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Free Questions › FRM › Valuation and Risk Models
Free FRM Valuation and Risk Models Practice Questions & Answers
400 exam-style Valuation and Risk Models questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 271
A credit rating assigned by an external rating agency is intended to measure:
Select an option first.
Correct answer: B — The agency's forward-looking assessment of a borrower's creditworthiness and relative likelihood of meeting financial obligations.
Explanation: Credit ratings are ordinal, forward-looking, and relative opinions of creditworthiness — they rank issuers from lowest to highest credit risk. They are not precise default probability forecasts (A), not price measures (C), and not recovery estimates (D). The 'through-the-cycle' approach is a common rating philosophy.
Question 272
Investment-grade bonds are typically rated:
Select an option first.
Correct answer: B — BBB− / Baa3 and above.
Explanation: Investment grade: BBB−/Baa3 and above (S&P/Moody's scale). Below this threshold = speculative grade (high yield, junk). The BBB−/BB+ boundary is critical — crossing it triggers 'fallen angel' status, affecting bond indices, capital requirements, and investor mandates.
Question 273
A credit rating 'notch' refers to:
Select an option first.
Correct answer: B — One step in the rating scale (e.g., A+ to A, or A to A−).
Explanation: A notch is a single step in the detailed credit rating scale (e.g., S&P: AAA, AA+, AA, AA−, A+, A, A−, BBB+, BBB, BBB−...). A full letter change (A to BBB) is 3 notches. Rating actions are measured in notches for precision.
Question 274
A 'rating transition matrix' shows:
Select an option first.
Correct answer: B — The historical probabilities of a credit moving from one rating category to another (or to default) over a specified time horizon.
Explanation: Transition matrices show conditional probabilities — given a starting rating, the probability of ending in each rating category (including default) after one year. They are used for credit VaR, portfolio credit risk modelling, and pricing credit risk instruments.
Question 275
The probability of default (PD) used in credit risk models is typically expressed as:
Select an option first.
Correct answer: B — The probability that a borrower fails to make a scheduled payment within a specified time horizon (usually one year).
Explanation: PD is the probability of a credit event (default) within a given time horizon. It is distinct from LGD (recovery-related) and EAD (exposure amount). PD varies by rating: AAA may have PD < 0.01% per year; CCC may have PD > 20% per year based on historical default studies.
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Question 276
Loss Given Default (LGD) is calculated as:
Select an option first.
Correct answer: B — 1 − Recovery Rate.
Explanation: LGD = 1 − Recovery Rate. If a defaulted bond is worth 40 cents on the dollar after recovery, LGD = 60%. Expected Loss = PD × LGD × EAD. Recovery rates vary significantly by instrument seniority and jurisdiction.
Question 277
Expected Credit Loss (ECL) for a loan is calculated as:
Select an option first.
Correct answer: B — PD × LGD × EAD.
Explanation: ECL = PD × LGD × EAD. Probability of Default × Loss Given Default × Exposure at Default = the statistical average loss from credit risk. This is also the basis of IFRS 9 expected credit loss accounting. All other formulas are incorrect.
Question 278
The term 'through-the-cycle' (TTC) rating refers to:
Select an option first.
Correct answer: B — A rating approach that attempts to measure credit quality across a full economic cycle, smoothing out cyclical effects to produce stable, long-run-focused ratings.
Explanation: TTC ratings are stable — they aim to reflect long-run, fundamental creditworthiness rather than current cyclical conditions. They change less frequently than PIT (point-in-time) ratings. The distinction is critical for capital requirements: TTC ratings are used for regulatory capital (Basel), while PIT ratings are used in internal models.
Question 279
A 'point-in-time' (PIT) credit assessment differs from 'through-the-cycle' in that it:
Select an option first.
Correct answer: B — Reflects current economic conditions and the borrower's current financial position, making it more sensitive to the economic cycle.
Explanation: PIT assessments incorporate current macro and firm-specific conditions — they deteriorate in recessions and improve in booms. Banks' internal models for IFRS 9 ECL and stress testing tend to use PIT estimates. TTC ratings are deliberately more stable. A, C, D are incorrect.
Question 280
External credit ratings are assigned by agencies such as S&P, Moody's, and Fitch. A primary criticism of these agencies following the 2008 financial crisis was:
Select an option first.
Correct answer: B — Conflicts of interest (issuer-pays model) and insufficient scrutiny of structured credit products like CDOs resulted in inflated ratings that misled investors.
Explanation: The issuer-pays model creates a conflict: rating agencies are paid by the issuers whose securities they rate. For structured products (CDOs), agencies were incentivised to issue favourable ratings to win business. Many AAA-rated CDO tranches defaulted in 2008 — a massive ratings failure.
Question 281
A sovereign credit rating assesses:
Select an option first.
