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Free Questions › FRM › Foundations of Risk Management
Free FRM Foundations of Risk Management Practice Questions & Answers
400 exam-style Foundations of Risk Management questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 361
A pension fund adopts a 'liability-driven investment' (LDI) strategy. This primarily involves:
Select an option first.
Correct answer: B — Structuring the investment portfolio to match the duration and cash flow profile of the pension liabilities, reducing funding ratio volatility
Explanation: LDI matches assets to liabilities — using interest rate swaps and long-dated bonds to hedge the sensitivity of the liability PV to interest rates. This reduces funding ratio volatility (the key risk for a pension fund) even if it sacrifices some upside. A ignores liability matching; C is too restrictive; D is alpha-seeking.
Question 362
Which of the following correctly defines 'active return' in portfolio management?
Select an option first.
Correct answer: C — The portfolio return minus the benchmark return
Explanation: Active return = Rp − Rb (portfolio minus benchmark). It measures the value added (or destroyed) by active management decisions. B is excess return (used in Sharpe); D is Jensen's alpha.
Question 363
A firm's risk management framework includes a 'heat map' of risks. This is best described as:
Select an option first.
Correct answer: B — A visual matrix plotting risks by their likelihood and potential impact, enabling prioritisation of the most material risks
Explanation: A risk heat map plots risks on a likelihood × impact matrix, helping management prioritise which risks to address. High likelihood + high impact = red zone requiring urgent attention. A, C, and D are incorrect.
Question 364
Which of the following is an example of a 'key risk indicator' (KRI) for operational risk?
Select an option first.
Correct answer: B — The number of failed trades (settlement failures) per week
Explanation: Settlement failures are a KRI for operational risk — a rising number signals deterioration in operational processes or systems. A is a business performance metric; C is a market risk measure; D is a credit risk indicator.
Question 365
Which of the following most accurately describes the role of a 'compliance officer' within a financial institution?
Select an option first.
Correct answer: B — To ensure the firm and its staff comply with applicable laws, regulations, and internal policies — reducing legal and regulatory risk
Explanation: Compliance (second line of defence) monitors regulatory adherence, provides guidance on regulatory requirements, and escalates breaches. A is inappropriate (regulatory arbitrage may breach rules); C is a partial function; D is a credit approval / operational control.
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Question 366
What is meant by 'countercyclical capital buffer' (CCyB) in Basel III?
Select an option first.
Correct answer: B — An additional capital buffer that regulators can require banks to build during periods of excessive credit growth, to be released during downturns to absorb losses and maintain lending
Explanation: The CCyB (0-2.5% of RWA) addresses pro-cyclicality: built up in booms (when credit grows rapidly) and released in busts (allowing banks to absorb losses without cutting lending). A describes the capital conservation buffer; C is the G-SIB/D-SIB surcharge; D is a liquidity concept.
Question 367
Which of the following is a primary objective of a firm's 'recovery plan'?
Select an option first.
Correct answer: B — To outline the actions management would take to restore the firm's financial strength and viability under severe stress, without resorting to resolution
Explanation: A recovery plan is a 'playbook' for management: actions to rebuild capital (capital raises, asset sales, dividend cuts, cost reductions) during severe stress. It differs from a resolution plan (living will), which deals with an orderly wind-down when recovery fails. A is the resolution plan; C is a sub-element; D relates to resolution.
Question 368
Which of the following best defines 'market efficiency' in the context of the Efficient Market Hypothesis (EMH)?
Select an option first.
Correct answer: B — Markets where prices fully and rapidly reflect all available information relevant to an asset's value
Explanation: EMH defines efficiency as rapid, unbiased incorporation of information into prices. This does not mean zero transaction costs (A), equal returns (C), or static prices (D) — prices change constantly as new information arrives.
Question 369
The Dodd-Frank Act (USA) was primarily designed to:
Select an option first.
