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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 91
Which of the following best describes the concept of 'risk transfer' as a risk management strategy?
Select an option first.
Correct answer: B — Shifting the financial consequences of a risk to a third party through instruments such as insurance, derivatives, or guarantees
Explanation: Risk transfer moves the financial exposure to another party — insurance, credit default swaps, guarantees. A is risk avoidance, C is risk retention/self-insurance, D is risk mitigation/reduction.
Question 92
Which of the following financial ratios is most commonly used as a quick measure of a firm's short-term liquidity health?
Select an option first.
Correct answer: C — Current ratio (current assets / current liabilities)
Explanation: The current ratio measures whether a firm has enough short-term assets to cover short-term liabilities. ROE measures profitability, D/E measures leverage, and P/E measures market valuation — none of these directly measure short-term liquidity.
Question 93
A sophisticated risk manager uses scenario analysis alongside VaR. The primary benefit of adding scenario analysis is:
Select an option first.
Correct answer: B — It captures risks from specific plausible events that may not appear in historical data or statistical models
Explanation: Scenario analysis complements VaR by exploring named scenarios (e.g., a pandemic, a geopolitical crisis) that might not exist in historical data. It provides qualitative richness that purely statistical models miss. A, C, and D are all incorrect.
Question 94
Which of the following is the most accurate reason why financial crises tend to produce losses far larger than pre-crisis risk models predicted?
Select an option first.
Correct answer: B — Models calibrated on benign historical data fail to capture the correlation spikes, liquidity evaporation, and fat-tailed events that characterise crises
Explanation: The fundamental problem is that models trained on normal times produce inputs (correlations, volatilities) that are far too benign for crisis conditions. Fat tails, correlation breakdown, and liquidity crises are systematically underestimated by standard models.
Question 95
What is the significance of the 'three lines of defence' framework in managing operational risk specifically?
Select an option first.
Correct answer: A — It ensures that no single individual or team has both the incentive to take risk and unchecked authority to do so
Explanation: The three lines prevent unchecked risk-taking by separating risk generation (line 1), risk oversight (line 2), and independent assurance (line 3). This separation of duties is critical in preventing the conflicts of interest that led to many historical operational risk disasters.
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Question 96
Which of the following best describes why 'pro-cyclicality' is a concern in risk management and financial regulation?
Select an option first.
Correct answer: A — During booms, VaR models report low risk (because volatility is low), leading to expanded leverage; during busts, VaR spikes, forcing deleveraging precisely when it is most harmful
Explanation: Pro-cyclicality means the financial system amplifies economic cycles: in good times, low measured risk enables more leverage; in bad times, high measured risk forces deleveraging, worsening the crisis. This is one of the fundamental critiques of VaR-based regulation.
Question 97
Net interest margin (NIM) for a bank is calculated as:
Select an option first.
Correct answer: B — (Interest income − Interest expense) / Average earning assets
Explanation: NIM = (Interest income − Interest expense) / Average earning assets. It measures the bank's core spread income efficiency. A uses wrong denominator; C is ROE; D is operating margin.
Question 98
Which of the following best describes 'pure risk'?
Select an option first.
Correct answer: B — Risk where only a loss or no loss outcome is possible, with no potential for gain
Explanation: Pure risk (e.g., fire, flood, theft) has only two outcomes: loss or no loss. Speculative risk (e.g., investing in stocks) can yield gain or loss. Insurance markets address pure risks. A describes speculative risk; C and D are too narrow.
Question 99
Which of the following is the best definition of 'exposure' in risk management?
Select an option first.
Correct answer: B — The amount that could be lost if a risk event materialises
Explanation: Exposure is the quantum at risk — the maximum amount that could be lost. Probability (A) is the likelihood of loss; average past loss (C) is historical loss data; D is loss frequency, not exposure.
Question 100
A firm buys insurance to protect against property damage. This is an example of which risk management strategy?
Select an option first.
Correct answer: C — Risk transfer
Explanation: Purchasing insurance transfers the financial consequence of a risk event to the insurer. A (risk retention) means accepting the loss internally. B (risk avoidance) means not undertaking the activity. D (risk mitigation) means reducing the likelihood or severity.
