You’re on a roll
Create a free account to save your FRM progress, track your accuracy by topic, and pick up right where you left off.
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 331
A country's 'default history' is incorporated into sovereign credit risk assessment through:
Select an option first.
Correct answer: B — The historical record of sovereign defaults, debt restructurings, and payment delays — persistent defaulters attract lower ratings and higher spread premiums.
Explanation: Sovereign credit history: countries that have repeatedly defaulted or restructured (e.g., Argentina, Ecuador) face 'reputation penalties' — investors demand higher spreads as compensation for perceived higher willingness-to-default risk, separate from ability-to-pay metrics. A, C, D are creditworthiness inputs but not the 'history' component specifically.
Question 332
Which of the following best describes the 'credit cycle' and its interaction with operational risk?
Select an option first.
Correct answer: B — During credit downturns, operational risk losses often increase because firms face financial stress, incentives to commit fraud rise, staff morale deteriorates, and cost-cutting reduces operational controls.
Explanation: Credit cycle and operational risk interaction: credit busts increase fraud (desperate borrowers, pressured employees), reduce IT investment (cost-cutting degrades systems), and may prompt management misconduct to conceal problems. Historical evidence (2001, 2008) shows operational losses spike during credit crises. A, C, D are wrong.
Question 333
A portfolio manager is assessing operational risk from outsourcing a key business process. The primary risk that remains with the firm after outsourcing is:
Select an option first.
Correct answer: B — Residual operational risk including: outsourcer failure, data security risk, reputational risk from the provider's conduct, and regulatory responsibility for the outsourced activity.
Explanation: Outsourcing does not transfer operational risk — it creates new risks (third-party risk). The firm remains legally and reputationally responsible for the outsourced activity in the eyes of customers and regulators. Third-party operational risk (vendor failure, data breach, service interruption) must be managed through due diligence, contracts, and monitoring.
Question 334
Country risk 'contagion' occurs when:
Select an option first.
Correct answer: A — The financial problems of one country spread to neighbouring or linked economies, even if those countries' fundamentals are sound.
Explanation: Contagion: investors facing losses in one country sell assets in similar or neighbouring countries to raise cash or reduce perceived risk, regardless of fundamentals. Examples: 1997 Asian financial crisis spreading from Thailand, 2010-2012 European sovereign debt crisis spreading from Greece. B, C, D describe different phenomena.
Question 335
Which of the following best describes 'double default' protection in credit risk management?
Select an option first.
Correct answer: A — A situation where both the primary borrower and a guarantor must default before any credit loss occurs, significantly reducing credit risk.
Explanation: Double default: if a guaranteed loan requires both the primary borrower AND the guarantor to default, the probability of loss is the joint probability PD_borrower × PD_guarantor × (1 − correlation benefit). This dramatically reduces credit risk when the two are uncorrelated. Basel IRB provides capital relief for eligible guarantees using the double default framework.
Get the full FRM question bank — free
Drop your email and we'll send you fresh FRM practice questions, fully worked solutions and exam-deadline reminders. No spam — unsubscribe in one click.
Want to save your score and take a full mock exam? Create a free account →
Question 336
Which of the following is the most accurate description of how 'stress testing' is used in operational risk management?
Select an option first.
Correct answer: B — Stress testing estimates the impact of extreme but plausible operational risk scenarios (e.g., major cyberattack, catastrophic fraud) to assess capital adequacy for tail events not captured by historical data alone.
Explanation: Operational risk stress scenarios: expert judgment defines plausible but extreme events (pandemic disrupting operations, major systems outage, catastrophic rogue trading). These scenarios are assigned frequency and severity estimates, integrated into the loss distribution to ensure adequate capital for tail events. A, C, D are incorrect.
Question 337
Default correlation in credit portfolios refers to:
Select an option first.
Correct answer: B — The tendency for defaults of different borrowers to cluster together rather than occur independently.
Explanation: Default correlation: when it is high, many borrowers default simultaneously (as in recessions), concentrating portfolio losses. When zero, defaults are independent, and diversification fully works. Default correlation is the critical parameter driving credit portfolio tail risk and is the basis of the Vasicek model underlying Basel IRB.
Question 338
Recovery rate in credit risk is:
Select an option first.
Correct answer: B — The fraction of the outstanding exposure recovered after default via bankruptcy or asset sale.
Explanation: Recovery rate = amount recovered / EAD. LGD = 1 − Recovery rate. Recovery varies by seniority: senior secured ≈ 50-70%; senior unsecured ≈ 40-50%; subordinated ≈ 10-30%; equity ≈ 0%. A is a probability statement; C is collateralisation ratio; D is credit spread.
Question 339
A credit rating 'watch' designation means:
Select an option first.
Correct answer: A — A potential rating action is anticipated within approximately 90 days.
Explanation: Credit watch (S&P) / rating review (Moody's): placed when a specific event has occurred or is likely to occur, making a rating change within ~90 days probable. Can be positive (upgrade possible) or negative (downgrade possible). Distinct from 'outlook' (6-24 month directional view). B, C, D are different events.