Correct answer: B — Strengthen financial regulation following the 2008 crisis by increasing oversight of systemically important institutions, derivatives markets, and consumer protection
Explanation: Dodd-Frank (2010) responded to the 2008 crisis by: creating FSOC (systemic risk oversight), mandating central clearing for standardised OTC derivatives, establishing the Consumer Financial Protection Bureau (CFPB), and introducing stress testing requirements. A, C, and D are incorrect.
Question 370
Central clearing of OTC derivatives (e.g., interest rate swaps through a Central Counterparty/CCP) primarily reduces:
Select an option first.
Correct answer: B — Counterparty credit risk by interposing the CCP between buyers and sellers, requiring margin and maintaining a default fund
Explanation: CCPs reduce bilateral counterparty risk through multilateral netting, daily margining, and the default waterfall (initial margin → variation margin → default fund). A is not directly reduced (market exposure remains); C and D are secondary benefits.
Question 371
Which of the following is the primary criticism of traditional mean-variance optimisation (MVO) in portfolio construction?
Select an option first.
Correct answer: B — It is extremely sensitive to errors in expected return estimates, often producing extreme and unstable portfolio weights
Explanation: 'Error maximisation': small errors in expected return estimates (the most uncertain input) produce large swings in optimal weights. In practice, MVO often suggests extreme concentrations or short positions that make no practical sense. A is wrong (it requires many inputs); C and D are incorrect.
Question 372
Which of the following best describes 'factor investing' (smart beta)?
Select an option first.
Correct answer: B — Constructing portfolios that systematically expose investors to academically documented return premia (factors) such as value, size, momentum, quality, and low volatility
Explanation: Factor investing (smart beta) is between passive and active: systematic, rules-based exposure to documented risk premia. It is cheaper than traditional active management but captures known sources of return beyond the market beta. A is cap-weighted passive; C is traditional active; D is just high-beta.
Question 373
In the context of risk governance, 'three lines of defence' means the internal audit function (third line) should:
Select an option first.
Correct answer: B — Operate independently of management and report to the audit committee/board, providing objective assurance without being involved in operations or risk management
Explanation: Internal audit's independence is paramount — it must report to the board/audit committee, not to the functions it audits. If it reports to the CEO (A) or is merged with risk management (C), its objectivity is compromised. D is too narrow.
Question 374
Which of the following is the most important reason why 'skin in the game' (risk retention) is considered a valuable risk management mechanism?
Select an option first.
Correct answer: B — When risk originators retain a portion of the risk they create, their incentives align with the interests of risk investors — encouraging better origination quality
Explanation: Skin in the game (e.g., the EU/US 5% risk retention rule for securitisations) addresses moral hazard: if originators keep a portion of the risk, they have an incentive to maintain quality. A is a balance sheet effect; C is incorrect (retention increases RWA); D is incorrect.
Question 375
A bank's ALCO (Asset-Liability Committee) primarily manages:
Select an option first.
Correct answer: B — The structural balance sheet risks — interest rate risk, funding liquidity risk, and capital management — arising from the mix and repricing of assets and liabilities
Explanation: ALCO oversees the balance sheet from a structural risk perspective: managing NIM sensitivity to rate changes, funding mix and maturity profile, capital adequacy, and liquidity buffers. A is a trading function; C is compliance; D is corporate communications.
Question 376
Which of the following is an example of a 'second-order effect' in risk governance failures?
Select an option first.
Correct answer: B — A risk governance failure that leads to a loss → reputational damage → customer withdrawal → funding crisis → forced asset sales at distressed prices
Explanation: Second-order effects cascade beyond the initial event: governance failure → direct loss → reputational impact → liquidity crisis → asset fire sales. Understanding these chains is critical for ERM. A and C are first-order; D is a minor consequence.
Question 377
In portfolio management, 'alpha decay' refers to:
Select an option first.
