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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 91
What is 'risk-weighted average cost of capital' (WACC) and how is it used?
Select an option first.
Correct answer: B — The weighted average of the costs of equity and debt (each weighted by their proportion in the capital structure), used as the discount rate for investment decisions — projects with returns above WACC create value; below WACC destroy value
Explanation: B is correct. WACC = (E/V × Ke) + (D/V × Kd × (1 − t)), where E = equity market value, D = debt, V = total value, Ke = cost of equity (CAPM), Kd = cost of debt, t = tax rate. Used in DCF valuation and capital budgeting. A company's WACC is its opportunity cost of capital. A is regulatory capital cost. C is ROIC. D is just the debt cost.
Question 92
What is 'sensitivity analysis' in risk management?
Select an option first.
Correct answer: B — Testing how a model output (option price, portfolio VaR, loan loss) changes when one input parameter is changed while holding others constant — identifies which inputs have the greatest impact on outcomes and therefore deserve the most careful estimation
Explanation: B is correct. Sensitivity analysis: change one variable, observe the output change. Example: option price sensitivity to volatility (vega), bond price sensitivity to yield (duration), DCF value sensitivity to growth rate assumption. Identifies key risk drivers and areas of model uncertainty. Used to communicate model risk to non-technical stakeholders. A is qualitative, not quantitative. C is back-testing. D is model comparison.
Question 93
What is 'model overlaying' or 'management overlay' in risk management?
Select an option first.
Correct answer: B — Adding expert qualitative adjustments to quantitative model outputs — used when models are known to have limitations in current conditions (e.g., overlaying a credit model output with expert judgment about specific sector risks not captured in historical data)
Explanation: B is correct. Management overlay: models are based on historical data and may not capture forward-looking risks. Expert judgment can supplement models: e.g., adjusting IFRS 9 ECL provisions upward for COVID-related risks not in historical data. Good practice: document overlays, quantify the adjustment, review regularly. A is model averaging. C is model replacement. D is regulatory capital adjustment.
Question 94
What is 'economic scenario generation' (ESG) in risk management?
Select an option first.
Correct answer: B — A simulation technique that generates large numbers of realistic economic scenarios (interest rate paths, equity paths, credit spread paths) for use in valuation, stress testing, and capital modelling of insurance companies and pension funds — must be market-consistent (calibrated to current market prices)
Explanation: B is correct. Economic scenario generation (Moody's Analytics, Conning): used in insurance (Solvency II internal models) and pension fund modelling. Two types: (1) Market-consistent (risk-neutral) for valuing insurance liabilities; (2) Real-world (actuarial) for capital and business planning. Scenario sets contain thousands of paths for each risk factor, calibrated to current term structures and volatility surfaces. A is ESG (different acronym). C is ESG (social/environmental). D is central bank forecasting.
Question 95
What is the 'Volcker Rule' in US banking regulation?
Select an option first.
Correct answer: B — A provision in the Dodd-Frank Act (2010) that prohibits US bank holding companies from engaging in proprietary trading (trading for their own account) and from owning or sponsoring hedge funds or private equity funds — aimed at reducing bank risk-taking subsidised by the government deposit guarantee
Explanation: B is correct. Volcker Rule (Section 619 Dodd-Frank): separates investment banking from commercial banking risk. Implementation complex: distinguishing proprietary trading from market-making, hedging, and underwriting. Significant compliance costs. Subsequent amendments in 2020 eased some requirements. A is capital adequacy regulation. C is compensation regulation. D is disclosure requirement.
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Question 96
What is 'mortgage credit risk' and how is it measured?
Select an option first.
