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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 331
What is 'vol of vol' (volatility of volatility)?
Select an option first.
Correct answer: B — The variability of implied volatility itself over time — when vol of vol is high, volatility is unpredictable, making volatility strategies (selling options) riskier
Explanation: B is correct. Vol of vol: measures how much implied volatility itself fluctuates. High vol-of-vol means uncertainty about future volatility is itself elevated — option prices are more uncertain. The VVIX (VIX of VIX) measures this. A is the volatility level. C is the volatility risk premium. D describes the vomma/volga Greek.
Question 332
What are the main return components of a commodity futures position?
Select an option first.
Correct answer: B — Spot return (change in spot price), roll return (gain/loss from rolling futures contracts — positive in backwardation, negative in contango), and collateral return (return on cash collateral posted as margin)
Explanation: B is correct. Commodity futures total return: (1) Spot: commodity price change. (2) Roll: futures vs spot price dynamics — in backwardation the roll is positive (near futures cheaper than distant, so rolling replaces cheaper with expensive and vice versa). (3) Collateral: interest on T-bills posted as margin. A is equity return components. C is only part of the roll concept. D is bond return components.
Question 333
What is the 'Yale Endowment model' and what principles does it embody?
Select an option first.
Correct answer: B — The investment framework pioneered by Yale's David Swensen — high allocation to illiquid alternatives (private equity, real assets, hedge funds) to capture illiquidity premium; diversification across many uncorrelated sources of return; reliance on external specialist managers for each asset class
Explanation: B is correct. Yale model: pioneered heavy allocation to alternatives (PE, venture, real estate, hedge funds, natural resources) — often 60-70% of the portfolio. Key insights: illiquidity premium compensates patient long-term investors; true diversification requires genuinely uncorrelated asset classes. Influenced many endowments and pension funds. A and D are conventional approaches. C is the opposite of Yale model.
Question 334
What is a 'venture capital' investment and what stages exist?
Select an option first.
Correct answer: B — Early-stage equity investment in companies with high growth potential — stages include: seed (initial concept), early stage (product development), growth stage (scaling operations), late stage (pre-IPO). Investors expect most companies to fail but rely on exceptional winners to drive portfolio returns
Explanation: B is correct. VC: high risk, high reward. Power law: a small number of companies (Google, Facebook) generate most of the total VC industry returns. Due to this, portfolio construction and manager selection are crucial. The J-curve applies — negative returns early, positive later. A is a mature company strategy. C and D are debt, not equity.
Question 335
What is 'dry powder' in private equity?
Select an option first.
Correct answer: B — Capital that has been committed by limited partners but not yet called (invested) by the general partner — available to deploy in future deals. High industry dry powder can signal competitive deal environments and elevated asset prices
Explanation: B is correct. Dry powder: undeployed committed capital. When PE dry powder is high globally (e.g., $3 trillion+), it signals potential for competitive bidding wars, higher acquisition multiples, and possibly lower future returns. A is not an investment concept. C is a specific cash holding. D is uncalled capital from investors who haven't yet committed.
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Question 336
What is a 'general partner' (GP) vs 'limited partner' (LP) in a PE or hedge fund structure?
Select an option first.
Correct answer: B — GP is the fund manager who makes investment decisions, manages the fund, and has unlimited liability; LP is the investor who provides capital, has no management role, and has liability limited to their investment
Explanation: B is correct. GP/LP structure: GP = manager (carried interest, management fees, decision-making authority, unlimited liability). LP = investor (capital commitment, limited liability up to investment, no management participation). The GP typically contributes 1-2% of fund capital (alignment). A reverses the roles. C is incorrect — only GP has management rights. D is incorrect — GP also receives carried interest.
Question 337
What is 'co-investment' in private equity?
Select an option first.