Correct answer: B — The tendency for identified alpha opportunities to diminish over time as more investors exploit them, eroding the excess return
Explanation: Alpha decay: once an anomaly or strategy is publicly known, arbitrageurs trade it away, reducing its profitability. This is one reason why even skilled managers find it difficult to sustain high information ratios over time.
Question 378
Which of the following best explains the purpose of the Basel III 'Capital Conservation Buffer' (CCB)?
Select an option first.
Correct answer: B — To require banks to build a buffer of 2.5% CET1 above the regulatory minimum during normal times, which can be drawn down during stress to absorb losses while restricting distributions
Explanation: The CCB (2.5% CET1) sits above the minimum and acts as a distribution restriction mechanism: if a bank's buffer is eroded, dividends, share buybacks, and bonuses are restricted to rebuild capital. A is Pillar 2 add-on; C is the CCyB's role; D is liquidity (LCR/NSFR), not capital.
Question 379
Which of the following best explains why 'regulatory arbitrage' is a persistent challenge in financial regulation?
Select an option first.
Correct answer: B — When regulations impose costs or constraints in one sector or jurisdiction, financial activity migrates to less-regulated alternatives (shadow banking, offshore centres, lightly-regulated instruments), shifting risk rather than eliminating it
Explanation: Regulatory arbitrage is one of the main challenges: regulation in one area pushes activity to unregulated or lightly-regulated alternatives (e.g., bank regulation pushing activity to shadow banks, US regulation pushing activity to Cayman vehicles). This can increase systemic risk by moving it to less transparent sectors.
Question 380
Which of the following best describes the 'procyclicality of margin requirements' as a systemic risk concern?
Select an option first.
Correct answer: B — During periods of market stress, increasing margin requirements force leveraged investors to sell assets at exactly the moment when markets are most fragile, amplifying price declines
Explanation: Counter-intuitively, rising margins (responses to higher volatility during stress) force deleveraging precisely when it is most damaging. This was evident during the 2020 COVID shock and the 2022 UK gilts crisis. C and D are incorrect; A describes an inverse relationship that doesn't exist.
Question 381
How does the concept of 'capital fungibility' affect group-level risk management at a multinational financial institution?
Select an option first.
Correct answer: B — Capital held in subsidiary entities may not be freely transferable to the parent due to local regulatory requirements, ring-fencing rules, or currency controls — meaning group-level capital may appear adequate while individual entities face stress
Explanation: Capital trapped in subsidiaries due to regulatory ring-fencing, minority interests, or sovereign restrictions cannot necessarily be deployed where it is needed — creating 'trapped capital'. This is a major challenge for G-SIB capital planning and resolution. A overstates fungibility; C and D are incorrect.
Question 382
Which of the following best describes the 'liability structure risk' of a bank with high reliance on short-term wholesale funding?
Select an option first.
Correct answer: B — The risk that wholesale market participants withdraw funding rapidly at the first sign of stress, leaving the bank unable to fund its assets — a classic bank run dynamic adapted for modern funding markets
Explanation: Unlike retail deposits (sticky, insured), wholesale funding is highly confidence-sensitive and can evaporate quickly. The 2007 Northern Rock and 2008 Bear Stearns/Lehman failures illustrated how rapidly short-term wholesale funding can disappear once confidence is shaken.
Question 383
Which of the following best explains why passive index fund growth creates a potential systemic risk concern?
Select an option first.
Correct answer: B — As passive funds grow, they own larger proportions of all companies simultaneously — reducing the diversity of shareholders, potentially reducing market efficiency, and creating herding in flows that can amplify market movements
Explanation: Large passive fund growth raises concerns: (1) reduced price discovery (less active analysis of individual securities), (2) herding — simultaneous buying/selling during rebalancing and index changes, (3) concentrated common ownership across an industry may reduce competitive incentives. This is an active area of regulatory and academic debate.
Question 384
A risk committee is reviewing a proposal to launch a new complex structured product. Which of the following is the MOST important risk governance question they should ask?
Select an option first.