Correct answer: B — The risk that mortgage borrowers default on their loans — key drivers: loan-to-value ratio (LTV, higher LTV = higher default risk), debt-to-income ratio (DTI, higher DTI = less capacity to pay), FICO/credit score, property location and type, and macroeconomic conditions (unemployment, house prices)
Explanation: B is correct. Mortgage credit risk: measured via: (1) Probability of Default (PD) — driven by borrower credit quality metrics; (2) Loss Given Default (LGD) — determined by LTV and property value recovery; (3) Exposure at Default (EAD) — outstanding principal + accrued interest. Basel floor for mortgages: standardised approach risk weight = 35-150% depending on LTV. A is interest rate risk. C is prepayment risk. D is operational risk.
Question 97
What is 'forward rate' vs 'spot rate' in interest rate markets?
Select an option first.
Correct answer: B — Spot rate: the interest rate for a loan or investment beginning immediately. Forward rate: the interest rate agreed today for a loan or investment beginning at a future date — derived from spot rates using no-arbitrage (e.g., the 1-year rate starting in 1 year is the implied forward rate from the 1-year and 2-year spot rates)
Explanation: B is correct. Forward rate calculation: (1 + s₂)² = (1 + s₁)(1 + f₁₋₂), solving for the forward rate f₁₋₂. Forward rates encode the market's expectation of future spot rates plus term premiums. Used in: swap pricing, bond forwards, FX forwards (via interest rate parity). A is about sourcing. C is only true for overnight rates. D is the expectations hypothesis (an approximation, not a certainty).
Question 98
What is 'term structure of volatility' in options markets?
Select an option first.
Correct answer: B — The relationship between implied volatility and the time to expiration of options — typically, short-dated options have higher implied volatility (near-term uncertainty) while longer-dated options have more stable lower volatility (mean reversion of volatility over time). This term structure is captured in interest rate cap/floor pricing and in VIX futures term structure
Explanation: B is correct. Term structure of vol (volatility surface combines strike and expiry): short-dated vol is typically higher and more volatile; long-dated vol is lower and more stable. In crises, near-term vol spikes more than long-term. VIX futures: near-dated VIX futures typically trade above longer-dated ones in crises (inverted term structure). Used in options hedging (vega hedging across different maturities). A is the volatility smile (different dimension). C is interest rate vol structure. D is historical vol trend.
Question 99
What is 'foreign exchange risk' management in a global investment portfolio?
Select an option first.
Correct answer: B — The risk that changes in currency exchange rates affect the value of foreign investments when converted back to the investor's home currency — managed through: currency forwards (hedge known exposures), currency swaps (long-term hedges), options (asymmetric hedge), natural hedging (matching revenues and costs in same currency)
Explanation: B is correct. FX risk management: a US investor holding Japanese equities faces equity price risk AND USD/JPY FX risk. Currency forward: lock in the exchange rate. Hedge ratio: fully hedge (100%) vs partially hedge (50%) vs unhedged. Research shows mixed evidence on whether currency hedging improves returns over long horizons for equity investors but reduces short-term volatility. A is political risk. C is capital controls risk. D is counterparty credit risk.
Question 100
What is 'Regulatory Technology' (RegTech) in risk management?
Select an option first.
Correct answer: B — The use of technology (AI, machine learning, natural language processing, blockchain) to help financial institutions comply with regulatory requirements more efficiently — including automated transaction reporting, AML monitoring, regulatory change management, and regulatory capital calculations
Explanation: B is correct. RegTech: reduces compliance costs through automation. Applications: (1) Transaction reporting (MiFID II, EMIR): automated generation of regulatory reports; (2) AML/KYC: ML models to detect suspicious activity; (3) Stress testing: automated scenario calculation; (4) Model risk management: automated model inventory and validation workflows. A is financial technology. C is supervisory technology (SupTech). D is trading technology.
Question 101
What is 'crypto-asset risk' and how is it classified by risk managers?
Select an option first.
