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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 361
What is the 'liquidity premium' in alternative investments and how large is it typically estimated to be?
Select an option first.
Correct answer: A — A fee paid for investing in liquid alternatives
Explanation: A is correct — wait, B is correct. Illiquidity premium: empirical estimates of 2-4% per annum for private equity vs public equity, similar for private real estate vs REITs. This premium compensates for: inability to exit quickly, valuation uncertainty, J-curve effects, and capital commitment uncertainty. A is a product description. The premium amounts vary significantly. B is the correct answer. C is a fee discount. D is a transaction spread.
Question 362
What is 'rebalancing alpha' (diversification return)?
Select an option first.
Correct answer: B — The return bonus from systematic rebalancing — a portfolio of assets with the same expected return but less than perfect correlation will earn more than the weighted average of the individual asset returns due to the buy-low/sell-high effect of rebalancing
Explanation: B is correct. Rebalancing alpha / diversification return: mathematically, the geometric mean of a diversified portfolio exceeds the weighted average geometric mean of its components when assets are less than perfectly correlated. Rebalancing systematically sells relatively expensive assets and buys cheaper ones. The bonus = approximately 0.5 × portfolio variance × (1 − average correlation). A is diversification benefit. C is active-passive return difference. D is within-class rebalancing.
Question 363
What is 'systematic risk' in the context of a credit portfolio?
Select an option first.
Correct answer: B — The component of credit risk that affects all borrowers simultaneously — driven by economic cycles, financial system stress, or sector-wide shocks. High systematic credit risk means many borrowers default at the same time, creating concentrated portfolio losses
Explanation: B is correct. Systematic credit risk: when correlations between defaults are high (e.g., during recessions), the portfolio behaves as if diversification didn't work. This is the key risk in credit portfolios — not the average default rate, but the clustering of defaults. CDO models in 2007 dramatically underestimated default correlation (systematic risk). A is idiosyncratic. C is model risk. D is total undiversified risk.
Question 364
What is 'alpha transport'?
Select an option first.
Correct answer: B — A strategy that separates alpha from its original market context and delivers it to a different market exposure — e.g., taking a bond manager's alpha and adding equity index futures to deliver equity-like total returns with bond alpha on top
Explanation: B is correct. Alpha transport (a form of portable alpha): the alpha of a bond manager is extracted via a market-neutral overlay, then equity beta is added using futures. Total return = Treasury rate + bond alpha + equity risk premium. Allows investors to access the best manager in each asset class while maintaining target asset allocation. A is position transfer. C is tax harvesting. D is management change.
Question 365
What is 'directional risk' vs 'non-directional risk' in hedge funds?
Select an option first.
Correct answer: B — Directional strategies take net market exposure bets (long/short imbalance) — returns depend on market direction. Non-directional strategies are market-neutral (near-zero beta) — returns depend on relative performance between positions, not market direction. Examples: directional = global macro; non-directional = pairs trading, merger arb
Explanation: B is correct. Directional: equity L/S (net long), global macro (large directional bets). Non-directional: market neutral, relative value, statistical arbitrage. Non-directional strategies should provide returns uncorrelated with market direction, offering genuine diversification. A confuses direction with market level. C is wrong. D conflates the two.
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Question 366
What is 'synthetic equity exposure' and how is it used by hedge funds?
Select an option first.
Correct answer: B — Creating equity market exposure using derivatives (equity swaps, total return swaps, futures) rather than buying physical shares — used to: gain exposure without cash outlay, avoid ownership disclosure (pre-13D filing), gain leverage, or access foreign equity markets without local custody requirements
Explanation: B is correct. Synthetic equity (equity swap/TRS): a hedge fund can pay the funding cost and receive the total return of a stock or index. Benefits: off-balance-sheet (until ISDA master agreements require collateral), leverage, no stamp duty (in some markets), avoids short-selling restrictions on physical shares. A is leveraged equity purchase. C is convertible arbitrage. D is a specific derivative type.
Question 367
What is 'credit spread' and how is it measured?
Select an option first.
Correct answer: B — The difference in yield between a corporate bond and a government bond of the same maturity — compensation for credit risk (default probability × loss severity) and liquidity risk. Credit spreads widen when markets price greater default risk and tighten when credit conditions improve
Explanation: B is correct. Credit spread = corporate bond yield − equivalent government bond yield. OAS (Option-Adjusted Spread): removes the effect of embedded options. Credit spread = compensation for PD × LGD + liquidity premium. Spreads widen in recessions (higher default risk) and tighten in expansions. A is a bid-ask spread. C is a CDS premium (related but different). D is a spread between market segments.
