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Free FRM Risk Management & Investment Management Practice Questions & Answers
400 exam-style Risk Management & Investment Management questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 301
What does 'TVPI' (Total Value to Paid-In) measure in private equity?
Select an option first.
Correct answer: B — The ratio of total realised and unrealised value (distributions + remaining NAV) to the total capital called — measures how much value has been generated per dollar invested
Explanation: B is correct. TVPI = (Distributions + Remaining NAV) / Capital Called. A TVPI of 2.0x means the fund has returned or retained $2 for every $1 invested. Related metrics: DPI (distributions only) and RVPI (remaining NAV only). A is fee analysis. C and D are incorrect definitions.
Question 302
What is the 'illiquidity premium' in alternative investments?
Select an option first.
Correct answer: A — The extra return demanded for investing in illiquid assets such as private equity and real estate, compensating investors for the inability to sell quickly
Explanation: A is correct. Illiquidity premium: investors in illiquid assets (PE, infrastructure, real estate) demand a higher return than liquid equivalents to compensate for the inability to sell. Academic studies estimate the illiquidity premium at 2-4% per annum over comparable liquid assets. B describes a fee premium. C is the bid-ask spread. D is a market impact premium.
Question 303
What is 'real estate investment trust' (REIT)?
Select an option first.
Correct answer: B — A publicly traded company or trust that owns income-producing real estate and distributes at least 90% of taxable income to shareholders as dividends
Explanation: B is correct. REIT: pools investor capital to invest in real estate assets (offices, retail, apartments, industrial). REITs must distribute ≥90% of taxable income, providing income-focused investors with real estate exposure without direct ownership. REITs trade on stock exchanges and offer liquidity not available in direct real estate. A is a developer. C is a government programme. D is a private real estate fund.
Question 304
What is 'cap rate' (capitalisation rate) in real estate?
Select an option first.
Correct answer: B — Net operating income (NOI) divided by the property value — used to estimate the yield on a real estate investment, analogous to earnings yield in equities
Explanation: B is correct. Cap rate = NOI / Property Value. A cap rate of 6% means the property generates $6 of NOI per $100 of value. Higher cap rates indicate either higher income or lower valuations. Used to value properties and compare real estate investments. A is borrowing cost. C uses gross (not net) income. D is loan-to-value inverted.
Question 305
What is 'infrastructure' as an investment asset class?
Select an option first.
Correct answer: B — Long-duration, real assets providing essential public services (roads, airports, utilities, pipelines) that generate stable, inflation-linked cash flows with high barriers to entry
Explanation: B is correct. Infrastructure: physical systems essential to society. Characteristics: regulated or contracted revenues (predictable cash flows), long asset lives (20-50 years), inflation linkage (often revenue-indexed to CPI), and monopolistic characteristics (high barriers to entry). A is municipal bonds. C is listed infrastructure equity. D is project contracts, not the asset class.
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Question 306
What is 'natural resources' as an asset class in alternative investments?
Select an option first.
Correct answer: B — Direct investment in physical commodities, timberland, farmland, and natural resource companies — providing inflation protection and diversification from traditional financial assets
Explanation: B is correct. Natural resources: timberland, farmland, oil/gas reserves, mineral deposits. They provide: inflation hedge (prices tend to rise with inflation), diversification, and long-term real returns. Return sources include biological growth, income, and price appreciation. A describes weather derivatives. C is ESG. D is short-term trading.
Question 307
What are 'commodities' as an asset class and what return components do they have?
Select an option first.
Correct answer: B — Physical goods (oil, gold, agricultural products, metals) with returns from three components: spot return (price change), roll return (from rolling futures contracts), and collateral return (interest on cash collateral)
Explanation: B is correct. Commodity total return = Spot return + Roll yield + Collateral return. Roll yield can be positive (backwardation — futures below spot) or negative (contango — futures above spot). A is equity in producers. C is commodity-linked bonds. D is a fund structure.
Question 308
What is 'backwardation' in futures markets?
Select an option first.
Correct answer: B — A situation where futures prices are below the current spot price — indicating that storage costs or supply constraints exist, or that physical buyers need inventory (convenience yield is high)
Explanation: B is correct. Backwardation: spot > futures. This generates positive roll yield for long futures positions — as the futures contract approaches maturity, its price rises toward the spot. Common in oil markets during supply disruptions. A describes contango. C is an interest rate term. D is a valuation concept.
