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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 31
What is 'risk culture' in an organisation?
Select an option first.
Correct answer: B — The shared values, beliefs, behaviours, and attitudes toward risk across all levels of an organisation — a strong risk culture supports appropriate risk-taking; a weak risk culture enabled frauds like Barings Bank and the 2008 financial crisis
Explanation: B is correct. Risk culture: 'tone from the top' — leaders set the example. Key indicators: willingness to raise concerns, how escalated issues are treated, whether risk is rewarded equally with short-term performance. A weak risk culture (e.g., Chase London Whale) allows excessive risk-taking to go unchallenged. A is documentation. C is training. D is compliance culture.
Question 32
What is 'incentive alignment' in the context of risk management?
Select an option first.
Correct answer: B — Structuring compensation so that employees are rewarded for long-term risk-adjusted performance rather than short-term gains that might come with excessive risk — reducing the principal-agent problem between management and shareholders/stakeholders
Explanation: B is correct. Incentive misalignment caused the 2008 crisis: traders earned bonuses on originating mortgages regardless of long-term performance; no clawback provisions. Reforms: bonus deferral (3-5 years), malus/clawback provisions, pay tied to long-term risk-adjusted metrics. A is a blunt restriction. C is a partial solution. D is a compensation adjustment.
Question 33
What is 'risk aggregation' and why is it challenging?
Select an option first.
Correct answer: B — Combining risk measures across different risk types, asset classes, business units, and time horizons to obtain a firm-wide risk picture — challenging because: correlation assumptions matter greatly, aggregation methods differ (simple addition vs diversification-adjusted), and different risk types are measured in incompatible units
Explanation: B is correct. Risk aggregation: to get enterprise-wide VaR, you can't simply add position-level VaRs (assumes correlation = 1). Proper aggregation requires correlations between all risk factors. Different risk types (market, credit, operational) are often expressed in different units and require different aggregation approaches. Tail correlations differ from normal correlations, complicating aggregate tail risk. A and C are oversimplifications. D is partial aggregation.
Question 34
What is 'model validation' in a risk management context?
Select an option first.
Correct answer: B — An independent assessment of whether a financial model is fit for purpose — verifying the theoretical soundness, testing accuracy against benchmarks, assessing sensitivity to assumptions, checking implementation, and evaluating appropriate usage
Explanation: B is correct. Model validation (SR 11-7 in US): three-step process — (1) conceptual soundness (is the theory correct?), (2) ongoing monitoring (does it perform?), (3) outcomes analysis (backtesting). Key elements: independent validation (not by the model builders), back-testing, sensitivity analysis, benchmarking against alternative models. A is an input audit. C is back-testing only. D is model comparison.
Question 35
What is 'P&L attribution' in market risk management?
Select an option first.
Correct answer: B — A process that explains a trading desk's daily P&L by attributing it to changes in specific market risk factors (delta, vega, gamma, theta) — used to verify model accuracy and understand the sources of P&L
Explanation: B is correct. P&L attribution (P&L explain): the desk's actual P&L is explained by the sum of: delta P&L (price movements × delta), vega P&L (vol movements × vega), theta (time decay), higher-order effects. If the explained P&L matches actual P&L, the risk model is accurate. Unexplained P&L signals model risk. A is accounting. C is trade allocation. D is year-on-year comparison.
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Question 36
What is 'backtesting' in the context of VaR models?
Select an option first.
Correct answer: B — Comparing VaR model predictions against actual losses to assess model accuracy — if actual losses exceed VaR more than the expected number of times at the given confidence level, the model is underestimating risk
Explanation: B is correct. VaR backtesting: for a 99% 1-day VaR, we expect losses to exceed VaR 1% of the time (≈2.5 days per year). The Basel traffic light test: green zone (0-4 exceptions per 250 days = acceptable), yellow (5-9 = increased capital multiplier), red (10+ = model rejected). A is historical simulation. C is strategy backtesting. D is index replication.