Correct answer: B — The right given to LPs to invest directly alongside the PE fund in specific transactions, typically on a fee-free or reduced-fee basis — allowing LPs to increase exposure to attractive deals while reducing overall fee burden
Explanation: B is correct. Co-investment: LPs receive the right to invest directly in a specific deal alongside the fund, typically with no management fee and reduced or no carry. Benefits: better economics, specific deal exposure. Challenges: requires LP resources to evaluate individual deals; concentration risk; adverse selection concern (GPs offer co-invest on less attractive deals). A is a club deal. C is GP co-investment. D is capital recycling.
Question 338
What is 'secondary market' investing in private equity?
Select an option first.
Correct answer: B — Buying and selling existing LP interests in PE funds from other investors — secondaries trade at discounts or premiums to NAV, providing liquidity for LPs who need to exit before the fund terminates and entry opportunities for buyers at potentially attractive prices
Explanation: B is correct. Secondary market: LP interests in PE funds can be sold before the fund's termination (typically 10 years). Buyers often get: vintage year diversification, reduced J-curve effect (portfolio is already partially built), and potential discounts to NAV. Secondary specialists (Lexington, Ardian) buy at discounts. A is a listed PE structure. C is different. D is a PE-to-PE deal.
Question 339
What is 'credit long/short' as a hedge fund strategy?
Select an option first.
Correct answer: B — A strategy that takes long positions in bonds/loans expected to increase in value (or compress in spread) and short positions in those expected to lose value (or widen in spread) — typically using CDS or bonds, seeking to profit from relative credit performance
Explanation: B is correct. Credit long/short: analogous to equity long/short but applied to credit markets. Long: undervalued credits or improving stories; Short: overvalued credits, deteriorating credits (via CDS). Reduces duration and interest rate exposure. Profit comes from credit selection skill. A is too narrow. C is a specific version. D is an income-enhancement overlay.
Question 340
What is a 'CLO' (Collateralised Loan Obligation)?
Select an option first.
Correct answer: B — A structured finance vehicle that issues tranched securities backed by a portfolio of leveraged loans — senior tranches (AAA) have priority of payment; equity tranche absorbs first losses; the CLO manager actively manages the loan portfolio within defined parameters
Explanation: B is correct. CLO: packages leveraged loans (below-investment-grade loans to companies) into tranches. Structure: Senior (AAA-AA) → Mezzanine (A-BB) → Equity (first loss). CLO managers reinvest proceeds during the reinvestment period. CLO equity earns residual returns after paying senior holders — high risk, high reward. A is a government agency bond. C is a CMBS. D is an ABS/CLO on auto loans.
Question 341
What is 'systematic' vs 'discretionary' investing in hedge funds?
Select an option first.
Correct answer: B — Systematic: rules-based strategies that use quantitative models (algorithms, data mining) to generate signals and trade automatically; Discretionary: fund managers apply subjective judgment, qualitative analysis, and human decision-making to generate investment theses
Explanation: B is correct. Systematic (quant): Citadel, Two Sigma, Renaissance Technologies. Model-driven, scalable, emotional discipline, but subject to model risk and crowding. Discretionary: Bridgewater (macro), Paulson. Human judgment, adaptable to new information, but subject to behavioural biases. Many modern funds use both (hybrid). A reverses the definitions. C is wrong. D overstates systematic.
Question 342
What is 'trend-following' (also called CTA or managed futures) and when does it perform best?
Select an option first.
Correct answer: B — A systematic strategy that goes long assets in uptrends and short assets in downtrends — using momentum signals across commodities, currencies, rates, and equities. Performs best during sustained directional market moves, particularly in extended bear markets and crises
Explanation: B is correct. Trend-following/CTA: profits from sustained directional moves. Historically provides crisis alpha — performed well in 2008 (short equities), 2022 (short bonds, long energy). Underperforms in choppy, mean-reverting markets. Provides genuine diversification to traditional portfolios. A is event-driven. C is mean-reversion/contrarian. D is passive replication.
Question 343
What is 'fixed income relative value' as a hedge fund strategy?
Select an option first.