Question 309
What is 'contango' in futures markets?
Select an option first.
Correct answer: B — When futures prices are above the current spot price — typically reflecting storage costs, insurance, and financing costs, resulting in negative roll yield for long positions
Explanation: B is correct. Contango: futures > spot. Long futures investors must roll contracts at a higher price, incurring negative roll yield. Gold and natural gas are frequently in contango. Common in markets where storage costs dominate. A describes backwardation. C is a flat yield curve. D is a supply-demand imbalance.
Question 310
What is 'convenience yield' in commodity markets?
Select an option first.
Correct answer: B — The implicit benefit of holding physical inventory — allowing immediate access to the commodity when needed, which is valued when supply is uncertain or storage is scarce
Explanation: B is correct. Convenience yield: the non-monetary benefit from holding physical inventory rather than a futures contract. High convenience yield → backwardation. It reflects the option value of having physical goods immediately available (e.g., a refinery needs crude oil on hand). A reverses the concept. C is collateral return. D is equity yield.
Question 311
What is 'survivorship bias' in evaluating hedge fund performance?
Select an option first.
Correct answer: B — The overestimation of average performance that results from only including currently surviving funds in a database while ignoring funds that have closed or failed
Explanation: B is correct. Survivorship bias: databases typically include only funds that are still operating. Failed funds are excluded, making average returns appear higher than reality. Studies estimate survivorship bias adds 1-3% to reported average hedge fund returns. A is strategy concentration. C and D are different concepts.
Question 312
What is 'backfill bias' (instant history bias) in hedge fund databases?
Select an option first.
Correct answer: B — The overstatement of performance because when a fund joins a database, its historical performance is added retroactively — since only funds with good early performance bother to register, the backfilled history is upward-biased
Explanation: B is correct. Backfill bias: funds report to databases after they have good performance to show. The historical returns backfilled into the database are thus selectively positive. Combined with survivorship bias, this means database returns significantly overstate true hedge fund performance. A is track record extension. C is back-testing. D is data imputation.
Question 313
What is 'stale pricing' in the context of hedge fund and PE valuation?
Select an option first.
Correct answer: B — Reporting asset values that are not updated frequently (e.g., quarterly or annually for illiquid assets), causing reported returns to lag true market values and understating volatility and correlations
Explanation: B is correct. Stale pricing: illiquid assets (PE, real estate, certain hedge fund holdings) are valued infrequently. This smooths reported returns artificially, understating true volatility and correlation with public markets. Sharpe ratios appear better than they truly are. Risk measures based on stale prices are misleading. A is a specific example. C is historical cost accounting. D is a valuation method that causes stale pricing.
Question 314
What is the 'smoothing problem' in alternative investment performance measurement?
Select an option first.
Correct answer: B — When reported returns are artificially smooth due to infrequent or managed marking of illiquid assets — this understates true volatility, overstates Sharpe ratios, and understates correlations with other asset classes
Explanation: B is correct. Smoothing: infrequent marks or deliberate mark management produces artificially low return volatility. Statistical de-smoothing techniques can adjust for this. Correlations with public markets are also understated, overstating diversification benefits. A is the opposite observation. C and D are different concepts.
Question 315
What is 'due diligence' in alternative investment manager selection?
Select an option first.
Correct answer: B — A comprehensive assessment of a manager's investment process, risk management, operations, compliance, and track record before committing capital
Explanation: B is correct. Due diligence for hedge/PE funds: operational DD (prime broker, admin, systems), investment DD (process, edge, risk management), legal/compliance DD (structure, conflicts, disclosures), reference checks. Operational failures (Madoff fraud) highlight the importance of operational DD alongside investment DD. A is subscription documentation. C is monitoring. D is regulatory reporting.
Question 316
What is 'drawdown risk' and why is it important for hedge fund investors?
Select an option first.
Correct answer: B — The risk of experiencing a significant peak-to-trough decline in portfolio value, which may take years to recover from and may be psychologically or contractually binding for investors
Explanation: B is correct. Drawdown risk: a 50% drawdown requires a 100% gain to recover. Investors may be locked up during the drawdown period. Deep drawdowns can trigger manager departures, redemptions (if allowed), and strategy abandonment. Maximum drawdown and time to recovery are key hedge fund risk metrics. A is a behavioural risk. C and D are operational concepts.