Question 37
What is 'risk decomposition' and why is it useful?
Select an option first.
Correct answer: B — Breaking down total portfolio risk into contributions from individual positions, sectors, factors, or risk types — enables identification of largest risk contributors so that risk can be managed efficiently within budget
Explanation: B is correct. Risk decomposition: if a portfolio's total VaR is $100M, risk decomposition shows that equities contribute $60M, rates $25M, credit $15M. This guides hedging decisions — hedge the largest contributors if risk budget is tight. A is a limited decomposition. C is loss attribution after the fact. D is P&L accounting.
Question 38
What is 'economic capital' and how does it differ from regulatory capital?
Select an option first.
Correct answer: B — Economic capital is the amount of capital a firm calculates it needs to absorb unexpected losses at a specific confidence level (e.g., 99.97% over 1 year) based on its own internal models — regulatory capital is the minimum required by regulation (Basel), often based on standardised approaches
Explanation: B is correct. Economic capital (EC): management's own view of required capital, typically higher confidence (99.97% matches AA credit risk profile). Regulatory capital (RC): Basel minimum using standardised or internal models. For well-run banks: EC > RC at typical confidence levels. RAPM (Risk-Adjusted Performance Measures) use economic capital. A is sometimes true but not definitionally. C and D are incorrect.
Question 39
What is 'RAROC' (Risk-Adjusted Return on Capital)?
Select an option first.
Correct answer: B — After-tax risk-adjusted profit divided by economic capital — a performance metric that compares business lines or products on a risk-adjusted basis, showing which activities create the most value per unit of risk capital consumed
Explanation: B is correct. RAROC = (Revenue − Expected Loss − Operating Costs + Return on Capital) / Economic Capital. It enables comparison of a loan, a trading desk, and an insurance product on the same risk-adjusted basis. A business with RAROC > hurdle rate creates value. A is ROA. C uses regulatory (not economic) capital. D is ROE.
Question 40
What is 'risk transfer' as a risk management strategy?
Select an option first.
Correct answer: B — Shifting the financial consequences of a specific risk to another party — through insurance, derivatives (hedging), securitisation, or contract terms — reducing the firm's net exposure while paying a premium for the transfer
Explanation: B is correct. Risk transfer mechanisms: (1) Insurance: pay premium, transfer event risk; (2) Derivatives: CDS transfers credit risk; FX forward transfers currency risk; (3) Securitisation: transfers credit risk to ABS investors; (4) Contractual clauses: indemnification provisions transfer liability risk. A is an organisational change. C is a governance change. D is position management.
Question 41
What is 'risk avoidance' as a risk management strategy?
Select an option first.
Correct answer: B — Choosing not to engage in an activity or business because its risk profile exceeds the firm's risk appetite — the most conservative response to risk, used when risk cannot be adequately mitigated, transferred, or accepted
Explanation: B is correct. Risk avoidance: exiting or not entering a business line because the risk is unacceptable. Example: a bank may avoid lending in a country with severe political instability. Different from risk mitigation (keeping the activity but reducing risk) or risk transfer (keeping but shifting consequences). A and C are not risk avoidance. D is risk reduction.
Question 42
What is the 'fundamental review of the trading book' (FRTB)?
Select an option first.
Correct answer: B — A major Basel III/IV reform of market risk capital requirements — replacing the old VaR-based approach with: Expected Shortfall (ES, confidence 97.5%), longer stress period, new boundary between banking and trading books, and stricter internal model approval
Explanation: B is correct. FRTB (Basel 3.5/IV): addresses flaws in pre-crisis market risk framework. Key changes: (1) ES replaces VaR (captures tail risk better); (2) 97.5% confidence level replaces 99%; (3) 12-month stressed period required; (4) Strict P&L attribution test for IMA approval; (5) Clearer trading/banking book boundary. A and C are internal processes. D is compliance monitoring.
Question 43
What is 'regulatory arbitrage' in the context of banking?