Correct answer: B — The government's willingness and ability to service all its debt obligations, both domestic and foreign currency.
Explanation: Sovereign ratings assess the government's ability AND willingness to repay. Foreign currency ratings may be lower than local currency ratings (a government can print local currency but not foreign currency). A is too narrow; C and D are inputs, not the rating's definition.
Question 282
Country risk encompasses which of the following components?
Select an option first.
Correct answer: B — A combination of sovereign risk, political risk, economic risk, legal/regulatory risk, and transfer risk affecting foreign investors and lenders.
Explanation: Country risk is multi-dimensional: (1) sovereign default risk, (2) political instability/expropriation, (3) economic policy risk (devaluation, capital controls), (4) legal/regulatory uncertainty, (5) transfer risk (inability to convert and repatriate profits). A single rating does not capture all dimensions.
Question 283
The 'equity risk premium' for an emerging market is typically higher than for a developed market because:
Select an option first.
Correct answer: B — Greater political risk, lower institutional quality, higher volatility, and less liquidity require investors to demand a larger premium for bearing these additional risks.
Explanation: Equity risk premia reflect compensation for all risks borne. Emerging markets carry additional political, currency, liquidity, and institutional risks not present in developed markets. Investors demand higher expected returns to compensate. A, C, D are incorrect generalisations.
Question 284
Which of the following is an input used in internal credit rating models (scorecards)?
Select an option first.
Correct answer: B — Financial ratios (leverage, coverage, profitability), qualitative factors (management quality, competitive position), and macro-economic inputs.
Explanation: Internal rating models combine: (1) quantitative financial data (financial ratios from financial statements), (2) qualitative assessments (management, industry position, governance), and (3) sometimes macro overlays. Market prices (A, D) and external ratings (C) may be inputs but are not the primary internal model drivers.
Question 285
Operational risk is defined in Basel II/III as:
Select an option first.
Correct answer: B — The risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events.
Explanation: Basel II/III definition of operational risk explicitly includes: internal process failures, human error, system failures, and external events (natural disasters, cyberattacks). It excludes strategic risk (D) and is distinct from market risk (A) and credit risk (C). This definition is used for regulatory capital calculation.
Question 286
Which of the following is an example of an operational risk event?
Select an option first.
Correct answer: B — A fraudulent wire transfer caused by an employee bypassing approval controls.
Explanation: Fraudulent wire transfer = internal fraud, a classic operational risk event. A is market risk (interest rate); C is credit risk (default); D is market/reputational risk. Basel classifies operational risk into event types: internal fraud, external fraud, EPWS, CPBP, DFF, BDSF, EDPM.
Question 287
The Basel II/III operational risk capital approaches in order of increasing sophistication are:
Select an option first.
Correct answer: B — BIA → TSA → AMA (Advanced Measurement Approach)
Explanation: Three approaches: (1) Basic Indicator Approach (BIA) — simplest, uses gross income; (2) Standardised Approach (TSA) — uses gross income per business line with different beta factors; (3) Advanced Measurement Approach (AMA) — most sophisticated, uses internal loss data, external data, scenario analysis, and business environment factors. Under Basel IV, AMA was replaced by the Standardised Approach.
Question 288
Under the Basic Indicator Approach (BIA) for operational risk capital, the capital charge is:
Select an option first.
Correct answer: B — 15% of average annual gross income over the past three years.
Explanation: BIA: Capital = α × GI, where α = 15% and GI = average annual gross income over the three most recent positive-income years. Gross income = net interest income + net non-interest income. This simplest approach does not differentiate by business line.
Question 289
Stress testing in risk management involves:
Select an option first.
Correct answer: B — Evaluating a portfolio or institution's performance under severe but plausible hypothetical or historical scenarios.
Explanation: Stress testing evaluates behaviour under extreme conditions — named scenarios (e.g., recession, rate spike, geopolitical shock) or hypothetical events. It complements VaR by capturing risks outside the VaR's confidence level and scenarios not present in historical data. A confuses stress testing with high-confidence VaR; C and D are incorrect.
Question 290
A 'scenario-based stress test' differs from a 'sensitivity analysis' in that:
Select an option first.
Correct answer: B — Scenario analysis simultaneously changes multiple risk factors according to a coherent economic narrative; sensitivity analysis changes only one factor at a time.
Explanation: Sensitivity analysis = one-factor tests (e.g., what if rates rise 100bp?). Scenario analysis = multi-factor, narratively coherent shock (e.g., '2008-style crisis: equities −40%, spreads +300bp, liquidity dries up'). Scenarios are more realistic because risk factors move together in real crises. A reverses the definition; C and D are wrong.
Question 291
The purpose of 'reverse stress testing' is:
Select an option first.
Correct answer: B — To identify what combination of events would cause the institution to breach capital thresholds or fail, working backwards from the failure condition.