Question 368
What is 'volatility arbitrage' and how is it implemented?
Select an option first.
Correct answer: B — Exploiting the difference between implied volatility (from options pricing) and expected future realised volatility — by delta-hedging an option position, the P&L depends only on the difference between implied and realised vol. If implied > expected realised: sell options (delta-hedged) to capture the vol premium
Explanation: B is correct. Volatility arbitrage: theoretical basis — if implied vol = 25% and expected realised = 20%, sell options at 25% implied and dynamically delta-hedge. The P&L = 0.5 × Gamma × S² × (σ²_implied − σ²_realised) accumulated over the option's life. Risk: if realised vol spikes above implied, the position loses money. A is index arbitrage. C is a spread trade. D is a different vol strategy.
Question 369
What is 'cross-asset correlation' in multi-strategy funds?
Select an option first.
Correct answer: B — The correlation between different strategies or asset classes within a multi-strategy fund — low cross-asset correlation increases diversification and reduces overall fund volatility relative to individual strategies. In crises, cross-asset correlations typically rise, reducing the diversification benefit exactly when it is most needed
Explanation: B is correct. Multi-strategy diversification: a fund running equity L/S + credit L/S + macro + CTA strategies expects low correlations between strategies in normal markets. In 2008, however, these correlations rose sharply — all strategies suffered simultaneously. Multi-strategy risk management: monitor inter-strategy correlations, include stress scenarios where correlations converge. A is concentration risk. C is allocation. D is active risk.
Question 370
What is the 'J-curve' in PE and how long does the period of negative returns typically last?
Select an option first.
Correct answer: B — The initial period (typically years 1-3) of negative IRR as management fees are charged, portfolio companies are acquired at cost, and no exits have occurred yet — followed by improving IRR as portfolio companies mature and are exited. The J-curve can be reduced by early distributions or buying a secondary stake (already past the J-curve)
Explanation: B is correct. J-curve timing: years 1-2 = significant negative IRR (fees + deployment of capital with no exits). Year 3-4 = inflection (some exits begin). Year 5-8 = strong positive IRR (mature portfolio, multiple exits). Year 8-10 = declining IRR as best companies already exited. Reducing J-curve: secondary investment (buy at year 4-5 when early capital is deployed). A: timing varies. C: it varies by strategy. D: applies to all PE including buyout.
Question 371
What is 'infrastructure financing' and what are the main project finance structures?
Select an option first.
Correct answer: B — Infrastructure projects are typically financed through project finance: a non-recourse or limited recourse structure where the project's own cash flows service the debt. Key structures: PPP (Public-Private Partnership), BOT (Build-Operate-Transfer), DBFM (Design-Build-Finance-Maintain) — equity investors are exposed to construction risk, ramp-up risk, and operating risk
Explanation: B is correct. Project finance: a special purpose vehicle (SPV) is created. The SPV borrows against future contracted revenues (e.g., toll road revenue, power purchase agreement). Equity investors: private equity, infrastructure funds. Lenders: project finance banks, institutional debt investors. Main risks: construction (cost overrun), ramp-up (traffic below forecast), regulatory (tariff changes). A is government subsidy. C is a funding instrument. D is a risk mitigation but not a structure.
Question 372
What is 'systematic global macro' and how does it differ from discretionary global macro?
Select an option first.
Correct answer: B — Systematic global macro: rule-based algorithmic models that trade macro markets (currencies, rates, commodities, indices) based on quantitative signals (trend-following, value, carry) — highly scalable, emotionally disciplined, consistent execution. Discretionary global macro: portfolio managers apply subjective judgment, geopolitical analysis, and qualitative views to make large directional macro bets
Explanation: B is correct. Systematic macro (Winton, Man AHL): model-driven, can scale, low manager dependence, replicable. Discretionary macro (Bridgewater, Soros): less scalable, alpha depends on key individuals, more adaptable to structural breaks that models miss. Many large macro funds now combine both. A reverses the definitions. C and D are structural differences not definitional.
Question 373
What is 'commodity term structure trading' as a hedge fund strategy?
Select an option first.
Correct answer: B — Exploiting pricing anomalies along the commodity futures curve — going long nearby contracts (undervalued) and short deferred contracts (overvalued) or vice versa, profiting from mean reversion of the curve shape rather than outright commodity price direction
Explanation: B is correct. Term structure trading: the shape of the futures curve changes as storage, supply-demand, and convenience yield conditions evolve. A trade might: long the 3-month contract and short the 12-month (calendar spread) expecting near-term supply tightness to push nearby contracts higher relative to deferred. This is market-neutral to outright commodity price moves. A is exchange arbitrage. C is cash-and-carry. D is long-maturity speculation.