Correct answer: B — Exploiting small pricing discrepancies between related fixed income instruments (e.g., on-the-run vs off-the-run Treasuries, swap spreads, yield curve anomalies) using leverage to amplify small mispricings into meaningful returns
Explanation: B is correct. FIRV: Long-Term Capital Management's primary strategy. Key trades: on-the-run/off-the-run Treasury spread (new vs old Treasury issues of the same maturity), swap spread arbitrage, yield curve butterfly trades. Requires high leverage (10-50x) because spreads are small (a few bps). When liquidity evaporates (1998 Russia/LTCM): convergence trades diverge, amplifying losses catastrophically. A is long-only. C is country comparison. D is buy-and-hold.
Question 344
What is 'statistical arbitrage' (stat arb)?
Select an option first.
Correct answer: B — A quantitative strategy that identifies and exploits statistical relationships between securities — typically mean-reversion of pairs of stocks with historically correlated returns. When prices diverge beyond historical norms, the strategy goes long the underperformer and short the outperformer, betting on reversion
Explanation: B is correct. Stat arb: pairs trading at its most sophisticated. Statistical models identify cointegrated pairs or factor-neutral baskets. Mean-reversion signal: when relative value diverges > 2σ from historical mean, enter trade. Risk: pairs can decouple permanently (regime change). D.E. Shaw, Renaissance are known stat arb practitioners. A describes options vol arb. C is index arb. D is exchange-to-exchange arb.
Question 345
What is 'event-driven special situations' as a hedge fund strategy?
Select an option first.
Correct answer: B — A sub-strategy within event-driven investing that focuses on corporate events other than mergers — spin-offs, stub trades, rights offerings, index inclusions/exclusions, capital structure arbitrage (e.g., buying bonds and shorting equity of the same company near distress)
Explanation: B is correct. Special situations: broader than merger arb. Examples: spin-off (the spun-off company may be mispriced initially); stub trade (long spin-off subsidiary, short parent); capital structure arb (relative value between debt and equity of the same issuer). A is a macro strategy. C is commodities. D is regulatory arbitrage.
Question 346
What is 'short-term interest rate' (STIR) trading in macro funds?
Select an option first.
Correct answer: B — Speculative trading in short-term interest rate futures (e.g., Eurodollar, SONIA futures) based on views on central bank policy and short-term rate movements — one of the most liquid futures markets globally
Explanation: B is correct. STIR trading: macro funds take positions in Eurodollar or Euribor futures strips to express views on central bank rate trajectories. Highly liquid, deep market — can express precise views on timing and magnitude of rate moves. A is equity macro. C is cash management. D is interest rate risk hedging.
Question 347
What is the 'risk premium' in finance?
Select an option first.
Correct answer: B — The extra return above the risk-free rate demanded by investors for bearing a specific type of risk — equity risk premium (for market risk), credit spread (for credit risk), illiquidity premium (for illiquidity), term premium (for duration risk)
Explanation: B is correct. Risk premium: compensation for bearing risk. Different risks have different premiums. Equity risk premium: ~5-6% historically above risk-free for US equities. Credit spread: compensation for credit risk. Illiquidity premium: 2-4% for illiquid assets. Term premium: compensation for holding long-duration bonds. A is return from leverage. C is insurance premium. D is hurdle rate.
Question 348
What is 'carry' as a return factor across asset classes?
Select an option first.
Correct answer: B — The return from holding an asset when there is no change in price — for bonds: the yield minus financing cost; for currencies: the interest rate differential; for commodities: roll yield. Carry strategies go long high-carry and short low-carry assets
Explanation: B is correct. Carry: a cross-asset return factor. FX carry: long high-yield currencies (AUD, MXN), short low-yield (JPY, CHF) — earned the interest rate differential. Bond carry: yield minus repo rate. Commodity carry: positive in backwardation. Carry works well but crashes during risk-off events (unwind of carry trades). A is only equity income. C is volatility carry. D is a cost.
Question 349
What is 'quantitative easing' (QE) and how has it affected asset management?
Select an option first.