Explanation: Reverse stress testing: start from failure → work backwards to identify scenarios that cause it. Unlike conventional stress testing (start with a scenario → compute impact), reverse stress testing identifies previously unconsidered vulnerabilities and 'black swan' combinations. Required by many regulators (PRA, ECB) as part of capital planning.
Question 292
Which of the following is a type of credit risk unique to derivative contracts?
Select an option first.
Correct answer: B — Pre-settlement (counterparty) credit risk — the risk that the counterparty defaults before final settlement, and the replacement cost of the contract is positive.
Explanation: Pre-settlement risk: over the life of a derivative, if the counterparty defaults when the contract has positive mark-to-market value to the holder, the holder loses that value. This differs from settlement risk (at the moment of exchange) and loan credit risk (no MTM exposure). A, C, D are related but distinct risks.
Question 293
Credit VaR is defined as:
Select an option first.
Correct answer: B — The difference between the worst-case credit loss at a given confidence level and the expected credit loss.
Explanation: Credit VaR = Unexpected Credit Loss at the specified confidence level = Worst-case loss at confidence α − Expected Loss. Expected loss is priced into margins/provisions; capital is held for unexpected loss. This is analogous to how VaR represents unexpected loss relative to the expected (mean) outcome in market risk.
Question 294
The 'loss distribution approach' (LDA) for operational risk modelling combines:
Select an option first.
Correct answer: B — A frequency distribution (how often events occur) with a severity distribution (how large each loss is) to build a total loss distribution for each risk category.
Explanation: LDA: separately model loss frequency (e.g., Poisson distribution) and loss severity (e.g., log-normal or Pareto). Combine using Monte Carlo convolution to produce the annual loss distribution for each operational risk category. The 99.9th percentile of this distribution gives the operational risk capital charge under AMA.
Question 295
What is the primary function of 'collateral' in managing counterparty credit risk?
Select an option first.
Correct answer: B — To reduce the net credit exposure — if the counterparty defaults, the collateral can be seized to offset losses.
Explanation: Collateral (margin) reduces credit exposure: if the counterparty defaults, the secured party liquidates the collateral to recover losses. Daily variation margin (in cleared/bilateral markets) keeps credit exposure close to zero by marking positions to market and calling for margin to cover losses. A, C, D are incorrect.
Question 296
A credit default swap (CDS) spread widening from 100 bps to 250 bps indicates:
Select an option first.
Correct answer: B — The market's assessment of default risk for the reference entity has increased, as the cost of credit protection has risen.
Explanation: Wider CDS spread = higher cost to buy protection = market perceives higher default risk. The CDS spread is an implied market-based credit risk metric. A reversed — improving quality narrows spreads. C is wrong (higher default risk → higher bond yield). D is wrong — wider spread benefits protection buyers, not sellers.
Question 297
Which of the following is the primary benefit of central clearing of OTC derivatives for managing counterparty credit risk?
Select an option first.
Correct answer: B — The CCP interposes between buyer and seller, applying daily margining and maintaining a default fund, dramatically reducing bilateral counterparty exposure.
Explanation: Central clearing: CCP becomes buyer to every seller and seller to every buyer. Daily variation and initial margining limits net exposure to single-day moves. Multilateral netting further reduces gross exposure. Default fund provides additional loss absorption. A, C, D are incorrect.
Question 298
Which of the following best describes 'country transfer risk'?
Select an option first.
Correct answer: B — The risk that a sovereign government imposes capital controls or currency restrictions that prevent a foreign investor or lender from repatriating earnings or receiving debt repayments.
Explanation: Transfer risk: even if a local subsidiary is profitable and solvent, government-imposed capital controls can prevent funds from being repatriated to the parent or from being used to service foreign currency obligations. This is distinct from sovereign default risk (A) and FX translation risk (C).
Question 299
Which of the following is a key characteristic of operational risk that makes it difficult to quantify?
Select an option first.
Correct answer: B — Operational risk loss distributions tend to have fat tails, sparse data (especially for severe events), and losses are not driven by tradeable market factors.
Explanation: Operational risk modelling challenges: (1) severity distribution has very fat tails (rare, catastrophic losses), (2) data is scarce — operational disasters are infrequent, (3) no market price or hedge to provide a natural risk anchor (unlike market risk), (4) loss events are heterogeneous and rarely exactly repeated. A, C, D are wrong.
Question 300
Which of the following external data sources can supplement internal operational loss data in an AMA model?
Select an option first.
Correct answer: B — Operational loss databases shared among financial institutions (e.g., ORX, GOLD).
Explanation: External operational loss databases: institutions share anonymised loss events to build a richer picture of rare, high-severity events that their own internal data may not contain. ORX (Operational Riskdata eXchange) and GOLD are examples. Without external data, operational risk capital would be understated for rare tail events.
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