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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 181
What is 'momentum' as an investment factor?
Select an option first.
Correct answer: B — Buying recent winners (strong prior-period returns) and selling recent losers, based on the tendency of trends to continue
Explanation: B is correct. Momentum factor: assets that performed well in the recent past (typically 3-12 months) tend to continue outperforming in the near term. The strategy goes long recent winners and short recent losers. A is contrarian/mean-reversion. C is the value factor. D is the income/yield factor.
Question 182
What is the 'value factor' in factor investing?
Select an option first.
Correct answer: B — Buying stocks that appear cheap relative to fundamentals (low P/E, P/B, or P/S ratios)
Explanation: B is correct. Value factor: stocks trading below their intrinsic value (low price-to-book, low price-to-earnings) tend to outperform expensive growth stocks over time. This was documented by Fama and French. A describes growth/expensive stocks. C is the growth factor. D is an earnings revision signal.
Question 183
What is 'mean-variance optimisation' in portfolio construction?
Select an option first.
Correct answer: B — Building a portfolio that maximises expected return for a given level of variance (or minimises variance for a given expected return)
Explanation: B is correct. Mean-variance optimisation (Markowitz, 1952) constructs portfolios on the efficient frontier. It uses expected returns, variances, and covariances as inputs to maximise the Sharpe ratio or achieve a target risk/return combination. A ignores risk. C is a statistical calculation. D ignores covariance, which is essential.
Question 184
What is a key practical limitation of mean-variance optimisation?
Select an option first.
Correct answer: B — Results are highly sensitive to small changes in expected return inputs, often producing concentrated, unstable portfolios
Explanation: B is correct. Mean-variance optimisation is notorious for 'error maximisation' — small estimation errors in expected returns lead to large portfolio weight changes. It tends to produce extreme, poorly diversified portfolios. Practitioners use constraints, Black-Litterman, or robust optimisation to address this. A is wrong — it requires many inputs. C and D are incorrect limitations.
Question 185
What is the Black-Litterman model used for?
Select an option first.
Correct answer: B — Combining market equilibrium expected returns with investor views to produce stable, well-diversified portfolio weights
Explanation: B is correct. Black-Litterman blends CAPM equilibrium returns (market-implied) with the investor's own return views, weighted by confidence. This produces more stable and diversified portfolios than raw mean-variance optimisation. A is a drawdown calculation, not BL. C is leverage management. D is stress testing.
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Question 186
What is 'resampling' in portfolio optimisation?
Select an option first.
Correct answer: B — A technique that runs mean-variance optimisation many times using return estimates drawn from the return distribution, then averages the resulting weights
Explanation: B is correct. Resampled efficient frontier (Michaud, 1989): generates many simulated return scenarios from the estimated distribution, optimises each, then averages the portfolio weights. The result is more stable and diversified than a single mean-variance optimisation. A is Monte Carlo sampling. C and D are incorrect descriptions.
Question 187
What is 'risk parity' as a portfolio construction approach?
Select an option first.
Correct answer: B — Allocating weights so that each asset contributes equally to total portfolio risk, rather than equal dollar allocation
Explanation: B is correct. Risk parity: each asset's risk contribution is equalised. Since bonds have lower volatility than equities, bonds receive higher weights (often with leverage) so that risk contributions balance. A is market-cap weighting. C is the traditional 60/40 portfolio. D is a different weighting scheme.
Question 188
What is 'portable alpha'?
Select an option first.
Correct answer: B — A strategy that separates the alpha source (e.g., a hedge fund) from the beta exposure (e.g., using futures on an index) so the alpha can be 'ported' onto any desired market exposure
Explanation: B is correct. Portable alpha: generate alpha from any source (e.g., a market-neutral long/short fund), then add desired market exposure using derivatives (e.g., S&P 500 futures). This decouples skill from market exposure. A is indexing. C is a regression technique. D is a tax concept.
Question 189
What is a 'benchmark' in portfolio management?
Select an option first.
Correct answer: B — A reference portfolio used to evaluate a manager's performance and define the investment universe
Explanation: B is correct. A benchmark is a standard against which portfolio performance is measured — typically a market index (e.g., S&P 500, Bloomberg Aggregate Bond Index). It should reflect the manager's investable universe and style. A is the risk-free rate. C is the maximum return portfolio. D is the minimum acceptable return (used in Sortino).
Question 190
What qualities should a good benchmark possess?
Select an option first.
Correct answer: B — It should be unambiguous, investable, measurable, appropriate, reflective of current opinions, specified in advance, and owned by the manager
Explanation: B is correct. The SAMURAI criteria for good benchmarks: Specified in advance, Appropriate, Measurable, Unambiguous, Reflective of current investment opinions, Accountable, Investable. A benchmark that can't be replicated passively makes performance evaluation unfair. A makes benchmarks harder to beat. C is circular. D violates the 'specified in advance' criterion.
Question 191
What is 'attribution analysis' in portfolio management?
Select an option first.