Question 374
What is 'co-mingling risk' in fund of funds?
Select an option first.
Correct answer: B — The risk that a FoF investor is exposed to all positions across all underlying funds simultaneously — if one underlying fund's strategy fails, it can affect investor returns even though they invested for diversification. Also includes the risk of underlying funds unknowingly holding the same positions (hidden correlation)
Explanation: B is correct. Co-mingling risk in FoF: FoF diversification can be illusory if underlying funds hold correlated positions — particularly in crises when many hedge funds de-lever simultaneously. 'Hidden correlation' emerges during market stress. Co-mingling also refers to: not segregating investor assets from manager assets (an operational risk). The double fee layer of FoF (FoF fee + underlying fund fees) is the other major concern. A and D are concentration risks. C is an operational segregation issue.
Question 375
What is 'prime of prime brokerage' and why did it emerge?
Select an option first.
Correct answer: B — An intermediary that provides smaller hedge funds with access to institutional prime brokerage services by acting as the counterparty (aggregator) between the hedge fund and a major bank's prime brokerage platform — emerged because many banks raised minimum account sizes post-2008, excluding smaller funds from direct prime brokerage relationships
Explanation: B is correct. Prime of Prime (PoP): post-Lehman, major banks increased minimum AUM requirements for hedge fund clients (often $250M+). Smaller funds couldn't access institutional execution and leverage. PoP brokers (e.g., Interactive Brokers, Sucden Financial): aggregate multiple smaller clients and access major banks' prime brokerage platforms, passing through institutional-quality execution. A is market position. C is a multi-prime setup. D is private banking.
Question 376
What is 'timberland' investing as an alternative asset?
Select an option first.
Correct answer: B — Direct ownership of commercial forest land — return components: biological growth (trees grow in value as timber volume and quality increase), timber price appreciation, and land value appreciation. Characteristics: low correlation with financial markets, inflation hedge, long investment horizon (10-30 years), and carbon credit potential
Explanation: B is correct. Timberland: NCREIF Timberland Index shows historically strong risk-adjusted returns with low correlation to equities and bonds. Key risks: timber price volatility, natural disasters (fire, disease), regulatory changes (logging restrictions). The TIMO (Timber Investment Management Organisation) structure is common. Carbon credits: timber forests sequester carbon and can generate carbon offset revenue. A is company equity. C is a REIT structure. D is commodity futures.
Question 377
What is 'PE secondary pricing' and what drives discounts/premiums to NAV?
Select an option first.
Correct answer: B — Secondary PE interests are priced based on: the quality and maturity of the underlying portfolio, the GP's reputation and track record, the remaining investment period (earlier = more discount for J-curve), current credit conditions (tighter credit = wider discounts), and the supply-demand balance in the secondary market. Discounts widened to 30-50% in 2009; premiums emerged in 2021-22
Explanation: B is correct. Secondary pricing drivers: Vintage/maturity: older funds with more visible exits trade at smaller discounts. GP quality: top-quartile GPs attract premiums. Credit environment: when bank financing for secondaries is expensive, discounts widen. Market supply: wave of forced selling (2009, 2020) drives discounts wider. A: discounts and premiums vary widely (0-50%). C: below-NAV pricing is common during market stress. D: market forces, not GPs, determine secondary prices.
Question 378
What is 'look-through' analysis in fund risk management?
Select an option first.
Correct answer: A — Identifying the individual positions within underlying funds to understand aggregate exposures — if an investor holds two fund of funds that each own the same underlying hedge fund, the investor has double the intended exposure. Look-through reveals: actual underlying exposures, hidden concentrations, and true diversification
Explanation: A is correct. Look-through: critical for FoF investors, asset owners investing in multiple managers, and risk managers assessing true portfolio exposures. Without look-through: apparent diversification may be illusory (ten hedge funds all short the same stocks). Tools: managers disclose positions to admin/risk aggregators. Look-through also applies to ETF holdings (look through ETF to see individual stocks). B and C are narrow or incorrect. D is a beneficial ownership/AML concept.
Question 379
What is 'macro-overlay strategy' in portfolio management?
Select an option first.