Question 340
A cross-default clause in a loan agreement means:
Select an option first.
Correct answer: B — Default on any other obligation triggers default on this loan — preventing selective default.
Explanation: Cross-default: if the borrower defaults on Debt A, all debt with cross-default clauses is also triggered into default. This prevents selective creditor preference and ensures equal treatment. A is a financial covenant breach; C is a joint guarantee structure; D is a credit-linked note or MAC clause feature.
Question 341
Subordination in structured finance means:
Select an option first.
Correct answer: B — Junior tranches absorb losses before senior tranches, providing credit enhancement.
Explanation: Subordination (tranching): equity tranche absorbs first losses; mezzanine next; senior only after others are exhausted. This structural protection allows senior tranches to achieve AAA ratings from pools of lower-rated loans. The thickness of subordination is the primary determinant of senior tranche credit quality.
Question 342
The investment-grade / speculative-grade boundary is at:
Select an option first.
Correct answer: C — BBB−
Explanation: BBB−/Baa3 is the lowest investment-grade rating. Below this (BB+/Ba1) is speculative grade. This boundary triggers forced selling by mandate-constrained investors (pension funds, money market funds, insurance companies) when a bond is downgraded below BBB−, creating the 'fallen angel' effect on bond prices.
Question 343
A credit analyst's primary role is:
Select an option first.
Correct answer: B — Assessing borrower creditworthiness using financial analysis and qualitative factors to assign an internal rating and recommend exposure limits.
Explanation: Credit analysts perform fundamental credit analysis: financial statements review, business model assessment, competitive positioning, management quality, cash flow projection → internal credit rating → credit approval recommendation and exposure limit setting. A is treasury/ALM; C is trading/structuring; D is risk modelling.
Question 344
Under Basel II, 'Internal Fraud' operational risk event type includes:
Select an option first.
Correct answer: B — Misappropriation of assets, securities fraud, or circumvention of regulations by insiders.
Explanation: Basel II defines 7 OR event types. Internal Fraud: intentional acts by insiders — fraudulent transactions, theft, tax evasion, bribery. Classic examples: rogue trading (Barings, SocGen), embezzlement, insider trading. B, C, D are market risk, credit risk, and liquidity risk respectively.
Question 345
The country ceiling concept in sovereign ratings means:
Select an option first.
Correct answer: B — The sovereign rating typically constrains the ratings of domestic private entities.
Explanation: Country ceiling: sub-sovereign entities (banks, corporates) rarely exceed the sovereign rating because a sovereign crisis impairs all domestic entities' ability to service foreign obligations (through capital controls, currency devaluation, legal changes). Exceptions exist for firms with dominant external revenues, assets, and offshore structures.
Question 346
Securitisation involves:
Select an option first.
Correct answer: B — Pooling assets and issuing securities backed by those cash flows, transferring credit risk to capital market investors.
Explanation: Securitisation (ABS, MBS, CDO, CLO): pools of loans are packaged, tranched, and sold as securities. The originator transfers credit risk off-balance-sheet to capital market investors. This is the originate-to-distribute model at the core of the pre-2008 structured finance ecosystem. A is a bilateral loan sale; C is margin posting; D is interest rate risk management.
Question 347
A rising loan-to-value ratio in a mortgage portfolio signals:
Select an option first.
Correct answer: B — Deteriorating credit quality — falling collateral values increase potential loss severity in default.
Explanation: Rising LTV: property prices fall → loan amount unchanged → LTV = Loan/Property rises → less collateral coverage → higher LGD in default. This is a leading credit quality indicator that bank risk managers monitor closely, particularly during property market downturns. A reverses the logic; C and D are unrelated.
Question 348
Concentration risk is best managed through:
Select an option first.
Correct answer: B — Setting single-name, sector, and geographic exposure limits to ensure adequate diversification.
Explanation: Concentration risk management: single-name limits (Basel large exposure rule: ≤25% Tier 1), sector limits, geographic limits. These prevent any one event from causing disproportionate portfolio losses. A addresses interest rate risk; C transfers but does not eliminate concentration; D is a maturity management tool.
Question 349
The Altman Z-score predicts:
Select an option first.
Correct answer: B — Corporate bankruptcy probability using financial ratios (working capital, retained earnings, EBIT, market equity, revenue — all scaled by assets or debt).
Explanation: Altman Z-score (1968) uses discriminant analysis on 5 ratios: working capital/assets (liquidity), retained earnings/assets (profitability/age), EBIT/assets (operating efficiency), market equity/total debt (leverage), revenue/assets (efficiency). Score below 1.8 signals high bankruptcy risk; above 2.99 is safe. A, C, D are other analytical objectives.
Question 350
Basel Pillar 3 requires:
Select an option first.
Correct answer: C — Public disclosure of risk profiles and capital adequacy for market discipline.
Explanation: Three pillars: Pillar 1 = minimum capital; Pillar 2 = SREP supervisory review; Pillar 3 = market discipline via mandatory public disclosure of risk exposures, capital ratios, and risk management practices. A is Pillar 1; B is Pillar 2; D is a specific liquidity metric within broader regulatory framework.