Correct answer: B — Decomposing portfolio returns to identify the sources of active return relative to a benchmark — allocation, selection, and interaction effects
Explanation: B is correct. Return attribution (Brinson-Hood-Beebower): decomposes active return into: (1) allocation effect (over/underweighting sectors), (2) selection effect (picking better stocks within sectors), and (3) interaction effect. This shows where manager skill was applied. A is tax calculation. C and D are different performance assessment concepts.
Question 192
In the Brinson attribution model, what does the 'allocation effect' measure?
Select an option first.
Correct answer: B — The return contribution from overweighting or underweighting sectors relative to the benchmark
Explanation: B is correct. Allocation effect = (w_p − w_b) × (R_b,sector − R_b,total), where w_p = portfolio weight, w_b = benchmark weight, and R_b,sector = benchmark sector return. It measures whether the manager added value by tilting toward better-performing sectors. A is the selection effect. C is the currency attribution effect. D is a separate cost attribution.
Question 193
What does the 'selection effect' measure in Brinson attribution?
Select an option first.
Correct answer: B — The return contribution from choosing securities within sectors that outperform the sector benchmark
Explanation: B is correct. Selection effect = w_b × (R_p,sector − R_b,sector). It measures the value added by selecting stocks that outperformed the benchmark within each sector, holding sector weights equal to the benchmark. A is the allocation effect. C and D are separate attribution components.
Question 194
What is 'factor attribution' in performance analysis?
Select an option first.
Correct answer: B — Decomposing portfolio returns into contributions from systematic risk factors (e.g., market, size, value, momentum) and the residual unexplained return (alpha)
Explanation: B is correct. Factor attribution uses a multi-factor model (e.g., Fama-French) to explain how much of the portfolio's return came from market beta, size, value, and other factors, with any unexplained return classified as alpha. A is skill evaluation, not attribution. C and D are organisational or time-series comparisons.
Question 195
What is a 'style analysis' (Sharpe's returns-based style analysis)?
Select an option first.
Correct answer: B — Decomposing portfolio returns into exposures to asset class indices to infer the manager's effective investment style without examining holdings
Explanation: B is correct. Sharpe (1992) regressed a manager's returns against asset class index returns to infer effective asset allocation. The regression coefficients sum to 1 and represent style exposures (e.g., 60% large-cap value, 30% small-cap growth, 10% bonds). A is not financial analysis. C and D are different analytical techniques.
Question 196
What is 'equity long/short' as an investment strategy?
Select an option first.
Correct answer: B — Taking long positions in stocks expected to rise and short positions in stocks expected to fall, seeking to profit from both directions
Explanation: B is correct. Equity long/short: the most common hedge fund strategy. Long positions in undervalued stocks, short positions in overvalued stocks. This reduces market exposure (beta) and isolates stock selection skill. A is income investing. C is balanced investing. D is a protective put strategy.
Question 197
What is a 'market neutral' strategy?
Select an option first.
Correct answer: B — A portfolio with a net beta close to zero, eliminating most market risk, with performance depending purely on stock selection (alpha)
Explanation: B is correct. Market neutral: by balancing long and short positions to achieve near-zero beta, the strategy's profit/loss is driven entirely by the relative performance of longs vs shorts, not market direction. A is a passive buy-and-hold. C is equal weighting. D is a risk-free strategy.
Question 198
What is the 'Omega ratio'?
Select an option first.
Correct answer: B — The ratio of gains above a threshold to losses below the same threshold, providing a complete picture of the return distribution
Explanation: B is correct. Omega ratio = E[max(R−L, 0)] / E[max(L−R, 0)], where L is the threshold return. It incorporates all moments of the distribution (not just mean and variance like the Sharpe ratio), making it useful for non-normal return distributions. A is the Calmar ratio. C is the coefficient of variation. D is the win/loss ratio.
Question 199
What is 'Value at Risk' (VaR) and how is it commonly stated?
Select an option first.
Correct answer: B — The maximum loss that a portfolio will not exceed with a specified probability over a given time horizon — e.g., '1-day 99% VaR of $1 million' means there is a 1% chance of losing more than $1 million in one day
Explanation: B is correct. VaR: a statistical measure of downside risk. '5% 10-day VaR of $500,000' means there is a 5% probability that losses will exceed $500,000 over 10 days. It is widely used by banks and regulators. A is expected loss. C is the portfolio's market value. D is drawdown rate.
Question 200
What are the three main methods for calculating VaR?
Select an option first.
Correct answer: B — Historical simulation, variance-covariance (parametric), and Monte Carlo simulation
Explanation: B is correct. The three VaR methods: (1) Historical simulation: uses actual historical return data. (2) Variance-covariance (parametric): assumes normal distribution, uses mean and standard deviation. (3) Monte Carlo simulation: generates thousands of random scenarios. A includes valuation models. C and D are related techniques but not the three standard VaR methods.
Question 201
What is 'Expected Shortfall' (ES), also known as Conditional VaR (CVaR)?
Select an option first.
Correct answer: B — The expected loss given that the loss exceeds the VaR threshold — the average of the worst-case losses in the tail of the distribution
Explanation: B is correct. ES/CVaR = E[Loss | Loss > VaR]. It is the average loss in the tail beyond VaR, providing more information about tail risk. ES is now preferred by Basel III/IV over VaR because it better captures tail risk and is coherent. A is the probability level. C is the historical maximum loss. D is a measure of tail volatility.