Correct answer: B — A set of unique risks associated with digital assets (Bitcoin, Ethereum, stablecoins, DeFi): market risk (extreme price volatility), liquidity risk (thin markets, exchange failures), operational risk (custody, private key management, smart contract bugs), regulatory risk (unclear legal status), and fraud risk (exchange collapses like FTX)
Explanation: B is correct. Crypto asset risks are multi-dimensional: Market (Bitcoin can fall 80% in bear markets), Liquidity (crypto markets can be illiquid during stress), Operational (Mt Gox, FTX — exchange custody failures), Regulatory (changing legal status in different jurisdictions), Technology (smart contract exploits, 51% attacks). Basel III assigned 1250% risk weight to unbacked crypto assets. A is too narrow. C is a subset. D: institutional exposure is growing.
Question 102
What is 'non-financial risk' (NFR) in modern risk management?
Select an option first.
Correct answer: B — An umbrella category covering operational, conduct, compliance, legal, reputational, and strategic risks — distinct from financial risks (market, credit, liquidity). NFR has received increased management focus after large operational failures, conduct scandals, and cyber incidents that caused larger losses than financial risks for many institutions
Explanation: B is correct. NFR: gained prominence as banks demonstrated that operational and conduct risks could cause existential losses (Barings, UBS rogue trader, PPI mis-selling £40bn). NFR cannot be reduced through diversification like financial risks and requires a different management approach (process controls, culture, incentives). A is a sectoral definition. C misses credit and liquidity. D is performance risk.
Question 103
What is 'risk dashboard' and what are its key features?
Select an option first.
Correct answer: B — A real-time or near-real-time visual display of key risk metrics, KRIs, and exposures, enabling management to quickly identify developing risk issues — key features: current vs limit comparison with traffic light colouring, trend indicators, drill-down capability, exception highlighting, and consolidated cross-risk view
Explanation: B is correct. Risk dashboard: should give senior management a rapid understanding of the risk profile. Key elements: exposure vs limit utilisation (with colour coding), KRI trends, breaches and actions, stress test results, and emerging risk flags. Integration of market, credit, and operational risk metrics in one view. A is a performance report. C and D are specific interfaces, not the concept.
Question 104
What is the 'risk-return tradeoff' and why is it fundamental to finance?
Select an option first.
Correct answer: B — The principle that to earn higher expected returns, investors must accept higher risk — no investment can offer both higher returns and lower risk simultaneously in efficient markets. This is the foundation of portfolio theory, CAPM, and risk management
Explanation: B is correct. Risk-return tradeoff: the fundamental principle underlying all of finance. In efficient markets, excess returns come only from bearing undiversifiable risk (beta in CAPM) or from genuine skill (alpha). The SML shows that higher beta stocks have higher expected returns. Investors who need higher returns must accept higher volatility or illiquidity. A is backwards. C is a mathematical curiosity, not a principle. D is incorrect.
Question 105
What is 'tracking error volatility' (TEV) and how is it used in manager mandates?
Select an option first.
Correct answer: B — The annualised standard deviation of active returns (portfolio return minus benchmark return) — used in manager mandates to control how far a manager can deviate from the benchmark. A mandate with 3% TEV allows more active management than one with 1% TEV
Explanation: B is correct. TEV: measures active risk. Formal mandate might specify: 'Maximum 3% tracking error; minimum 30% active share.' Constrains how much the manager can deviate from the benchmark in any direction. Low TEV mandates: close to benchmark (closet indexing). High TEV: genuinely active management. TEV and information ratio determine potential alpha: α = IR × TEV. A is a tracker fund deviation. C and D are different error measures.
Question 106
What is 'expected credit loss' (ECL) under IFRS 9 and how does it differ from IAS 39?
Select an option first.
Correct answer: B — An accounting standard requiring financial institutions to provision for expected future credit losses — rather than waiting for a loss event (incurred loss model under IAS 39). IFRS 9 uses a three-stage model: Stage 1 (12-month ECL for performing loans), Stage 2 (lifetime ECL for significantly deteriorated loans), Stage 3 (lifetime ECL for defaulted loans)
Explanation: B is correct. IFRS 9 ECL vs IAS 39: IAS 39 incurred loss: provision only when a loss event has occurred (too little, too late). IFRS 9 expected loss: forward-looking, recognises deterioration earlier. Stage 2 trigger: significant increase in credit risk (SICR). COVID-19: banks had to make large forward-looking IFRS 9 provisions in early 2020 based on economic forecasts. A is Basel regulatory capital. C and D are different concepts.