Select an option first.
Correct answer: B — Structuring transactions to minimise regulatory capital requirements or exploit gaps between regulatory regimes, without reducing economic risk — e.g., moving assets off-balance-sheet to avoid capital charges
Explanation: B is correct. Regulatory arbitrage: pre-2008, banks moved assets to off-balance-sheet vehicles (SIVs, conduits) to avoid capital requirements while retaining economic exposure. Basel reforms (FRTB, Basel IV) reduce arbitrage opportunities by tightening rules. A is FX arbitrage. C is market arbitrage between regulated and unregulated venues. D is regulatory shopping/jurisdictional arbitrage.
Question 44
What is 'procyclicality' in financial regulation and how does it affect banks?
Select an option first.
Correct answer: B — The tendency for risk measures (VaR, credit ratings, collateral values) to understate risk in booms and overstate it in busts — causing banks to expand lending and reduce capital in good times and contract sharply in bad times, amplifying economic cycles
Explanation: B is correct. Procyclicality: VaR models estimate low risk during calm periods (low historical volatility) → banks expand. During crises: VaR spikes → banks cut lending simultaneously → amplifies the downturn. Basel III countercyclical capital buffer (CCyB) addresses this by requiring extra capital during credit booms. A is market cycles. C is model updating. D is a correlation measure.
Question 45
What is 'Too Big to Fail' (TBTF) and what policy responses address it?
Select an option first.
Correct answer: B — The problem that very large financial institutions are seen as needing government bailout because their failure would cause systemic damage — creating moral hazard (encourages risk-taking) and competitive advantage (implicit government guarantee reduces funding costs)
Explanation: B is correct. TBTF: Lehman showed that large bank failure causes systemic damage; Bear Stearns, AIG were bailed out. Policy responses: G-SIB surcharges (extra capital 1-3.5%), total loss-absorbing capacity (TLAC), living wills (resolution plans), recovery and resolution frameworks. A is irrelevant. C is competition policy. D is position limits.
Question 46
What is 'resolution planning' or a 'living will' for banks?
Select an option first.
Correct answer: B — A regulatory requirement for G-SIBs to maintain a detailed plan showing how they could be wound down in an orderly way if they failed, without requiring taxpayer bailout or causing systemic disruption
Explanation: B is correct. Living wills / resolution plans (Dodd-Frank, BRRD): regulators require large banks to map their legal and operational structure, identify critical services, show how the firm could be resolved over a weekend without market disruption. Key elements: separation of critical functions, sufficient TLAC, operational continuity. A is succession planning. C is credit concentration management. D is risk appetite statement.
Question 47
What is 'TLAC' (Total Loss-Absorbing Capacity)?
Select an option first.
Correct answer: B — A minimum regulatory requirement for G-SIBs to hold a minimum amount of equity and eligible long-term debt that can absorb losses and be written down or converted in resolution, protecting taxpayers from bailout costs
Explanation: B is correct. TLAC (FSB standard, adopted in Basel III): minimum TLAC = 16-18% of RWA (rising to 18% from 2022). Eligible instruments: equity + long-term unsecured senior debt that can be bailed in. This ensures sufficient loss-absorbing capacity so resolution authorities can recapitalise a failed bank without taxpayer support. A is a balance sheet total. C is RWA. D is LCR.
Question 48
What is 'risk governance' at the board level?
Select an option first.
Correct answer: B — The board of directors' responsibility for overseeing the firm's risk management framework — including setting and approving risk appetite, ensuring adequate risk management resources, receiving and challenging risk reports, and overseeing senior risk management appointments
Explanation: B is correct. Board risk governance: the board is ultimately responsible for the risk profile. Responsibilities: approve risk appetite statement, receive and challenge board-level risk reports, ensure the CRO has adequate independence and resources, oversee risk culture, and understand the firm's key risk exposures. A is management's role. C is CFO/CRO responsibility. D is risk management's operational function.