Question 202
What is a key weakness of VaR as a risk measure?
Select an option first.
Correct answer: B — VaR is not a coherent risk measure — it is not sub-additive, meaning a portfolio's VaR can exceed the sum of its components' VaRs, underestimating diversification or correlation effects
Explanation: B is correct. VaR is not sub-additive: VaR(A+B) can be > VaR(A) + VaR(B) in some cases. This violates a key property of coherent risk measures. VaR also tells nothing about the severity of losses beyond the threshold. Expected Shortfall corrects both issues. A reverses the criticism. C is wrong. D is incorrect.
Question 203
What are the four properties of a 'coherent risk measure'?
Select an option first.
Correct answer: B — Monotonicity, sub-additivity, positive homogeneity, and translational invariance
Explanation: B is correct. A coherent risk measure (Artzner et al., 1999) satisfies: (1) Monotonicity (more risk = higher measure), (2) Sub-additivity (portfolio risk ≤ sum of parts — diversification benefit), (3) Positive homogeneity (doubling position doubles risk), (4) Translational invariance (adding a risk-free asset reduces risk proportionally). VaR fails sub-additivity. A lists statistical moments. C and D are not risk measure properties.
Question 204
What is 'stress testing' in portfolio risk management?
Select an option first.
Correct answer: B — Evaluating portfolio performance under extreme but plausible scenarios (e.g., 2008 financial crisis, sudden interest rate shock) that may fall outside normal VaR models
Explanation: B is correct. Stress testing complements VaR by examining performance under tail scenarios: market crashes, credit crises, rapid rate rises. It identifies vulnerabilities not captured by statistical VaR (which assumes conditions similar to the historical estimation period). A describes VaR. C is the opposite of stress testing. D is risk benchmarking.
Question 205
What is 'scenario analysis' in investment risk management?
Select an option first.
Correct answer: B — Evaluating portfolio performance under multiple defined hypothetical or historical scenarios to understand potential P&L outcomes under different market environments
Explanation: B is correct. Scenario analysis examines portfolio P&L under specific defined scenarios: interest rates rise 200bps, equity markets fall 30%, credit spreads widen by 100bps. Both historical (2008 crisis) and hypothetical (geopolitical shock) scenarios are used. A is a single scenario (stress test). C is simulation. D is manager comparison.
Question 206
What is 'volatility targeting' as a portfolio strategy?
Select an option first.
Correct answer: B — Dynamically adjusting position sizes to maintain a constant target level of portfolio volatility, increasing exposure when volatility falls and reducing it when volatility rises
Explanation: B is correct. Volatility targeting: when market volatility increases, the strategy reduces leverage/exposure to maintain the target volatility. When volatility falls, it increases exposure. This produces more consistent risk levels and can improve risk-adjusted returns. A is static allocation. C is a low-volatility factor strategy. D is a technical trading rule.
Question 207
What is 'tail risk hedging'?
Select an option first.
Correct answer: B — Using options (e.g., put options on equity indices) or volatility instruments to protect a portfolio against extreme left-tail events that standard hedging may not cover
Explanation: B is correct. Tail risk hedging specifically targets the extreme left tail of the return distribution — low-probability, high-severity events. Common instruments: out-of-the-money put options, VIX calls, CDS. These are expensive in normal markets but provide large payoffs during crashes. A increases tail risk. C and D are standard risk reduction, not tail-specific.
Question 208
What does 'beta hedging' involve?
Select an option first.
Correct answer: B — Taking an offsetting position (e.g., short index futures) to reduce or eliminate the portfolio's systematic market exposure (beta)
Explanation: B is correct. Beta hedging: if a portfolio has beta of 1.2, shorting index futures with a notional equal to 1.2 × portfolio value reduces portfolio beta to approximately zero. This isolates the alpha component. A is credit risk hedging. C is FX hedging. D is factor neutralisation.
Question 209
What is the Fama-French three-factor model?
Select an option first.
Correct answer: B — An extension of CAPM that adds two additional factors — small-minus-big (SMB, size premium) and high-minus-low (HML, value premium) — to better explain cross-sectional stock returns
Explanation: B is correct. Fama-French (1993): E(R) = Rf + β₁(Rm−Rf) + β₂(SMB) + β₃(HML). SMB captures the size premium (small caps outperform large caps). HML captures the value premium (high book-to-market outperforms). This explains more return variation than CAPM alone. A is just CAPM. C is a fixed income model. D is the Carhart four-factor model.
Question 210
What did Carhart add to the Fama-French three-factor model?
Select an option first.
Correct answer: B — A momentum factor (prior 12-month return minus the most recent month), creating a four-factor model
Explanation: B is correct. Carhart (1997) added a momentum factor (UMD: up-minus-down, or winners minus losers) to the three Fama-French factors. The four-factor model explains mutual fund returns better than three factors. A is the Pástor-Stambaugh liquidity factor. C is a macro factor. D is in the Fama-French five-factor model.
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