Question 107
What is the 'separation of duties' in operational risk management?
Select an option first.
Correct answer: B — A key internal control principle ensuring that no single individual controls all steps of a process — e.g., the person who executes a trade should not also settle it, and neither should be responsible for its valuation. This reduces the risk of fraud and errors going undetected
Explanation: B is correct. Separation of duties: a foundational operational risk control. In trading: (1) Front office executes; (2) Middle office (risk) measures and monitors; (3) Back office confirms, settles, accounts. Rogue trading (Nick Leeson, Jerome Kerviel) exploited inadequate separation — traders had access to their own settlement or booking systems. A is a team structuring concept. C is a governance separation. D is a management structure.
Question 108
What is 'asset-liability management' (ALM) in banking?
Select an option first.
Correct answer: B — The process of managing a bank's balance sheet to: control interest rate risk (gaps between asset and liability repricing), manage liquidity risk (funding gaps), optimise net interest income (NII), and maintain regulatory compliance (LCR, NSFR) — typically overseen by a bank's Asset-Liability Committee (ALCO)
Explanation: B is correct. ALM: core banking risk management function. Tools: gap analysis (repricing mismatches), duration matching, scenario analysis (NII sensitivity to rate changes), fund transfer pricing (FTP — allocating the cost of funding to business units). ALCO: typically weekly meeting of senior management reviewing the balance sheet risk profile. A is investment management. C is derivatives/OBS management. D is perfect matching (impractical).
Question 109
What is 'fund transfer pricing' (FTP) in banking?
Select an option first.
Correct answer: B — A mechanism that allocates an internal cost or benefit of funding to each business line based on the tenor and liquidity of the assets or liabilities they create — ensures business lines properly account for the cost of funds provided by the central treasury
Explanation: B is correct. FTP: the treasury acts as an internal bank. A loan originating business is 'charged' the FTP rate (cost of funds of the matching tenor and liquidity). A deposit-taking business receives the FTP rate as a credit. This ensures that profitability of each business unit reflects the true cost of funding, not a subsidised internal rate. A is customer loan pricing. C and D are different concepts.
Question 110
What is 'insurance risk' in the context of enterprise risk management?
Select an option first.
Correct answer: B — The risk arising from insurance activities — including underwriting risk (pricing risk, catastrophe risk, reserve risk), mortality/longevity risk, lapse/surrender risk, and market risk on the investment portfolio backing insurance liabilities — increasingly important as insurers are large institutional investors and counterparties
Explanation: B is correct. Insurance risk: insurers face unique risks: (1) Underwriting: mispricing insurance policies; (2) Reserving: inadequate loss reserves for claims; (3) Catastrophe: correlated losses from a single event (hurricane, pandemic); (4) Longevity: policyholders living longer than expected; (5) Investment: mismatch between assets and insurance liabilities. Solvency II (EU) and NAIC (US) are the regulatory frameworks. A is too narrow. C is a procurement risk. D is a subset.
Question 111
What is 'political risk' in the context of investment management?
Select an option first.
Correct answer: B — The risk that government actions, instability, or policy changes will adversely affect investments — including expropriation (government seizure of assets), currency controls (inability to repatriate profits), political instability (war, coups), regulatory changes (nationalisation, new taxes), and sovereign debt restructuring
Explanation: B is correct. Political risk: assessed for cross-border investments. Key indices: World Bank governance indicators, PRS Group political risk ratings. Mitigation: political risk insurance (MIGA, export credit agencies), structuring investments through bilateral investment treaties (BITs), joint ventures with local partners. A is shareholder activism risk. C is governance risk. D is legal/regulatory risk (related but distinct).
