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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 151
The 'yield spread' between two bonds of different credit quality but similar maturity reflects:
Select an option first.
Correct answer: B — The market's compensation for taking on the additional credit risk, liquidity risk, and other risks of the lower-quality bond
Explanation: B is correct: the yield spread between a corporate bond and a Treasury of the same maturity = credit spread. It compensates investors for: default risk (probability of default × loss given default); liquidity risk (wider bid-ask, thinner market); and other factors (tax treatment differences, optionality). A is wrong — coupon rate differences don't determine yield spreads directly. C is wrong — domestic bonds in the same currency have no FX risk. D is wrong — duration differences affect interest rate risk, not credit spreads.
Question 152
A 'warehouse line' in the context of mortgage banking is:
Select an option first.
Correct answer: B — A short-term revolving credit facility that allows mortgage originators to fund newly-originated mortgages before they are sold to investors in the secondary market
Explanation: B is correct: a warehouse line provides bridge financing for mortgage originators — they use the line to fund new mortgages and repay it when the mortgages are sold to investors (e.g. Fannie Mae) or pooled into MBS. A is wrong — that is a commercial real estate mortgage. C is wrong — warehouse ABS is a separate instrument. D is wrong — internal limits are management tools.
Question 153
The 'net present value' (NPV) of a project investment equals:
Select an option first.
Correct answer: B — The present value of all future cash inflows minus the present value of all future cash outflows (including the initial investment), using the appropriate discount rate
Explanation: B is correct: NPV = Σ [CF_t / (1+r)^t] − Initial investment. A positive NPV means the project creates value above the cost of capital. The NPV rule states: invest in projects with NPV > 0. A is wrong — undiscounted sum ignores time value. C is wrong — that is accounting return on investment. D is wrong — IRR is the discount rate that makes NPV = 0.
Question 154
The concept of 'duration gap' in bank ALM measures:
Select an option first.
Correct answer: B — The difference between the duration of assets and the weighted duration of liabilities — indicates the bank's sensitivity of equity value to interest rate changes
Explanation: B is correct: duration gap = D_A − (L/A) × D_L, where D_A is asset duration, D_L is liability duration, L/A is the leverage ratio. A positive duration gap means assets have longer duration than liabilities — rising rates reduce equity value (assets fall more than liabilities). A is wrong — maturity difference is a crude measure. C is wrong — that is settlement risk. D is wrong — credit gap is different.
Question 155
The 'risk-free rate' in the CAPM framework represents:
Select an option first.
Correct answer: B — The return on an investment with zero systematic risk — used as the baseline return that any investment should earn without bearing market risk
Explanation: B is correct: in CAPM, the risk-free rate is the return on an asset with zero beta (zero covariance with the market). An investor earns the risk-free rate for simply deferring consumption without bearing market risk. Additional return above the risk-free rate (the equity risk premium) compensates for bearing systematic risk. A is wrong — market expected return includes the risk premium. C is wrong — the minimum variance portfolio has some systematic risk. D is wrong — policy rates approximate but do not define the risk-free rate.
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Question 156
In the context of Islamic finance, 'sukuk' are:
Select an option first.
Correct answer: B — Islamic financial certificates structured to comply with Sharia principles — instead of interest, returns are based on profit-sharing, asset rental, or other permissible structures
Explanation: B is correct: Sharia prohibits riba (interest). Sukuk are structured so that investors receive returns based on the underlying asset's performance or rental income rather than interest. Common structures include ijara (lease-based), murabaha (cost-plus sale), and musharaka (partnership). A is wrong — fixed-coupon bonds are not Sharia-compliant. C is wrong — sukuk are debt-like instruments. D is wrong — deposit guarantees are a separate concept.
Question 157
The 'information ratio' measures a portfolio manager's skill as:
Select an option first.
Correct answer: B — Active return (portfolio return − benchmark return) / Tracking error — measures the consistency of alpha generation relative to active risk taken
Explanation: B is correct: information ratio (IR) = (R_p − R_b) / σ(R_p − R_b) = active return / tracking error. A high IR indicates the manager consistently generates positive alpha relative to the benchmark per unit of active risk taken. A is wrong — that is a form of Sharpe ratio vs market. C is wrong — no benchmark comparison. D is wrong — not a standard definition.
Question 158
The concept of 'regulatory arbitrage' in banking refers to:
Select an option first.
Correct answer: B — Banks structuring transactions to minimise regulatory capital requirements without reducing actual economic risk — exploiting gaps or inconsistencies between regulatory rules and economic reality
Explanation: B is correct: regulatory arbitrage occurs when banks exploit loopholes or inconsistencies in regulatory frameworks to achieve lower capital requirements for the same level of economic risk. Examples include moving assets off-balance-sheet (SIVs), using synthetic transactions, or exploiting differences between book value and fair value. This was a major contributor to the 2008 crisis. A is wrong — international trading is legitimate business. C is wrong — interest rate differences are market phenomena. D is wrong — relocation is a different concept.