Correct answer: B — A central bank policy of purchasing financial assets (typically government bonds) to inject money into the financial system, lower long-term yields, and support asset prices — forced investors to seek higher yields in riskier assets (equities, credit, real estate), compressing risk premiums
Explanation: B is correct. QE effects on asset management: compressed bond yields forced investors out the risk spectrum (search for yield). Distorted valuations across asset classes. Reduced natural hedge between equities and bonds (both rose). Created potential vulnerability when QE reversed (2022). A is the opposite policy (rate hikes). C is fiscal policy. D is credit regulation.
Question 350
What is 'duration risk' in a fixed income portfolio?
Select an option first.
Correct answer: B — The sensitivity of a portfolio's value to changes in interest rates — a portfolio with longer duration will experience larger price declines when interest rates rise. Duration risk is the primary risk for most fixed income portfolios
Explanation: B is correct. Duration risk: Price change ≈ −ModDur × Δy. A 10-year government bond (duration ≈ 8 years) falls ~8% in value for every 1% rise in yields. This was devastating for bond portfolios in 2022 when rates rose 4%+. Managing duration risk is central to fixed income portfolio management. A is time-to-maturity risk. C is reinvestment risk. D is model risk.
Question 351
What is 'credit spread duration' (spread duration)?
Select an option first.
Correct answer: B — The sensitivity of a bond's price to changes in its credit spread — for a 5-year corporate bond with spread duration of 4.5 years, a 100bps widening of spreads reduces the bond price by approximately 4.5%
Explanation: B is correct. Spread duration: measures how sensitive a bond's price is to changes in its credit spread (not the benchmark rate). Distinct from interest rate duration. High-yield portfolios have high spread duration — vulnerable to credit spread widening. Investment grade: lower spread duration but significant interest rate duration. A is a reset schedule. C is interest rate duration. D is a CDS concept.
Question 352
What is 'mortgage-backed security' (MBS) and what unique risk does it carry?
Select an option first.
Correct answer: B — A bond backed by a pool of residential mortgages — unique risk is prepayment risk (homeowners can prepay mortgages when rates fall, shortening MBS duration exactly when investors want longer duration for capital gains) and extension risk (prepayments slow when rates rise, extending duration)
Explanation: B is correct. MBS (RMBS for residential): negative convexity due to prepayment option. When rates fall: homeowners refinance (prepay) → investors receive principal back when reinvestment rates are low (extension risk is low but reinvestment risk high). When rates rise: prepayments slow → extension risk. Agency MBS (Fannie, Freddie) have government guarantee. A is a HELOC-backed security. C is CMBS. D is government housing debt.
Question 353
What is 'real return' vs 'nominal return'?
Select an option first.
Correct answer: B — Real return adjusts the nominal return for inflation: approximately Real Return ≈ Nominal Return − Inflation. More precisely: (1 + Real) = (1 + Nominal) / (1 + Inflation). An investor who earns 6% nominal with 3% inflation earns approximately 3% real
Explanation: B is correct. Real vs nominal: the real return measures actual purchasing power gained. If nominal = 6% and inflation = 3%, real ≈ 3% (precisely: 1.06/1.03 − 1 = 2.91%). For long-term financial planning (pension funds, endowments), real returns matter most. A: real return is calculated before or after taxes independently. C: applies to all assets. D: that's net return.
Question 354
What is 'gold' as an investment asset and what are its key characteristics?
Select an option first.
Correct answer: B — A precious metal that serves as: a store of value, an inflation hedge (partial), a safe-haven in times of geopolitical or financial stress, and a low/negative correlation asset to equities in crises — no yield, so opportunity cost is the risk-free rate
Explanation: B is correct. Gold characteristics: no cash flows (unlike equities/bonds) — return is purely price appreciation. Inflation hedge: moderate over long periods, less reliable over short periods. Safe haven: spikes during crises (2008, COVID). Negative correlation with USD. Portfolio role: diversification, tail risk hedge. A ignores store-of-value function. C: gold has limited industrial use. D: no cash flows.
Question 355
What is 'transaction cost analysis' (TCA) and why is it important in portfolio management?