Question 112
What is 'scenario planning' vs 'risk scenarios' in ERM?
Select an option first.
Correct answer: B — Scenario planning: a strategic tool that creates narrative descriptions of multiple plausible future states to stress-test business strategy (used in corporate strategy). Risk scenarios: specific adverse events defined for quantitative risk assessment (used in operational risk, Basel, Solvency II). Both involve imagining the future but serve different organisational purposes
Explanation: B is correct. Scenario planning (Shell pioneered this): explores multiple uncertain futures to test strategy robustness. Risk scenarios (Basel/BCBS operational risk): defines specific extreme but plausible loss events for quantifying capital requirements under the AMA. Both involve structured imagination of possible futures, but one is strategic (qualitative narrative) and the other is operational risk measurement (quantitative loss distribution). A conflates them. C and D are generalisations.
Question 113
What is 'operational resilience testing' and what does it evaluate?
Select an option first.
Correct answer: B — A structured exercise evaluating whether a financial firm can continue delivering its critical business services within defined impact tolerances during severe but plausible disruptions — including: scenario walkthroughs, simulation exercises, live exercises, and tabletop exercises. Required by FCA/PRA since 2021 for UK firms
Explanation: B is correct. Operational resilience testing (FCA/PRA PS21/3): firms must identify important business services (e.g., payments, custody), set impact tolerances (maximum downtime tolerable), test ability to remain within those tolerances under severe disruptions, and remediate gaps. Tests include: tabletop (discuss scenarios), simulation (mock disruption), live (actual failure response). A is technical DR testing. C is efficiency testing. D confuses resilience with efficiency.
Question 114
What is 'climate scenario analysis' in banking risk management?
Select an option first.
Correct answer: B — A forward-looking assessment of how different climate scenarios (e.g., a 2°C orderly transition, 3°C disorderly transition, net-zero by 2050) affect a bank's balance sheet — through physical risk (assets damaged by climate events), transition risk (carbon-intensive loans impaired by carbon pricing), and liability risk (litigation). Required by major central banks (ECB, PRA, Fed)
Explanation: B is correct. Bank climate scenario analysis: NGFS (Network for Greening the Financial System) provides standardised scenarios. Banks map their loan book exposure to sectors with high physical or transition risk. Key questions: what % of mortgages are in flood-prone areas? What % of loans are to high-carbon industries? How do these evolve under different climate trajectories? A is facility management. C is disclosure only. D is sentiment analysis.
Question 115
What is 'internal model approach' (IMA) for market risk capital under FRTB?
Select an option first.
Correct answer: B — A regulatory approval for banks to use their own risk models (Expected Shortfall at 97.5%) to calculate market risk capital for the trading book, subject to: P&L attribution test (model must explain 80%+ of actual P&L), backtesting (number of exceptions < threshold), and desk-level model approval. Banks failing these tests revert to Standardised Approach
Explanation: B is correct. FRTB IMA: more capital-efficient than SA for most portfolios, but complex to implement. Desk-level model approval: each trading desk must pass P&L attribution and backtesting. Key test: if the ES model systematically fails to explain P&L (material unexplained component), the desk loses IMA approval and must use SA (typically higher capital). A is the SA approach. C is a regulatory model. D is supervisory analysis.
Question 116
What is 'risk culture assessment' and how do regulators evaluate it?
Select an option first.
Correct answer: B — An evaluation of the attitudes, values, and behaviours toward risk across all levels of an organisation — regulators (PRA, ECB) assess risk culture through: interviews with staff at all levels, behavioural observation during meetings, analysis of risk escalation patterns, review of incentive structures, and evaluation of how risk concerns are treated when raised
Explanation: B is correct. Risk culture assessment: regulators recognise that 'tone from the top' can differ from 'tone from the middle' (what actually happens day-to-day). Red flags: employees punished for raising concerns, short-term P&L dominating risk decisions, inconsistency between stated values and actual behaviour. Thematic reviews: PRA has published findings on risk culture across banks. A is HR satisfaction. C is risk measurement. D is policy review.