Question 49
What is 'risk appetite statement' (RAS)?
Select an option first.
Correct answer: B — A formal document approved by the board that articulates the types and amounts of risk the organisation is willing to accept in pursuing its strategy — including qualitative risk principles and quantitative risk limits and thresholds
Explanation: B is correct. RAS: communicates the board's risk appetite to management and regulators. Contains: qualitative statements (e.g., 'we do not engage in speculative trading'), quantitative metrics (e.g., 'maximum 1% daily VaR'), and linkage to strategy. Used to set limits, manage breaches, and guide business decisions. A is a business plan. C is risk reporting. D is a regulatory submission.
Question 50
What is 'integrated risk management' and why is it important?
Select an option first.
Correct answer: B — A holistic approach that connects risk management across market, credit, operational, liquidity, and other risk types within a single framework — recognising interdependencies and correlations across risk categories to give a more accurate picture of total risk
Explanation: B is correct. Integrated risk management: siloed risk management can miss correlations (credit spreads widen AND liquidity evaporates simultaneously in crises). Integration: common data infrastructure, enterprise-wide risk aggregation, consistent confidence levels and time horizons across risk types. A is siloed approach. C is a specific governance decision. D is data integration (a tool, not the concept).
Question 51
What is 'investment risk management' in a pension fund context?
Select an option first.
Correct answer: B — The management of investment risks in a pension fund — including asset-liability management (ALM), interest rate and inflation risk (liabilities are long-duration and inflation-linked), equity risk, credit risk, and managing funded status (asset/liability gap)
Explanation: B is correct. Pension fund investment risk: unique because liabilities are also long-duration and linked to inflation. ALM: match asset duration to liability duration to reduce funded status volatility. Key risks: equity market decline reduces assets; rate decline increases liability PV; inflation rises liability value. LDI (liability-driven investing) is the dominant approach. A is the pension promise (liability). C and D are operational and governance decisions.
Question 52
What is 'liability-driven investing' (LDI)?
Select an option first.
Correct answer: B — A strategy where a pension fund or insurer structures its investment portfolio to closely match the sensitivity of its liabilities to interest rates and inflation — using bonds and derivatives to hedge the interest rate and inflation risk of pension obligations
Explanation: B is correct. LDI: UK pension funds pioneered LDI — using long-duration gilt funds and swaps to hedge the interest rate sensitivity (duration) of pension liabilities. Result: changes in interest rates affect assets and liabilities similarly, reducing funding ratio volatility. The 2022 UK gilts crisis showed LDI risks when rates rise sharply, triggering margin calls. A is not the LDI definition. C is too narrow. D is vague.
Question 53
What is 'immunisation' in fixed income portfolio management?
Select an option first.
Correct answer: B — A bond portfolio strategy that eliminates interest rate risk by matching the portfolio's duration (and ideally convexity) to the investment horizon, so that price changes and reinvestment rate changes offset each other exactly
Explanation: B is correct. Immunisation: if duration of assets = duration of liabilities, a parallel shift in the yield curve leaves the funded status unchanged. Price effect (bond price falls when rates rise) is exactly offset by reinvestment effect (coupons reinvested at higher rates). Requires rebalancing as duration drifts. A is a medical metaphor. C eliminates return too. D is cash flow matching (a stricter strategy).
Question 54
What is 'interest rate risk in the banking book' (IRRBB)?
Select an option first.
Correct answer: B — The risk to a bank's net interest income (NII) and economic value of equity (EVE) arising from changes in interest rates affecting the banking book — mismatches between asset and liability repricing dates, basis risk, and optionality (e.g., prepayment of mortgages)
Explanation: B is correct. IRRBB (Basel IRRBB guidelines, 2016): banks must assess interest rate risk in their banking book under two measures: (1) EVE — economic value impact on the balance sheet; (2) NII — net interest income impact over 12 months. Risks: repricing risk (assets/liabilities reprice at different times), basis risk (different reference rates), yield curve risk, optionality. A is trading book rate risk. C reverses the definition. D is policy rate risk.
