrong — that is also Pillar 2.
Question 138
The 'velocity of money' concept in monetary economics states:
Select an option first.
Correct answer: B — GDP = Money supply (M) × Velocity (V): V = GDP/M — velocity measures how often each unit of currency is used in transactions in a given period
Explanation: B is correct: the quantity theory of money: MV = PY, where M = money supply, V = velocity, P = price level, Y = real output. Velocity V = nominal GDP / M, measuring how many times money 'turns over' in a year. Central banks use this framework to understand the link between money supply and economic activity/inflation. A is wrong — rearranged but incomplete. C is wrong — velocity and rates are related but not simply. D is wrong — velocity is empirically variable.
Question 139
A bank run occurs when:
Select an option first.
Correct answer: B — Many depositors simultaneously withdraw their funds due to fears about the bank's solvency — the self-fulfilling nature means even solvent banks can fail due to liquidity exhaustion
Explanation: B is correct: a bank run is a self-reinforcing liquidity crisis. Even solvent banks can fail if enough depositors simultaneously demand their money — the bank cannot liquidate long-term assets quickly enough. Deposit insurance and lender-of-last-resort functions exist precisely to prevent runs. B is correct. A is wrong — runs are triggered by fear of loss, not higher returns. C is wrong — runs are triggered by concerns about solvency. D is wrong — negative rates are a monetary policy phenomenon.
Question 140
The 'capital market line' (CML) in modern portfolio theory represents:
Select an option first.
Correct answer: B — The set of optimal portfolios combining the risk-free asset and the market portfolio — showing the best risk-return trade-off available
Explanation: B is correct: the CML shows all possible combinations of the risk-free asset and the market portfolio (tangency portfolio). Every point on the CML is optimal — investors choose their position on the CML based on risk tolerance. The CML slope is the Sharpe ratio of the market portfolio. A is wrong — the efficient frontier excludes the risk-free asset. C is wrong — CML is about portfolio allocation. D is wrong — credit spreads are a fixed income concept.
Question 141
Under the Basel standardised approach for credit risk, the risk weight for an unrated corporate exposure is:
Select an option first.
Correct answer: B — 100% — the default risk weight for unrated corporate exposures
Explanation: B is correct: under the Basel II/III standardised approach, an unrated corporate loan receives a 100% risk weight as the default. Rated corporates can receive lower weights (20% for AAA-AA, 50% for A, 100% for BBB-BB, 150% below BB). Without an external rating, 100% applies. A is wrong — 0% is for OECD government bonds. C is wrong — 50% is for A-rated corporates. D is wrong — 150% is for below BB.
Question 142
The 'risk-free rate' used in derivatives pricing is most commonly:
Select an option first.
Correct answer: B — The OIS (overnight index swap) rate — which is nearly risk-free as it is based on collateralised overnight lending and contains minimal credit risk
Explanation: B is correct: post-crisis, OIS rates replaced LIBOR as the risk-free discount rate for derivatives pricing, especially for fully collateralised trades. OIS reflects the compounded overnight rate (SOFR, SONIA, €STR) with virtually no credit or liquidity premium. A is wrong — policy rates apply to overnight borrowing but OIS is more liquid for curve construction. C is wrong — 10Y government yields include a term premium. D is wrong — deposit rates include bank credit risk.
Question 143
Central clearing of standardised OTC derivatives (mandated post-2008) reduces systemic risk primarily by:
Select an option first.
Correct answer: B — Multilateral netting through the CCP — bilateral counterparty exposures are replaced by exposures to a single, well-capitalised CCP, reducing gross and net exposures across the system
Explanation: B is correct: the key benefit of central clearing is multilateral netting. Instead of each pair of counterparties having bilateral exposures, all trades are novated to the CCP. The CCP nets all positions with each participant, dramatically reducing total system-wide gross exposures. Additionally, CCPs collect robust margin and maintain default funds. A is wrong — CCPs clear OTC contracts, which remain OTC in economic terms. C is wrong — CCPs require more margin. D is wrong — most cleared derivatives remain cash-settled.
Question 144
The 'carry' in a fixed income investment refers to:
Select an option first.