Select an option first.
Correct answer: B — The measurement and analysis of implementation costs (commission, bid-ask spread, market impact) when executing portfolio trades — important because transaction costs can significantly erode alpha, particularly for high-frequency strategies or large trades in illiquid markets
Explanation: B is correct. TCA: total implementation shortfall = explicit costs (commission) + implicit costs (bid-ask spread, market impact from moving the price) + opportunity cost (cost of delayed execution). High-turnover strategies are most affected. For institutional investors, minimising implicit costs (market impact) is often more important than negotiating commissions. A is narrow. C and D are subsets.
Question 356
What is 'implementation shortfall' in execution analysis?
Select an option first.
Correct answer: B — The difference between the decision price (when the portfolio manager decided to trade) and the actual execution price plus all costs — measures the full cost of execution including delay, market impact, and commissions
Explanation: B is correct. Implementation shortfall (IS) = (Decision Portfolio Return − Executed Portfolio Return) = Delay cost + Market impact + Commission + Opportunity cost. IS captures the 'leakage' between a manager's theoretical ideas and actual portfolio performance. A is qualitative implementation failure. C and D are related but different concepts.
Question 357
What is 'market impact' in trading?
Select an option first.
Correct answer: B — The price movement caused by the trade itself — large orders move prices adversely against the trader (buying pushes prices up, selling pushes them down). Market impact depends on trade size relative to market depth and average daily volume
Explanation: B is correct. Market impact: when a large order enters the market, it consumes available liquidity at each price level, pushing the execution price away from the arrival price. Minimising market impact requires: breaking large orders into smaller pieces, algorithmic execution (VWAP, TWAP), dark pools, and patience. A is price discovery. C is macro market effect. D is data costs.
Question 358
What is an 'ABCP' (Asset-Backed Commercial Paper) conduit and what risk did it create in 2007-2008?
Select an option first.
Correct answer: B — A short-term financing structure where a bank-sponsored vehicle issued short-term commercial paper and used the proceeds to buy long-term structured assets (MBS, ABS) — created a maturity mismatch. In 2007, when ABCP markets froze, banks had to take the assets back on-balance-sheet, triggering the credit crisis
Explanation: B is correct. ABCP conduits: maturity transformation — borrow short (ABCP, 30-90 day paper) to fund long assets (MBS, ABS). When ABCP investors refused to roll over paper in August 2007, conduits couldn't fund themselves → sponsor banks were legally obligated to provide liquidity backup → banks absorbed the assets, triggering balance sheet stress. A is a long-term ABS. C is a money market fund. D is a central bank facility.
Question 359
What is 'ESG investing' and how does it differ from traditional investing?
Select an option first.
Correct answer: B — An investment approach that considers Environmental (climate, resource use), Social (labour practices, diversity), and Governance (board composition, executive pay) factors alongside financial analysis — either as a screening tool, risk management lens, or return-enhancement strategy
Explanation: B is correct. ESG: three pillars — Environmental, Social, Governance. Approaches: exclusion screening (negative screens), best-in-class (highest ESG score by sector), ESG integration (ESG factors into financial models), impact investing (specific positive outcomes). Growing evidence that strong governance correlates with better long-term performance; environmental risks are material in certain sectors. A is too narrow. C and D miss the governance and social dimensions.
Question 360
What is 'impact investing'?
Select an option first.
Correct answer: B — Investments made with the intention to generate positive, measurable social or environmental impact alongside a financial return — goes beyond ESG screening to actively seek investments that create positive change (e.g., microfinance, renewable energy, affordable housing)
Explanation: B is correct. Impact investing: the key distinction is intentionality (the impact outcome is a primary objective, not just a by-product). Measured by specific metrics (e.g., tonnes of CO2 avoided, jobs created, loans made to underserved communities). Spectrum: concessionary (below-market returns), market-rate. Examples: green bonds, social impact bonds, development finance institutions. A is growth investing. C is event-driven. D is passive ESG.
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