Question 55
What is 'duration' in fixed income risk management?
Select an option first.
Correct answer: B — The weighted average time to receive all of a bond's cash flows, expressed in years — Macaulay duration. Modified duration measures price sensitivity: a 1% change in yield causes an approximately Modified Duration % change in bond price
Explanation: B is correct. Macaulay Duration: weighted average timing of cash flows. Modified Duration = Macaulay Duration / (1 + y/m). Price change ≈ −Modified Duration × Δy. A long-duration bond (e.g., 30-year zero coupon) is much more price-sensitive than a short-duration bond. A is maturity. C is current yield. D is time-to-maturity in periods.
Question 56
What is 'convexity' in fixed income and why is it important?
Select an option first.
Correct answer: B — The curvature in the price-yield relationship for a bond — a bond with high convexity experiences smaller price declines when yields rise and larger price increases when yields fall, compared to a lower-convexity bond with the same duration
Explanation: B is correct. Convexity: the duration-based price approximation is linear; convexity corrects for the non-linearity. ΔP/P ≈ −D × Δy + ½ × C × (Δy)². Positive convexity is favourable — the bond gains more than it loses for equal yield moves. Mortgage-backed securities can have negative convexity (prepayment option). A is not convexity. C is credit spread duration. D is coupon sensitivity.
Question 57
What is 'DV01' (Dollar Value of 01 or PVBP — Price Value of a Basis Point)?
Select an option first.
Correct answer: B — The change in the price of a bond (or portfolio) for a 1 basis point (0.01%) decrease in yield — DV01 = Modified Duration × Price × 0.0001
Explanation: B is correct. DV01: a practical measure of interest rate sensitivity. A DV01 of $5,000 means the portfolio gains/loses $5,000 per basis point move in rates. Used for hedging: to hedge a portfolio with DV01 of $50,000, short $50,000/$DV01(hedge) units of the hedging instrument. A describes a coupon concept. C is a futures lot value. D is par value.
Question 58
What is 'basis risk' in hedging?
Select an option first.
Correct answer: B — The residual risk that arises when a hedge instrument does not perfectly offset the underlying position — e.g., hedging a corporate bond with a government bond futures contract exposes to the spread between corporate and government yields moving independently
Explanation: B is correct. Basis = Spot Price − Futures Price. Basis risk arises when: (1) the underlying and hedge are not identical instruments; (2) different delivery dates; (3) different geographic locations (for commodities). Perfect hedging requires no basis risk. Using T-bond futures to hedge corporate bonds leaves credit spread risk as basis risk. A is a perfect hedge (no basis risk). C is timing/rollover risk. D is a selection error.
Question 59
What is 'delta hedging' in options risk management?
Select an option first.
Correct answer: B — A hedging strategy that holds a quantity of the underlying asset equal to the option's delta (∂V/∂S) to neutralise the price sensitivity of an option position — requires continuous rebalancing as delta changes with price and time
Explanation: B is correct. Delta hedging: if a call option has delta = 0.6, the hedger buys 0.6 shares per option to be delta-neutral. As the stock price changes, delta changes (gamma effect), requiring rebalancing. Delta hedging eliminates first-order price risk but leaves gamma, theta, vega, and rho risks. A is perfect hedging (impossible with options alone). C and D are different concepts.
Question 60
What is 'vega' in options risk management?
Select an option first.
Correct answer: B — The sensitivity of an option's price to a 1% change in the implied volatility of the underlying asset — long option positions have positive vega (gain value when volatility rises), short positions have negative vega
Explanation: B is correct. Vega (or kappa): ∂V/∂σ. Positive vega (long options): option value rises when volatility increases. Negative vega (short options): value falls when volatility increases. Vega is highest for at-the-money options and decreases for deep in/out-of-the-money options. A is delta. C is theta. D is rho.
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