Question 317
What is a 'prime broker' in the hedge fund ecosystem?
Select an option first.
Correct answer: B — A large financial institution (typically a major bank) that provides hedge funds with a bundled package of services: financing (margin), securities lending (for short selling), trade execution, custody, and reporting
Explanation: B is correct. Prime broker (Goldman Sachs, Morgan Stanley, JPMorgan): the central counterparty providing hedge funds with leverage, ability to short, operational infrastructure. Multiple prime brokers reduce counterparty risk. The 2008 Lehman collapse showed the systemic risk of over-reliance on a single prime broker. A is an investment banking advisor. C is the regulator. D is the fund administrator.
Question 318
What is 'leverage' in a hedge fund context and how is it measured?
Select an option first.
Correct answer: B — Using borrowed capital to amplify returns — measured as total assets (or gross exposure) divided by net assets (equity). A fund with $100M equity that borrows $200M and holds $300M in positions has 3x leverage
Explanation: B is correct. Leverage = Gross Exposure / Net Assets. 3x leverage means a 1% loss on the portfolio creates a 3% loss on equity. Leverage amplifies both gains and losses. Hedge funds also use 'notional leverage' through derivatives. A is a balance sheet description. C and D are specific leveraged instruments.
Question 319
What is 'short selling' and what risks does it entail?
Select an option first.
Correct answer: B — Borrowing and selling securities not currently owned, expecting to buy them back at a lower price — risks include: unlimited potential loss (price can rise indefinitely), short squeeze (forced covering when prices rise), and recall risk (lender recalls shares)
Explanation: B is correct. Short selling: borrow security → sell → hope price falls → buy back at lower price → return to lender. Key risks: losses are theoretically unlimited (long losses capped at 100%). Short squeeze: rising price forces covering, pushing price further up. Recall: the lender reclaims the borrowed shares, forcing premature covering. A is closing a long position. C is a futures short. D is bond selling.
Question 320
What is 'securities lending' and who are the participants?
Select an option first.
Correct answer: B — The process where large investors (pension funds, insurers) lend securities to short sellers (via prime brokers) in exchange for collateral and a lending fee — enabling short selling while generating income for lenders
Explanation: B is correct. Securities lending: beneficial owner lends securities (for a fee) against collateral (cash or other securities). The borrower (typically a short seller via prime broker) uses the securities to sell short. Lenders earn income; borrowers enable short positions. A is central bank lending. C and D are incorrect descriptions of the participants.
Question 321
What is 'crowded trade risk' in hedge funds?
Select an option first.
Correct answer: B — The risk that many hedge funds hold similar positions — when one fund is forced to sell (e.g., due to redemptions), this triggers a price move that forces other funds to sell, creating a liquidity spiral
Explanation: B is correct. Crowded trade risk: when hedge funds hold similar positions (e.g., popular 'crowded longs'), forced selling by one creates losses for all, triggering simultaneous de-leveraging. This 'quant quake' phenomenon (August 2007) caused losses across many quant funds simultaneously. A is concentration risk. C is strategy crowding. D is regulatory concern.
Question 322
What is 'counterparty risk' in derivatives and securities lending?
Select an option first.
Correct answer: B — The risk that the other party to a financial contract will default on their obligations before settlement, leaving the non-defaulting party with an unrealised gain that cannot be collected
Explanation: B is correct. Counterparty risk (CCR): if a counterparty defaults when you have a positive mark-to-market position, that gain is lost. The exposure is the current replacement cost plus potential future exposure. Central clearing (CCPs) reduces bilateral CCR. A is model risk. C is operational/reconciliation risk. D is exchange/CCP default risk.
Question 323
What is a 'credit default swap' (CDS) and how is it used in risk management?
Select an option first.
Correct answer: B — A bilateral contract where the protection buyer pays a periodic premium (spread) to the protection seller, who pays a lump sum if the reference entity defaults — used to hedge credit risk or to take speculative credit positions
Explanation: B is correct. CDS: the protection buyer pays a spread (e.g., 100bps per annum on notional). Upon a credit event (default, restructuring), the protection seller pays par minus recovery. Used by: banks to hedge loan book credit risk, hedge funds to speculate on credit quality changes. A is a floating rate bond concept. C is a contingent convertible (CoCo). D is a CDO/CLN.