Correct answer: B — The income return — coupon income less funding cost. Positive carry means the coupon earned exceeds the cost of financing the position
Explanation: B is correct: carry = income received − financing cost. For a bond funded in the repo market: carry = coupon income − repo rate × bond price. Positive carry means the bond earns more than it costs to hold. A is wrong — capital gain is price return. C is wrong — that is credit spread. D is wrong — roll-down is a separate return component (the price appreciation as the bond 'rolls down' the yield curve with the passage of time).
Question 145
A 'reverse mortgage' allows homeowners to:
Select an option first.
Correct answer: B — Access equity in their home by borrowing against it, with no repayments required until the home is sold or the owner vacates — the loan balance grows over time as interest accrues
Explanation: B is correct: a reverse mortgage allows older homeowners (typically 62+) to convert home equity into cash. No monthly payments are required — instead, the loan balance grows as interest accrues. The loan is repaid when the owner sells the home, moves out, or dies. B is correct. A is wrong — that is a conventional mortgage. C is wrong — that is refinancing. D is wrong — that is porting.
Question 146
A 'special purpose acquisition company' (SPAC) is:
Select an option first.
Correct answer: B — A blank-check shell company that raises capital through an IPO with the sole purpose of acquiring or merging with a target company within a specified timeframe
Explanation: B is correct: a SPAC (blank-check company) raises money from investors through an IPO, then has a fixed window (typically 18-24 months) to identify and complete an acquisition/merger. If no deal is completed, investors receive their money back. SPACs provide an alternative route to public markets for target companies. A is wrong — that describes distressed debt funds. C is wrong — that describes GSEs like Fannie Mae. D is wrong — that describes a fund of funds.
Question 147
The 'Jensen's alpha' of a portfolio measures:
Select an option first.
Correct answer: B — The excess return of the portfolio above the return predicted by the CAPM, given the portfolio's systematic risk (beta)
Explanation: B is correct: Jensen's alpha = Portfolio return − [Risk-free rate + beta × (Market return − Risk-free rate)] = actual return − CAPM expected return. A positive alpha indicates the portfolio earned more than expected given its systematic risk — suggesting skill or mispricing. A is wrong — Sharpe ratio measures return per unit of total risk. C is wrong — market timing is one source of alpha. D is wrong — that is risk-adjusted return (Sharpe ratio).
Question 148
The 'risk appetite' of a financial institution is best described as:
Select an option first.
Correct answer: B — The aggregate level and types of risk a firm is willing to assume in pursuit of its business objectives, expressed through qualitative and quantitative measures and approved by the board
Explanation: B is correct: risk appetite is a forward-looking framework defining the types and magnitudes of risk the institution is willing to accept. It is approved at board level and translates into risk limits across business lines, risk types, and regions. A is wrong — risk capacity/profile reflects historical risk-taking. C is wrong — regulatory minimums are external constraints. D is wrong — VaR limits are risk tolerance measures, subsets of risk appetite.
Question 149
The 'Treynor ratio' measures a portfolio's performance as:
Select an option first.
Correct answer: B — (Portfolio return − Risk-free rate) / Portfolio beta — return per unit of systematic (market) risk
Explanation: B is correct: Treynor ratio = (R_p − R_f) / β_p. It measures excess return per unit of systematic risk (beta). Unlike the Sharpe ratio (which uses total risk), Treynor uses only the non-diversifiable (systematic) component, making it more appropriate for comparing well-diversified portfolios. A is wrong — that is the Sharpe ratio. C is wrong — that is a return-to-risk ratio without the risk-free adjustment. D is wrong — that is the information ratio.
Question 150
Under a 'net asset value' (NAV) framework for money market funds, breaking the buck means:
Select an option first.
Correct answer: B — The NAV per share falls below $1.00 (for a $1.00 constant NAV fund) — signalling that the fund's assets are worth less than the par value of its shares, potentially triggering a run
Explanation: B is correct: constant NAV (CNAV) money market funds maintain a fixed $1.00 per share NAV. 'Breaking the buck' occurs when the fund's mark-to-market NAV falls below $0.995 per share. This is rare but catastrophic — it triggers investor runs. The 2008 Reserve Primary Fund broke the buck due to Lehman Brothers exposure, contributing to the money market freeze. A is wrong — fees erode returns gradually. C is wrong — two months of negative returns is separate. D is wrong — benchmarks are separate.
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