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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 31
Which of the following is NOT a category of financial risk?
Select an option first.
Correct answer: D — Aesthetic risk
Explanation: Aesthetic risk is not a recognised financial risk category. Market risk, credit risk, and liquidity risk are well-established categories in risk management. The question tests whether candidates can spot a fabricated term.
Question 32
A company's risk that it may lose sales because a rival introduces a better product is classified as:
Select an option first.
Correct answer: B — Business/strategic risk
Explanation: Competitive risk — the possibility of losing business to rivals — is a form of business or strategic risk. It stems from decisions in the competitive landscape rather than financial market movements, counterparty defaults, or internal process failures.
Question 33
Which of the following describes 'political risk'?
Select an option first.
Correct answer: B — The risk of financial losses due to changes in government policy, instability, or geopolitical events
Explanation: Political risk includes the potential for losses from government instability, policy reversals, expropriation, sanctions, or war. A is governance risk, C is commodity market risk, D could be regulatory/market risk but central bank independence is a feature not a risk.
Question 34
Inflation risk in a bond portfolio refers to:
Select an option first.
Correct answer: B — The risk that rising inflation erodes the real purchasing power of fixed cash flows
Explanation: Fixed-income investors face inflation risk because the fixed coupon and principal payments lose purchasing power when inflation rises. A is not a risk (issuers generally cannot unilaterally raise coupons on fixed-rate bonds). C is liquidity risk. D is not a recognised risk.
Question 35
Reinvestment risk refers to:
Select an option first.
Correct answer: A — The risk that received cash flows must be reinvested at lower rates than originally anticipated
Explanation: Reinvestment risk is the possibility that coupon or principal payments received must be reinvested at rates lower than the original yield. B is call risk (related but distinct). C is equity financing risk. D is operational/strategic risk.
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Question 36
Which of the following statements about the risk management process is correct?
Select an option first.
Correct answer: B — Risk management is a continuous cycle involving identification, measurement, management, and monitoring of risks
Explanation: Risk management is an ongoing process — risks change over time and need continual monitoring. A is incorrect (it is cyclical). C is incorrect (it is enterprise-wide). D is incorrect (all organisations face risks).
Question 37
A portfolio manager hedges an equity position using index futures. The remaining unhedged exposure is best described as:
Select an option first.
Correct answer: B — Basis risk
Explanation: When hedging with index futures, the hedge is rarely perfect — differences between the specific portfolio and the index leave a residual called basis risk. The hedge eliminates most systematic risk but basis risk remains.
Question 38
Which of the following is a primary driver of market risk across all asset classes?
Select an option first.
Correct answer: B — Changes in underlying risk factors such as prices, rates, and volatility
Explanation: Market risk across equities, fixed income, FX, and commodities is ultimately driven by movements in underlying risk factors — prices, yields, exchange rates, and implied volatilities. A is credit risk; C is operational risk; D is governance/strategic risk.
Question 39
What does 'risk appetite' mean for a financial institution?
Select an option first.
Correct answer: B — The level and type of risk an institution is willing to accept in pursuit of its objectives
Explanation: Risk appetite is a forward-looking statement of intent — how much risk management is prepared to tolerate. It differs from regulatory capital (A, C) and from historical loss data (D).
Question 40
Which of the following is an example of technology (IT) risk within operational risk?
Select an option first.
Correct answer: B — A cyberattack disrupting a bank's payment systems
Explanation: Technology/IT risk — system outages, cyberattacks, data breaches — is a subset of operational risk. A is credit risk; C is market risk; D is funding liquidity risk.
Question 41
The three lines of defence in risk management refers to:
Select an option first.
Correct answer: B — Business lines that own risk, risk management functions, and internal audit
Explanation: The three lines of defence framework: (1) business lines that generate and own risk, (2) risk management/compliance functions that oversee, and (3) internal audit that provides independent assurance. The other options describe capital structures or office functions.
Question 42
Economic capital differs from regulatory capital in that:
Select an option first.
Correct answer: B — Economic capital is the firm's internal estimate of capital needed to absorb unexpected losses at a chosen confidence level
Explanation: Economic capital is an internal risk measure — the amount of capital the firm believes it needs to remain solvent given its actual risk profile. Regulatory capital is externally mandated. A and D swap the definitions; C is not always true.
Question 43
Which of the following best describes 'enterprise risk management' (ERM)?
Select an option first.
Correct answer: B — A holistic approach to identifying, assessing, and managing all types of risk across an entire organisation
Explanation: ERM takes an integrated, firm-wide view of all risks — financial and non-financial — rather than managing them in silos. A is too narrow (financial only), C is too narrow (regulatory only), D is too narrow (CFO only).
Question 44
Which of the following is the best example of reputational risk materialising?
Select an option first.
Correct answer: B — A bank faces a large wave of customer withdrawals after press reports of alleged misconduct
Explanation: Reputational risk materialises when negative publicity — whether justified or not — leads customers, counterparties, or investors to lose confidence. A is market risk; C is operational/settlement risk; D is model risk.
Question 45
Which of the following best defines 'expected loss' in the context of a loan portfolio?
Select an option first.
Correct answer: B — The average or mean loss anticipated over a given period based on historical data and risk parameters
Explanation: Expected loss (EL) = PD × LGD × EAD — it is the statistical average loss the portfolio is expected to experience. It is not the worst-case loss (A), nor a periodic event (C), nor a valuation gap (D).
Question 46
Unexpected loss refers to:
Select an option first.
Correct answer: B — The volatility (standard deviation) of losses around the expected loss — the portion of loss the firm must hold capital against
Explanation: Unexpected loss is the statistical variability in losses around the mean. Capital is held to absorb unexpected losses, not expected ones (which should be covered by pricing/provisioning). A is the mean (expected loss), C conflates 'unexpected' with 'extreme', D is irrelevant.