Question 117
What is 'pillar 2 requirement' (P2R) and 'pillar 2 guidance' (P2G) in banking regulation?
Select an option first.
Correct answer: B — P2R (Pillar 2 Requirement): a binding additional capital requirement set by the supervisor above Pillar 1, based on the SREP, to cover risks not fully captured by Pillar 1 (e.g., IRRBB, concentration risk, model risk). P2G (Pillar 2 Guidance): non-binding guidance set above P2R indicating the level of capital the supervisor expects the bank to maintain. Breaching P2G restricts distributions (dividends)
Explanation: B is correct. P2R and P2G (SREP outcome): P2R: mandatory — the bank must hold this capital or face regulatory action. P2G: supervisory expectation — falling below P2G triggers MDA (Maximum Distributable Amount) restrictions (limits on dividends, AT1 coupons, bonuses). Together: Total SREP Capital Requirement = Pillar 1 + P2R. A is incorrect. C and D are wrong contexts.
Question 118
What is 'Non-Performing Loan' (NPL) ratio and why is it an important banking risk indicator?
Select an option first.
Correct answer: B — The proportion of a bank's loan book where borrowers are significantly behind on payments (typically 90+ days past due) — a rising NPL ratio signals deteriorating loan quality, increasing credit losses, capital erosion, and potential systemic stress if concentrated in a sector or country
Explanation: B is correct. NPL ratio = NPLs / Total Gross Loans. ECB threshold for concern: >5% NPL ratio (European Banking Authority definition). High NPL ratios (Italy, Greece in 2015-2016: 15-40%) can: constrain new lending (balance sheet clogged), require large provisions (erode capital), and reduce bank profitability. NPL management: sales to distressed debt investors, loan restructuring, write-offs. A is performing loan status. C is loan origination rate. D is borrower type.
Question 119
What is 'AI in finance risk' (algorithmic risk) and how is it managed?
Select an option first.
Correct answer: B — Risks arising from the use of AI and algorithmic systems in finance: model risk (biased training data, overfitting, unexpected behaviour in novel conditions), operational risk (system failures, algorithmic errors causing flash crashes), conduct risk (biased AI decisions disadvantaging customers), and systemic risk (correlated AI behaviour amplifying market moves). Management: model governance, explainability requirements, circuit breakers, human oversight
Explanation: B is correct. AI risks in finance: 2010 Flash Crash demonstrated that algorithmic trading can amplify market dislocations. Overfitting: an AI trained on historical data may fail catastrophically in new market regimes. Bias: AI trained on historical lending decisions may perpetuate discriminatory patterns. Explainability (XAI): regulators increasingly require model transparency. Management: rigorous model validation, ongoing monitoring, kill switches, human review of AI outputs in critical decisions. A is a displacement risk. C is a different concern. D is complexity risk.
Question 120
What is 'BCBS 239' and what does it require of banks?
Select an option first.
Correct answer: B — Principles for effective risk data aggregation and risk reporting — BCBS 239 (2013) requires G-SIBs to: aggregate risk data accurately and quickly across the institution, produce reliable risk reports for management, and be able to generate risk data in a timely manner during stress. Required 14 principles covering data governance, accuracy, completeness, timeliness, and adaptability
Explanation: B is correct. BCBS 239: motivated by 2008 crisis where banks couldn't quickly assess their total exposures to Lehman Brothers. 14 principles: Governance (risk data and IT architecture), Data capabilities (accuracy, integrity, completeness, timeliness), Reporting practices (accuracy, comprehensiveness, clarity, frequency, distribution). G-SIBs: implementation required; supervisors assess compliance annually. Key finding: many large banks still not fully compliant years after the standard. A is capital regulation. C and D are different standards.
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