Question 159
The 'resolution authority' for a failing bank has powers to:
Select an option first.
Correct answer: B — Use a range of resolution tools including bail-in (writing down creditors), bridge bank (transferring assets), purchase-and-assumption (selling parts to another bank), and asset separation (bad bank)
Explanation: B is correct: modern resolution frameworks (BRRD in EU, Dodd-Frank in US) give authorities tools to resolve failing banks while maintaining financial stability: bail-in (writing down/converting debt); bridge bank (temporary bank holding viable operations); purchase and assumption (selling assets/liabilities to a healthy bank); bad bank (segregating toxic assets). A is wrong — multiple tools are available. C is wrong — liquidity support is the lender-of-last-resort function. D is wrong — authorities cannot force shareholders to invest.
Question 160
The 'pass-through rate' on a mortgage-backed security is:
Select an option first.
Correct answer: B — The interest rate passed through to MBS investors after deducting servicing, guarantee, and other fees from the weighted average coupon (WAC) of the pool
Explanation: B is correct: pass-through rate = WAC − servicing fee − guarantee fee (for agency MBS). For example, if the pool WAC is 6.5% and fees total 0.5%, the pass-through rate is 6.0%. Investors receive interest based on this net rate applied to the outstanding balance. A is wrong — WAC is gross of fees. C is wrong — prepayment rate is CPR. D is wrong — YTM incorporates prepayment assumptions.
Question 161
The 'swap curve' (par swap rates at various maturities) is used as a benchmark in fixed income because:
Select an option first.
Correct answer: B — It represents liquid market rates for high-credit-quality institutions, providing a comprehensive term structure reference used for discounting, pricing, and risk management
Explanation: B is correct: the swap curve provides benchmark rates at each standard maturity (1Y through 30Y+) based on liquid interbank swap transactions. It is used for: discounting derivative cash flows; pricing new bond issues; and measuring credit/liquidity spreads above the risk-free curve. The swap curve is slightly above the Treasury curve (swap spread reflects interbank credit risk). A is wrong — swap rates are typically above Treasuries. C is wrong — swap rates are market-determined. D is wrong — the swap curve is relevant for all fixed income.
Question 162
The 'Black Swan' concept in risk management refers to:
Select an option first.
Correct answer: A — A low-probability but high-impact event that is virtually impossible to predict based on historical data — and that conventional risk models systematically underestimate
Explanation: A is correct: Nassim Taleb's 'Black Swan' describes rare, extreme events that: (1) lie outside normal expectations (historically unprecedented); (2) have massive impact; and (3) in retrospect, people create explanations as if they were predictable. VaR models based on historical distributions catastrophically fail for Black Swan events. The 2008 crisis, 9/11, and COVID-19 are often cited as Black Swans. A is correct. B, C and D are wrong — not related to the concept.
Question 163
The 'equity risk premium' (ERP) represents:
Select an option first.
Correct answer: B — The expected excess return of equities over the risk-free rate — compensation investors demand for bearing the additional risk of equity markets relative to safe assets
Explanation: B is correct: ERP = E(R_market) − R_f. It is the additional expected return that investors require to hold risky equities instead of risk-free assets. Historically, the ERP has been approximately 4-6% per annum for developed markets, though estimates vary widely. A is wrong — that is the risk-free rate itself. C is wrong — dividend yield is one component of equity return. D is wrong — relative volatility is a risk measure, not a return measure.
Question 164
A bank's 'concentration risk' arises when:
Select an option first.
Correct answer: B — Exposures are heavily concentrated in a single borrower, sector, geography, or product — meaning a single adverse event can cause disproportionately large losses
Explanation: B is correct: concentration risk occurs when credit or market exposures lack diversification. Examples include: a bank with 40% of its loan book to real estate; a bank heavily exposed to a single large corporate; or geographic concentration in a single country's assets. Regulators impose large exposure limits (typically 25% of Tier 1 capital to a single counterparty) to mitigate concentration risk. A is wrong — diversification reduces concentration risk. C is wrong — many small borrowers is better diversified. D is wrong — funding diversification is liquidity risk management.
Question 165
The 'money market basis' (MMB) conversion formula to convert a discount yield to a money market yield for a T-bill is:
Select an option first.