Correct answer: B — Do we fully understand the risks this product creates — for the firm, for clients, and for the system — and do our risk management capabilities match the complexity of the product?
Explanation: Governance requires understanding risk before launch: model risk (valuation complexity), liquidity risk (exit strategy), conduct risk (client suitability), and systemic risk (if widely distributed). Revenue (A), competitive positioning (C), and distribution maximisation (D) are commercial questions that should follow, not precede, risk assessment.
Question 385
Which of the following most accurately captures the purpose of 'recovery and resolution planning' for systemically important financial institutions?
Select an option first.
Correct answer: B — To require SIFIs to plan how they would first attempt to recover through their own actions, and — if that fails — how they could be resolved in an orderly manner without taxpayer support, by removing legal, structural, and operational impediments to resolution
Explanation: Recovery and resolution planning (RRP) has two components: (1) recovery plans — management's playbook for self-rescue; (2) resolution plans — regulators' framework for orderly wind-down without taxpayer funds. A is the 'too big to fail' problem RRP is designed to solve; C and D are not accurate.
Question 386
Which of the following most comprehensively explains the failure of risk governance at major financial institutions in the lead-up to the 2008 financial crisis?
Select an option first.
Correct answer: B — A combination of: inadequate risk appetite frameworks, compensation systems rewarding short-term risk-taking, excessive complexity in structured products, failure of board oversight, misplaced reliance on credit ratings, and regulatory blind spots — all interacting to obscure and amplify risk accumulation
Explanation: The 2008 crisis reflects multi-dimensional governance failure: cultural (bonus culture rewarding short-term risk), structural (originate-to-distribute creating misaligned incentives), analytical (over-reliance on ratings and models), regulatory (pro-cyclical rules, gaps in oversight of shadow banking), and behavioural (groupthink). Single-cause explanations (A, C, D) are inadequate.
Question 387
The Carhart Four-Factor Model extends the Fama-French Three-Factor Model by adding which factor?
Select an option first.
Correct answer: B — A momentum factor (stocks that performed well recently tend to continue performing well in the near term)
Explanation: Carhart (1997) added momentum (MOM or WML: Winners Minus Losers) to the Fama-French three factors (market, SMB, HML). Momentum was documented empirically by Jegadeesh and Titman (1993). A is in the Fama-French Five-Factor; C and D are other documented factors not in Carhart.
Question 388
A fund uses a '130/30' long-short strategy. This means:
Select an option first.
Correct answer: B — The fund holds 130% long equity positions and 30% short equity positions, resulting in 100% net market exposure but with greater ability to express active views
Explanation: 130/30 (long-short equity): 130% long + 30% short = 160% gross exposure, 100% net equity exposure. The short proceeds (30%) fund the extra 30% long, enabling more active expression of both overweight and underweight views without increasing net market exposure.
Question 389
Which of the following best describes 'rebalancing risk' in strategic asset allocation?
Select an option first.
Correct answer: B — The risk that rebalancing to target weights requires selling outperforming assets and buying underperforming assets at inopportune times, or that transaction costs erode returns
Explanation: Rebalancing risk: (1) mechanically selling winners and buying losers may feel counter-intuitive and create short-term underperformance, (2) transaction costs and taxes reduce net returns, (3) in illiquid markets, rebalancing itself moves prices adversely. These are real implementation costs of strategic asset allocation.
Question 390
Which of the following best describes the role of 'risk limits' in preventing 'risk creep' within a financial institution?
Select an option first.
Correct answer: B — Explicit, monitored risk limits prevent the gradual, incremental accumulation of risk beyond the board-approved appetite — each small increase alone seems acceptable but the cumulative effect crosses risk appetite boundaries
Explanation: Risk creep occurs when risk grows gradually — each individual step seems minor but the cumulative position exceeds appetite. Monitored limits with automatic escalation triggers prevent this. A is contrary to risk limits' purpose; C is too narrow; D is incorrect (limits constrain but don't guarantee against loss).
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