Correct answer: B — A strategy applied on top of an existing portfolio that uses derivatives (futures, options, swaps) to express macroeconomic views, hedge unwanted exposures, or adjust the portfolio's beta, duration, or currency profile without changing the underlying holdings
Explanation: B is correct. Macro overlay: the underlying portfolio (e.g., 60/40 equities/bonds) is unchanged. The overlay adds: reduced equity beta (short equity futures) when the view is bearish; extended duration (long bond futures) when rates are expected to fall; currency hedge (FX forward) when USD is expected to strengthen. Advantages: cost-efficient, fast to implement, doesn't disturb the manager selection process. A is an allocation decision. C is research. D is a specific overlay.
Question 380
What is 'private market valuation methodology' and the main approaches?
Select an option first.
Correct answer: B — Private market assets (PE, real estate, infrastructure) use three main valuation approaches: (1) Market approach: comparable transactions or public market multiples (EV/EBITDA, P/E); (2) Income approach: discounted cash flow using projected free cash flows; (3) Asset approach: adjusted net asset value (for asset-heavy businesses). IPEV guidelines govern PE and VC valuations
Explanation: B is correct. Private market valuation (IPEV, ASC 820 Level 3): GPs typically use: Market approach for trading businesses (revenue or EBITDA multiples from public comps or recent transactions); DCF for assets with stable cash flows (infrastructure, real estate); NAV for holding companies. The choice depends on the business type and stage. A is historical cost (inappropriate after initial period). C is stale pricing. D is too narrow.
Question 381
What is 'the risk of leverage' in alternative investments?
Select an option first.
Correct answer: B — Leverage amplifies both gains and losses — a 3x leveraged portfolio that falls 10% loses 30% of equity. If losses exceed equity (leverage wipeout), the investor faces margin calls and potential insolvency. Leverage also creates funding risk: forced selling during market stress magnifies losses
Explanation: B is correct. Leverage risk: mathematical amplification. 5x leverage: a 20% drawdown in the underlying wipes out 100% of equity. Hedge funds with high leverage (LTCM: 25x) can fail spectacularly when correlated positions move adversely and liquidity dries up simultaneously. Margin calls force selling at distressed prices. A is wrong. C: leverage improves nominal returns but typically worsens risk-adjusted returns. D: leverage risks exist in all market conditions.
Question 382
What is 'alpha decay' and what causes it in systematic strategies?
Select an option first.
Correct answer: B — The erosion of a strategy's excess returns over time as: (1) more capital chases the same signal (crowding); (2) the mispricing the strategy exploits is arbitraged away; (3) academic publication of the strategy allows widespread implementation; (4) market microstructure changes reduce the opportunity
Explanation: B is correct. Alpha decay in systematic strategies: when a strategy (e.g., a specific value metric) is published academically and implemented by many quant funds, the subsequent returns to that factor typically decline. McLean and Pontiff (2016): return anomalies decay 26% after publication. Capacity constraints also contribute — a $10B fund cannot exploit the same small-cap opportunities as a $100M fund. A is a rate sensitivity. C is an inverse relationship. D is different.
Question 383
What is 'tail risk' in alternatives and how do hedge funds face it?
Select an option first.
Correct answer: B — The risk of extreme negative events that fall in the far left tail of the return distribution — many hedge fund strategies implicitly sell tail risk (e.g., selling options, providing liquidity, carry trades) and earn small regular premiums but suffer large periodic losses during crises
Explanation: B is correct. Tail risk in hedge funds: option-selling strategies, credit strategies, and carry trades all share a common feature — they earn positive carry most of the time but suffer large drawdowns during tail events. This creates negatively skewed return profiles. Measuring performance with Sharpe ratio alone overstates the true risk-adjusted performance of these strategies. A is size risk. C is position performance risk. D is a trimming technique.
Question 384
What is 'redemption risk' in hedge funds?
Select an option first.
Correct answer: B — The risk that investor redemption requests exceed the fund's liquidity, forcing the manager to sell illiquid positions at distressed prices — creating losses for remaining investors and potentially triggering further redemptions (a 'run on the fund')
Explanation: B is correct. Redemption risk: if many investors request redemptions simultaneously (e.g., during a market crisis), the fund may be forced to sell liquid positions (good assets sold first, leaving remaining investors with illiquid remainder — 'side pocket' problem). Gates and lock-ups help manage this. In 2008 many hedge funds gated or suspended redemptions. A is a fee risk. C is competitive risk. D is a contractual concern.
Question 385
What is 'infrastructure debt' as an alternative asset?
Select an option first.