Question 47
A trading book position earns a spread over the risk-free rate. This additional return compensates investors primarily for bearing:
Select an option first.
Correct answer: B — Credit risk and liquidity risk premium
Explanation: Credit spreads compensate investors for credit risk (default probability and loss given default) and a liquidity risk premium (compensation for difficulty selling the position). Operational and reputational risk are not explicitly priced into credit spreads.
Question 48
Correlation risk in a credit portfolio refers to:
Select an option first.
Correct answer: B — The risk that defaults tend to cluster together — when one borrower defaults, others are more likely to also default
Explanation: Correlation risk in credit portfolios is the tendency for defaults to be correlated — in recessions, many borrowers fail simultaneously, making diversification less effective. A is interest rate/market risk, C is duration/ALM risk, D is model risk.
Question 49
Which type of risk best describes the danger that a bank's derivatives counterparty will default before the contract's final settlement date?
Select an option first.
Correct answer: C — Pre-settlement (counterparty) credit risk
Explanation: Pre-settlement credit risk is the risk that a counterparty defaults during the life of a contract, before final settlement. Settlement risk occurs specifically at the moment of exchange. Market risk drives mark-to-market value, not default.
Question 50
Which of the following statements about liquidity and solvency is most accurate?
Select an option first.
Correct answer: B — A firm can be solvent (assets > liabilities) but still face a liquidity crisis if it cannot convert assets to cash quickly
Explanation: Solvency and liquidity are distinct: a firm may have positive net worth but lack immediate cash. The 2008 crisis showed that many institutions were initially illiquid rather than insolvent. A, C, and D are all incorrect.
Question 51
A bank holds a large position in a thinly traded structured credit product. During a market crisis, it is forced to sell at a 40% discount. This situation primarily illustrates:
Select an option first.
Correct answer: C — Trading liquidity risk (market liquidity risk)
Explanation: The inability to sell without accepting a massive price concession is the textbook definition of trading liquidity risk — the bid-ask spread widens dramatically, or there are simply no buyers at fair prices.
Question 52
Which of the following is an example of 'wrong-way risk'?
Select an option first.
Correct answer: B — A credit default swap purchased on a counterparty who is also exposed to the same risk factors that cause their default
Explanation: Wrong-way risk arises when the credit exposure to a counterparty is positively correlated with the probability of that counterparty defaulting. A CDS protection seller that is exposed to the same systemic shock as the reference entity is a classic example.
Question 53
A multinational firm reports in USD but has significant EUR-denominated revenues. If the EUR depreciates against the USD, the firm experiences:
Select an option first.
Correct answer: B — A reduction in its reported USD revenues when EUR earnings are translated
Explanation: Translation risk: when a stronger USD means that EUR-denominated revenues convert to fewer USD on reporting. This is the transaction/translation dimension of FX risk. A incorrectly states the direction; C ignores accounting reality; D mischaracterises the impact.
Question 54
Which of the following illustrates the concept of 'contagion risk'?
Select an option first.
Correct answer: B — A single bank failure triggering a loss of confidence that spreads through the financial system
Explanation: Contagion risk is where financial distress at one institution spreads to others through real or psychological linkages, potentially causing a systemic crisis. A is operational/credit risk, C is sector/systematic risk, D is credit/reputational risk.
Question 55
The concept of 'economic exposure' in FX risk refers to:
Select an option first.
Correct answer: B — The impact of exchange rate movements on a firm's future cash flows and competitive position
Explanation: Economic exposure (also called operating exposure) goes beyond accounting — it captures how exchange rate changes affect a firm's long-run competitiveness and cash-generating ability. A is translation exposure; C is transaction/translation; D is political/sovereign risk.
Question 56
Systemic risk is best characterised as:
Select an option first.
Correct answer: B — The risk that a failure or stress in one part of the financial system triggers widespread disruption across the entire system
Explanation: Systemic risk refers to the potential for localised failures to cascade into a broader financial crisis — the 'too interconnected to fail' problem. A is idiosyncratic; C is model risk; D is regulatory/political risk.
Question 57
Which of the following best describes the difference between known unknowns and unknown unknowns in risk management?
Select an option first.
Correct answer: A — Known unknowns are measurable risks; unknown unknowns are immeasurable, unanticipated risks
Explanation: Known unknowns are risks we know exist but cannot precisely quantify (e.g., we know credit losses will occur but not exactly when/how much). Unknown unknowns are risk types we haven't even conceptualised yet — the truly unexpected. B, C, and D are incorrect.
Question 58
Which statement best describes 'gap risk' in interest rate risk management?
Select an option first.
Correct answer: B — The risk arising from mismatches between the repricing dates of a firm's assets and liabilities
Explanation: Gap risk (or repricing risk) arises when assets and liabilities reprice at different times, exposing the firm to net interest income fluctuations when rates change. A is credit/spread risk; C is market risk; D is operational/governance risk.
Question 59
A pension fund's liabilities are long-duration fixed payments to retirees. If it holds short-duration assets, this creates:
Select an option first.
Correct answer: B — Duration (interest rate) mismatch risk
Explanation: A duration mismatch between assets (short duration) and liabilities (long duration) means rising interest rates will reduce the value of liabilities more than assets — a favourable move — but falling rates will increase liabilities faster than assets, creating a funding gap.
Question 60
A firm that relies solely on VaR to manage its risk exposure faces which significant limitation?
Select an option first.
Correct answer: B — VaR tells you nothing about the magnitude of losses beyond the confidence threshold
Explanation: VaR tells you the loss not exceeded with a given probability, but says nothing about how bad losses could get beyond that threshold. Expected Shortfall (ES) was developed to address this limitation. A and C are incorrect; D is not always true.
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