Question 101
Which of the following is an example of risk mitigation?
Select an option first.
Correct answer: B — A firm installs a sprinkler system to reduce fire damage
Explanation: Risk mitigation reduces the severity or frequency of a loss (sprinkler system reduces fire damage). A is risk avoidance. C is risk transfer. D is risk retention with provisioning.
Question 102
What does 'probability of default' (PD) measure?
Select an option first.
Correct answer: C — The likelihood that a borrower will fail to meet its debt obligations within a specified period
Explanation: PD is the statistical probability of a credit event (default) occurring within a given horizon (usually 1 year). Loss Given Default (LGD) is A/B; Exposure at Default (EAD) is D.
Question 103
Loss Given Default (LGD) is best described as:
Select an option first.
Correct answer: B — The fraction of the exposure that is lost when a borrower defaults, after accounting for recoveries
Explanation: LGD = 1 − Recovery Rate. If a $1 million loan defaults and $400,000 is recovered, LGD = 60%. PD is A; EAD is C; D is not a standard risk metric.
Question 104
Exposure at Default (EAD) refers to:
Select an option first.
Correct answer: B — The total outstanding amount owed by a borrower at the time they default
Explanation: EAD is the total credit exposure outstanding when default occurs — the 'at risk' amount. For revolving facilities, it may include drawn and undrawn amounts. PD × LGD × EAD = Expected Loss.
Question 105
Which of the following is an example of 'execution risk' in financial markets?
Select an option first.
Correct answer: B — A trade is executed at a price worse than expected due to market impact, slippage, or a delay in order processing
Explanation: Execution risk is an operational risk — slippage, market impact, failed orders. A is counterparty/credit risk. C is investment/strategic risk. D is regulatory/compliance risk.
Question 106
Which of the following best defines 'net risk exposure'?
Select an option first.
Correct answer: B — Gross risk exposure minus the risk reduction from hedges, insurance, guarantees, and other mitigants
Explanation: Net (residual) exposure = Gross exposure − Risk reduction from mitigants. Risk managers track both to understand true vulnerability. A is gross; C is total (not necessarily net); D refers to post-event realised losses.
Question 107
Counterparty credit risk on an interest rate swap is highest when:
Select an option first.
Correct answer: C — The swap has a significant positive mark-to-market value to the holder, meaning the counterparty owes them money
Explanation: Counterparty credit risk (pre-settlement) is highest when the swap has a large positive MTM to the holder — if the counterparty defaults, the holder loses that value. When the swap is negative (A, B), default by the counterparty is irrelevant to the holder.
Question 108
Which of the following best describes 'wrong-way risk' in a derivatives portfolio?
Select an option first.
Correct answer: B — The risk that a counterparty's likelihood of defaulting increases at the same time as their exposure to the holder also increases
Explanation: Wrong-way risk: exposure and default probability move in the same direction — the counterparty is most likely to default exactly when they owe the most. This was prominent in 2008 with monoline insurers. A is basis risk; C is maturity mismatch; D is market risk.
Question 109
A firm that holds a large unhedged inventory of raw materials is primarily exposed to:
Select an option first.
Correct answer: B — Commodity price risk (market risk)
Explanation: An unhedged inventory means the firm's profit and loss are directly exposed to commodity price movements — a form of market risk. A is a supply chain/credit risk; C is a physical operational risk; D is a regulatory consideration.
Question 110
Which of the following is a direct consequence of 'fire sale' risk in a financial crisis?
Select an option first.
Correct answer: B — Forced sellers drive down asset prices, which reduces collateral values for all holders of those assets, creating further margin calls and a downward spiral
Explanation: Fire sale risk is self-reinforcing: forced selling depresses prices, which reduces collateral values for all leveraged holders, triggering more margin calls and more forced selling. A, C, and D are all incorrect or oversimplified.
Question 111
Which of the following distinguishes 'inherent risk' from 'residual risk'?
Select an option first.
Correct answer: B — Inherent risk is the raw risk before any controls; residual risk is the risk remaining after controls are applied
Explanation: Inherent risk = gross risk (no controls assumed). Residual risk = net risk after controls and mitigants. Risk managers assess both to understand control effectiveness. A reverses the definitions; C and D are incorrect.