Question 324
What is a 'CDO' (Collateralised Debt Obligation)?
Select an option first.
Correct answer: B — A structured security backed by a pool of debt instruments (loans, bonds) that is divided into tranches with different risk/return profiles — senior tranches have first claim on cash flows, equity tranches absorb first losses
Explanation: B is correct. CDO: pools assets (loans, bonds, ABS) and issues tranches: senior (AAA, lowest yield), mezzanine (BBB/BB), and equity (first-loss, highest yield). CDOs amplified the 2008 crisis because: model assumptions underestimated correlation between mortgage defaults. A is a single security. C is government debt. D is an interest rate derivative.
Question 325
What is 'correlation risk' in a portfolio context?
Select an option first.
Correct answer: B — The risk that correlations between assets increase significantly during market stress, reducing diversification benefits precisely when they are most needed
Explanation: B is correct. Correlation risk: correlations estimated in normal markets tend to rise sharply during crises (flight to quality causes diverse assets to sell off simultaneously). This is sometimes called 'correlation breakdown.' Diversification that appeared robust in normal conditions can fail catastrophically in a crisis. A is estimation error risk. C is basis risk. D is model risk.
Question 326
What does 'factor model decomposition' mean in the context of hedge fund returns?
Select an option first.
Correct answer: B — Separating total hedge fund returns into systematic (factor-based) components and alpha (skill-based unexplained residual) using a multi-factor regression
Explanation: B is correct. Factor decomposition: regress fund returns on factors (market, credit, momentum, volatility). The factor exposures explain 'alternative beta' — return for taking systematic risks. The residual is true alpha (skill). Much 'alpha' in hedge funds is actually alternative beta that can be replicated more cheaply using systematic strategies. A is equal attribution. C is fee decomposition. D is time attribution.
Question 327
What is 'alternative beta' or 'liquid alternatives'?
Select an option first.
Correct answer: B — Systematic, rules-based strategies that replicate hedge fund risk factors (momentum, carry, value) using liquid instruments at lower cost than hedge fund fees
Explanation: B is correct. Alternative beta: many hedge fund returns can be replicated by systematic exposure to alternative risk factors. Examples: carry trade (long high-yield currencies, short low-yield), trend-following momentum, and equity long/short beta. These are accessible at lower fees (0.5-1%) vs traditional hedge funds (2+20). A is plain beta. C is true alpha. D is a trading frequency.
Question 328
What is 'risk-adjusted performance' and why is it important for comparing investments?
Select an option first.
Correct answer: B — Adjusting raw returns for the level of risk taken, using metrics like Sharpe ratio or risk-adjusted return on capital — essential because a higher return does not indicate better skill if it was achieved through greater risk-taking
Explanation: B is correct. Risk-adjusted performance: two managers may earn the same return, but if one took twice the risk, the other is the better performer. Sharpe, Treynor, Sortino, and Jensen's alpha all adjust for different dimensions of risk. A is raw return measurement. C is fee adjustment. D is real return calculation.
Question 329
What is a 'volatility swap' or 'variance swap' in risk management?
Select an option first.
Correct answer: B — A derivatives contract where one party pays a fixed 'strike' volatility and receives the actual realised volatility (for variance swaps: squared volatility) of an asset over the contract period
Explanation: B is correct. Variance swap payoff = Notional × (Realised Variance − Strike Variance). These instruments allow direct trading of volatility without the path dependency of options. Used by: hedge funds to speculate on volatility, risk managers to hedge volatility exposure. A is a volatility-linked rate swap (different). C is FX hedging. D is a total return swap.
Question 330
What is the 'VIX' index?
Select an option first.
Correct answer: B — A measure of the market's expectation of 30-day volatility of the S&P 500, derived from the prices of options on the S&P 500 — often called the 'fear gauge' because it spikes during market stress
Explanation: B is correct. VIX (CBOE Volatility Index): calculated from S&P 500 option prices across a range of strikes, reflecting the market's expectation of 30-day implied volatility. VIX typically rises sharply during market downturns (flight to options protection). VIX > 30 typically indicates high fear; VIX < 15 indicates complacency. A is realised (historical) volatility. C is the MOVE index (bond volatility). D is not the VIX definition.
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