Correct answer: B — Senior or subordinated debt financing long-lived infrastructure assets (toll roads, airports, utilities, hospitals) — characteristics: long maturity (15-30 years), stable cash flows from regulated or contracted revenues, inflation linkage, illiquidity premium over public bonds, and strong security (first-lien on essential assets)
Explanation: B is correct. Infrastructure debt: an alternative fixed income asset class. Increasingly popular for pension funds (long duration matches long liabilities; inflation linkage). Examples: project finance loans for a wind farm, bridge loans for an airport expansion. Typically rated BBB/BBB+ but yields infrastructure premium above public investment-grade debt. A is an equity investment. C is short-term construction finance. D is public sector debt.
Question 386
What is a 'hedge fund replication' strategy?
Select an option first.
Correct answer: B — A systematic strategy that uses factor exposures (market beta, credit beta, momentum, carry, value) to replicate the return characteristics of a diversified hedge fund index at lower cost — using liquid instruments (futures, ETFs) without the illiquidity, lock-ups, or high fees of actual hedge funds
Explanation: B is correct. Hedge fund replication (Hasanhodzic & Lo, 2007): most hedge fund returns can be explained by systematic factor exposures. A replication portfolio uses: equity beta (long equity futures), credit beta (long IG/HY credit), trend-following (CTA factor), and merger arb factor. Cost: 0.5-1% vs 2+20. Captures systematic portion but misses manager-specific alpha. A is position cloning (different). C is strategy mimicking. D is a fund structure.
Question 387
What is 'commodity storage theory' and how does it explain futures pricing?
Select an option first.
Correct answer: B — The theory that futures prices reflect: spot price + cost of carry (storage costs + financing cost − convenience yield). When supply is abundant, storage costs dominate and futures trade above spot (contango). When supply is tight, convenience yield is high and futures trade below spot (backwardation)
Explanation: B is correct. Cost-of-carry model: F = S × e^((r+c−y)T), where r = interest rate, c = storage cost, y = convenience yield. When y > r + c (physical inventory scarce): backwardation. When y < r + c (inventory abundant): contango. Gold: no storage scarcity, so mostly in contango. Crude oil: alternates based on inventory levels. A ignores convenience yield. C describes backwardation only. D: applies to all physical commodities.
Question 388
What is 'total expense ratio' (TER) in fund management?
Select an option first.
Correct answer: B — The total annual cost of holding a fund as a percentage of NAV — including management fee, administration, custody, legal, auditing, and other fund expenses (but typically excluding transaction costs). Higher TER directly reduces net investor returns
Explanation: B is correct. TER (or Ongoing Charges Figure in EU/UK): the all-in annual fee burden on investors. For passive index ETFs: 0.03-0.20%. For active mutual funds: 0.5-1.5%. For hedge funds: the TER can be 2-3% management fee alone, plus performance fee on top. TER drag compounds over time: 1% annual TER reduces a $100K portfolio's value by ~18% over 20 years vs no TER. A is performance fee. C is firm profitability. D is prime brokerage fee.
Question 389
What is 'fund governance' in hedge funds and PE?
Select an option first.
Correct answer: B — The legal and organisational structure ensuring accountability to investors — including: independent board/directors (for offshore funds), independent administrator (NAV calculation), independent auditor (financial statements), independent prime broker (custody). Good governance reduces operational risk and fraud risk
Explanation: B is correct. Fund governance: post-Madoff, investors and regulators emphasised operational governance — was it a genuine fund or a Ponzi scheme? Operational due diligence evaluates: independent administrator (not the manager calculating its own NAV), independent auditor (known firm with capacity), and custody (assets held by an independent custodian). A is investment governance. C is portfolio company governance. D is regulatory framework.
Question 390
What is 'listed infrastructure' vs 'unlisted (direct) infrastructure' investing?
Select an option first.
Correct answer: B — Listed: publicly traded shares of infrastructure companies (e.g., airports, toll roads, utilities) — liquid, transparent, but exposes investors to equity market volatility. Unlisted/direct: ownership of infrastructure assets or infrastructure funds — illiquid, requires large capital, less correlated with equity markets, captures full illiquidity premium but limited to large institutional investors
Explanation: B is correct. Listed vs unlisted infrastructure: Listed (MSCI Infrastructure Index): liquid, low transaction cost, but ~50% correlation with equities during crises (equity market beta). Unlisted (direct): 5-10 year lock-up, quarterly valuation, lower measured correlation (partly smoothed), full illiquidity premium. Institutional investors (pension funds) typically access both: listed for liquidity, unlisted for premium. A, C and D are incorrect.
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