Question 112
Which of the following is the best example of 'conduct risk'?
Select an option first.
Correct answer: B — A bank employee mis-selling an unsuitable financial product to a retail customer
Explanation: Conduct risk arises from inappropriate behaviour by firm employees or the firm itself — mis-selling, market manipulation, conflicts of interest. A is market risk; C is operational risk (systems); D is credit/reputational risk.
Question 113
A global bank has significant bilateral derivatives exposures across thousands of counterparties. Which of the following risk management practices most directly reduces its credit risk from these exposures?
Select an option first.
Correct answer: B — Implementing netting agreements and requiring collateral (margin) to be posted on a daily basis
Explanation: Netting reduces exposure by offsetting positive and negative MTM values with the same counterparty. Daily margining (variation margin) caps the exposure to one day's price movement. A and C don't reduce credit risk; D increases exposure duration.
Question 114
A stress scenario reveals that a bank would breach its minimum capital ratio if two major borrowers defaulted simultaneously. This illustrates:
Select an option first.
Correct answer: B — Concentration risk — excessive exposure to a small number of large borrowers creating vulnerability to correlated defaults
Explanation: Two large borrowers defaulting simultaneously highlights concentration risk — insufficient diversification across the credit portfolio. Diversification would be the remedy. A is wrong (two counterparties is not well-diversified); C and D are different categories.
Question 115
Which of the following best describes the relationship between credit risk and the economic cycle?
Select an option first.
Correct answer: B — Credit risk is pro-cyclical — defaults tend to rise in recessions when firms and households face financial stress
Explanation: Credit risk is pro-cyclical: in recessions, unemployment rises, revenues fall, and borrowers default more frequently. This is why capital frameworks include countercyclical buffers — to prevent banks from cutting lending precisely when the economy needs credit most.
Question 116
Which risk management technique involves accepting a small certain loss (the cost of the hedge) to avoid the possibility of a large uncertain loss?
Select an option first.
Correct answer: C — Hedging
Explanation: Hedging is the deliberate trade-off: pay a small certain cost (premium, basis risk, foregone upside) to protect against a potentially large uncertain loss. This is the core logic of insurance, options, and futures hedging. A is directional risk-taking; B is riskless profit; D amplifies risk.
Question 117
Which of the following scenarios best illustrates 'event-driven correlation' between market and credit risk?
Select an option first.
Correct answer: B — A corporate default triggers a broad sell-off in credit markets, which also reduces liquidity and pushes up yields in the equity market
Explanation: Event-driven correlation: a credit event triggers a chain reaction across markets — credit spreads widen, risk appetite falls, equity valuations drop, liquidity dries up. This is how localised credit events become systemic. A has wrong direction; C is true but not a risk interaction; D is a NIM benefit, not a risk event.
Question 118
Which of the following is an example of 'franchise risk'?
Select an option first.
Correct answer: B — The risk that a series of conduct failures destroys customer trust and causes a permanent loss of business
Explanation: Franchise risk is a severe form of reputational risk — repeated conduct failures or a catastrophic event erodes the firm's franchise value (its ability to attract and retain customers and counterparties). A is property/operational risk; C is M&A risk; D is contract/legal risk.
Question 119
Which of the following best explains why risk appetite and risk limits are complementary but distinct concepts?
Select an option first.
Correct answer: B — Risk appetite sets the strategic direction and desired level of risk; risk limits translate that appetite into specific, measurable, operational thresholds for each risk type and business line
Explanation: Risk appetite is high-level and strategic; risk limits operationalise it — defining the specific boundaries (maximum VaR, maximum single-name exposure, etc.) that, if breached, trigger action. Without limits, appetite is aspirational but unenforceable.
Question 120
Which of the following factors makes operational risk losses particularly difficult to quantify statistically?
Select an option first.
Correct answer: B — The loss distribution is typically heavy-tailed, data is scarce and often censored (unreported), and individual events are rarely repeated in identical form
Explanation: Operational risk modelling challenges: fat left tail of the severity distribution, sparse data (especially for high-severity low-frequency events), under-reporting bias, and the non-repeating nature of catastrophic events. A is wrong (too infrequent, not frequent); C and D are incorrect.
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