Correct answer: B — MMY = (F − P) / P × (360 / days) — using the purchase price as the denominator instead of face value
Explanation: B is correct: the money market yield (bond equivalent yield for short maturities) uses the purchase price as the denominator: MMY = (F − P)/P × (360/days). This is higher than the discount yield (which uses face value F in the denominator) because P < F. The formula correctly annualises the return based on actual investment. A is wrong — algebraically equivalent but B is the cleaner form. C is wrong — simple day-count adjustment doesn't convert properly. D is wrong — not annualised.
Question 166
A 'prime rate' is:
Select an option first.
Correct answer: B — A benchmark lending rate historically set by commercial banks for their most creditworthy corporate customers — typically set above the federal funds rate
Explanation: B is correct: the prime rate is a benchmark rate historically used by US commercial banks for short-term loans to their best corporate clients. It is typically set at the federal funds rate plus 300 basis points (3%). While less prominent now (with SOFR and other benchmarks), the prime rate is still used for certain consumer and business loans. A is wrong — that is the discount rate. C is wrong — the risk-free rate in CAPM is typically the T-bill rate. D is wrong — deposit minimums are set separately.
Question 167
The 'Fisher effect' in interest rate theory states:
Select an option first.
Correct answer: A — Nominal interest rates equal real interest rates plus expected inflation
Explanation: A is correct: the Fisher equation: (1 + nominal rate) = (1 + real rate) × (1 + expected inflation), approximately: nominal rate ≈ real rate + expected inflation. This means nominal rates incorporate inflation expectations — when inflation expectations rise, nominal rates rise correspondingly to maintain the real rate. A is correct. B is wrong — real rates are typically positive. C is wrong — deflation would push nominal rates below real rates. D is wrong — the Fisher effect specifically states inflation affects nominal rates.
Question 168
A bank's 'asset quality' is most directly measured by:
Select an option first.
Correct answer: B — Non-performing loan (NPL) ratios, loan loss provision coverage ratios, and net charge-off rates — indicators of credit quality in the loan portfolio
Explanation: B is correct: asset quality metrics focus on the credit quality of the loan portfolio: NPL ratio (non-performing loans / total loans); provision coverage ratio (loan loss allowance / NPLs); and net charge-off rate (actual loan losses net of recoveries / average loans). These indicate whether the bank has adequately recognised and provisioned for credit losses. A is wrong — ROE is a profitability metric. C is wrong — securities yield is an income metric. D is wrong — NIM is a profitability metric.
Question 169
A forward contract obligates the parties to:
Select an option first.
Correct answer: B — Exchange an asset at a specified price and date in the future — one party buys, the other sells the underlying
Explanation: B is correct: a forward contract is an obligation (not an option) for both parties to transact in an underlying asset at a predetermined forward price on a specified future date. The buyer is long (agrees to buy) and the seller is short (agrees to sell). A is wrong — that describes an option on an asset. C is wrong — contingent payment is an option feature. D is wrong — immediate delivery is a spot transaction.
Question 170
The key difference between a forward contract and a futures contract is:
Select an option first.
Correct answer: B — Futures are exchange-traded, standardised, and marked-to-market daily with margin requirements; forwards are OTC, customised, and settled at maturity
Explanation: B is correct: futures are standardised contracts traded on organised exchanges with daily mark-to-market (variation margin). Forwards are OTC, allowing full customisation of size, maturity, and settlement terms, but with counterparty credit risk. A is wrong — the descriptions are reversed. C is wrong — forwards can be used for any underlying. D is wrong — both can have physical or cash delivery.
Question 171
The cost of carry model for the forward price of a non-dividend-paying stock is:
Select an option first.
Correct answer: B — F = S × e^(r×T) (or F = S × (1+r)^T in discrete compounding)
Explanation: B is correct: for a non-dividend-paying asset, the no-arbitrage forward price is F = S₀ × e^(rT) under continuous compounding, where S₀ is the current spot price, r is the risk-free rate, and T is time to maturity. This reflects the cost of carrying the asset (funding cost). A is wrong — subtracting is incorrect. C is wrong — that discounts the spot price (present value formula). D is wrong — not the correct formula.
Question 172
A forward price is set such that the initial value of the forward contract is:
Select an option first.
Correct answer: B — Zero — no payment is made at initiation; the forward price is set so that neither party gains an advantage
Explanation: B is correct: a forward contract has zero initial value by construction — the forward price is set to make the contract fair to both parties, so no payment is required at initiation. During the life of the contract, its value fluctuates as the spot price and forward price change. A is wrong — no upfront premium is paid. C is wrong — the forward price includes the cost of carry. D is wrong — that is a different valuation concept.
Question 173
If a futures price is above the no-arbitrage forward price (cash-and-carry price), an arbitrageur would:
Select an option first.