Question 351
Credit enhancement in structured finance works through:
Select an option first.
Correct answer: B — Structural features (subordination, over-collateralisation, excess spread, reserve accounts) that improve senior tranche credit quality.
Explanation: Credit enhancement: (1) subordination — junior absorbs first losses; (2) over-collateralisation — more assets than liabilities; (3) excess spread — interest income buffer; (4) reserve accounts — cash cushion. Together these allow senior tranches rated AAA even when underlying loans are speculative grade. A, C, D are either not structural or incorrect.
Question 352
Pari passu ranking in bankruptcy means:
Select an option first.
Correct answer: B — Creditors of the same class share losses pro-rata from available assets.
Explanation: Pari passu (equal standing): creditors of the same class are treated identically. If $100m is owed to 10 equal pari passu creditors and only $40m is recovered, each receives $4m (40 cents on the dollar). A describes absolute priority (senior before junior); C reverses priority; D describes full recovery which is rare.
Question 353
A material adverse change (MAC) clause allows a lender to:
Select an option first.
Correct answer: B — Accelerate repayment or cancel the facility upon significant deterioration in the borrower's financial condition.
Explanation: MAC clause: if there is a material adverse change in the borrower's financial position, business, or prospects, the lender can declare an event of default and demand early repayment. This is a protective covenant allowing exit from a deteriorating credit before formal default occurs. A is a rate reset; C is convertible debt; D is loan assignment/participation.
Question 354
A qualitative input in an internal credit scorecard is:
Select an option first.
Correct answer: C — Management quality and experience of the senior leadership team.
Explanation: Scorecards blend quantitative financial metrics (A, B, D) with qualitative assessments: management depth, corporate governance quality, competitive positioning, industry dynamics, and strategic clarity. Qualitative factors can override quantitative scores for companies undergoing leadership transitions or strategic pivots. They require analyst judgment and are less objective.
Question 355
Securitisation risk retention rules require:
Select an option first.
Correct answer: B — Originators to retain a minimum economic interest (e.g., 5%) in the credit risk of securitised assets.
Explanation: Risk retention (skin in the game): EU Securitisation Regulation and US Dodd-Frank require originators to retain ≥5% of credit risk. This aligns originator incentives with investor interests, preventing the moral hazard of originate-and-distribute. Without retention, originators have no financial stake in the quality of originated loans.
Question 356
Mark-to-market credit risk arises even without a formal default event because:
Select an option first.
Correct answer: B — Bond prices fall when spreads widen or ratings are downgraded, creating economic losses before technical default.
Explanation: MTM credit risk (migration risk): a BBB bond downgraded to BB immediately sees its spread widen and price fall — an economic loss that occurs without default. For trading books and mark-to-market portfolios, this is a real P&L loss even though the borrower continues paying. PD/LGD/EAD (A) focus on the default event specifically.
Question 357
Portfolio ECL for 100 loans each with PD=2%, LGD=45%, EAD=$1m:
Select an option first.
Correct answer: A — $900,000
Explanation: ECL = n × PD × LGD × EAD = 100 × 2% × 45% × $1m = 100 × $9,000 = $900,000. B uses LGD=22.5%; C doubles; D uses PD=0.2%. By Wald's identity, portfolio EL = n × E[single loan EL].
Question 358
Under recession stress: PD doubles (2%→4%), LGD rises 20% (40%→48%), base ECL=$100m. Stressed ECL:
Select an option first.
Correct answer: B — $240m
Explanation: Stressed ECL = Original ECL × (stressed PD/base PD) × (stressed LGD/base LGD) = $100m × (4/2) × (48/40) = $100m × 2 × 1.2 = $240m. A only doubles PD; C only applies LGD stress; D quadruples incorrectly.
Question 359
Sovereign bond from Country X yields 9% vs US Treasury 3.5%, with LGD=100%. Implied annual PD ≈:
Select an option first.
Correct answer: C — 5.5%
Explanation: Spread = 9%−3.5% = 5.5%. With LGD=100%: PD ≈ Spread/LGD = 5.5%/1.0 = 5.5%. A is the risk-free rate; B is the total yield; D adds the rates. This is the simplified bond spread-PD relationship: Spread ≈ PD × LGD.
Question 360
Operational risk LDA uses Poisson frequency (mean=3/year) and lognormal severity (mean=$200k). Expected annual loss:
Select an option first.
Correct answer: B — $600,000
Explanation: E[Annual Loss] = E[Frequency] × E[Severity] = 3 × $200,000 = $600,000. This is Wald's identity for compound distributions. The lognormal σ affects tail shape but not the expected value calculation. A is just severity mean; C halves; D multiplies by 10.
More free FRM topics
Ten questions in
- The ones you miss are saved as a drill you can repeat
- Your place is kept, on this device and any other
- A streak, if that is the thing that gets you back tomorrow
Every question on this page stays free and open either way.