Correct answer: B — Buy the underlying asset (borrow money), short the futures contract, and hold until expiry — earning a riskless profit as futures price converges to spot
Explanation: B is correct: cash-and-carry arbitrage: if F > S × e^(rT), you buy the spot asset (funded by borrowing at r), short the overpriced futures, and deliver the asset at expiry. At expiry, the futures converges to spot, and the repayment of the borrowing equals the delivery price at the correct forward level — generating a riskless profit. A is wrong — buying futures when they are overpriced does not generate arbitrage. C is wrong — that is reverse cash-and-carry (used when F < S×e^rT). D is wrong — mispricings do allow arbitrage.
Question 174
The value of a long forward position after initiation is:
Select an option first.
Correct answer: B — The current spot price minus the present value of the forward price: V = S − F × e^(−rT)
Explanation: B is correct: the value of a long forward contract entered at forward price K, with time remaining T, is V = S₀ − K × e^(−rT), where S₀ is the current spot price and K is the contracted forward price. This reflects the difference between the current spot and the present value of the agreed delivery price. A is wrong — value is zero only at initiation when K = F₀. C is wrong — the denominator includes time value. D is wrong — value can change after initiation.
Question 175
Futures contracts differ from OTC forwards in that futures have:
Select an option first.
Correct answer: B — Daily settlement (mark-to-market), standardised terms, and the exchange/CCP as counterparty — virtually eliminating counterparty credit risk
Explanation: B is correct: futures are marked-to-market daily, with gains/losses flowing through margin accounts. The exchange or CCP stands between all buyers and sellers, effectively eliminating bilateral counterparty risk. A is wrong — futures have less counterparty risk than OTC forwards. C is wrong — futures require both initial and variation margin. D is wrong — OTC forwards can have longer maturities.
Question 176
The basis in futures markets is defined as:
Select an option first.
Correct answer: B — The spot price minus the futures price (basis = S − F) — basis tends to approach zero as the futures approaches expiry (convergence)
Explanation: B is correct: basis = spot price − futures price = S − F. At expiry, the futures price converges to the spot price, so basis approaches zero. Basis risk is the risk that the basis changes unexpectedly, affecting the hedge's effectiveness. A is wrong — that is the price range. C is wrong — margin is separate. D is wrong — yield is a fixed income concept.
Question 177
The optimal hedge ratio using futures is calculated as:
Select an option first.
Correct answer: B — h* = ρ × (σ_S / σ_F), where ρ is the correlation between spot and futures returns, and σ_S and σ_F are the standard deviations of spot and futures returns respectively
Explanation: B is correct: the minimum variance hedge ratio h* = ρ_{S,F} × (σ_S / σ_F). It minimises the variance of the hedged position. If ρ = 1 and σ_S = σ_F, then h* = 1 (perfect hedge). A is wrong — that is a naive ratio. C is wrong — h* depends on correlation and volatility. D is wrong — the product is not used.
Question 178
A commodity futures price is above the expected future spot price (futures > expected spot). This situation is called:
Select an option first.
Correct answer: B — Contango — futures are at a premium to expected spot, often reflecting storage costs and financing
Explanation: B is correct: contango describes a market where futures prices are above the expected spot price (or current spot + cost of carry). This is common for storable commodities where storage and financing costs justify the premium. A is wrong — backwardation is when futures are below the spot/expected future spot. C is wrong — roll yield is the gain/loss from rolling futures positions. D is wrong — basis risk is the risk of basis changes.
Question 179
Normal backwardation in commodity futures occurs when:
Select an option first.
Correct answer: B — Futures prices are below the expected future spot price — often attributed to hedgers (typically commodity producers who are naturally short) needing to pay a premium to attract speculators to take the long side
Explanation: B is correct: in Keynes' normal backwardation hypothesis, commodity producers (naturally short the commodity) will sell futures below the expected future spot price to attract speculators to go long, providing insurance to producers. Speculators earn a risk premium (long futures tend to rise toward spot). A is wrong — that is contango. C is wrong — yield curve inversion is a separate concept. D is wrong — that affects whether backwardation or contango exists but doesn't define normal backwardation.
Question 180
The convenience yield on a commodity reflects:
Select an option first.
Correct answer: B — The benefit from physically holding the commodity (e.g. being able to use it in production or profit from unexpected shortages) — it reduces the futures price below the full cost-of-carry level
Explanation: B is correct: the convenience yield is the implicit benefit of holding a physical commodity — e.g. an oil refinery values having oil on hand to maintain continuous production. It effectively reduces the forward price: F = S × e^((r + u − y)T) where u = storage cost rate, y = convenience yield. A is wrong — commodities pay no dividends. C is wrong — that is roll yield. D is wrong — commodity repo is separate.
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