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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 391
Wrong-way risk increases derivative credit exposure capital because:
Select an option first.
Correct answer: B — When counterparty credit quality deteriorates as derivative MTM rises, high exposure and high default probability coincide — amplifying expected and unexpected losses beyond average estimates.
Explanation: Wrong-way risk amplification: EL = E[PD × Exposure] ≥ E[PD] × E[Exposure] when PD and Exposure are positively correlated. The covariance term between PD and exposure adds to expected loss. Basel and ISDA require specific wrong-way risk treatment in derivative capital calculations — exposure profiles must be stressed to reflect the correlation.
Question 392
Monte Carlo credit simulation draws a systematic factor Z to:
Select an option first.
Correct answer: B — Model the state of the economy — conditional on Z, individual defaults are independent; distribution of Z determines simultaneous default clustering.
Explanation: Vasicek-based MC: (1) draw Z (systematic factor — economy state) from standard normal; (2) conditional on Z, compute conditional PD for each borrower; (3) draw uniform(0,1) for each borrower and compare to conditional PD to determine default. Z drives the co-movement of defaults — extreme negative Z → many simultaneous defaults → heavy loss tail. Thousands of Z draws build the portfolio loss distribution.
Question 393
Mortgage 'seasoning' means:
Select an option first.
Correct answer: B — Default rates follow a hump shape — low initially, peaking around years 3-5, then declining as stressed borrowers have defaulted and survivors demonstrate repayment capacity.
Explanation: Seasoning curve: initial borrowers are screened and making payments (low default rate); over time, financially vulnerable borrowers default (peak rate around year 3-5); survivors have proven creditworthiness and face lower default rates thereafter. Seasoned pools (5+ years old) typically have better credit performance than freshly originated pools at the same LTV.
Question 394
Portfolio homogeneity across banks (same sector concentrations, same risk models) creates macroprudential concern because:
Select an option first.
Correct answer: B — Homogeneity creates herding risk — all banks deleverage the same assets simultaneously during stress, amplifying fire sale dynamics and credit crunches.
Explanation: Portfolio herding: when many banks hold similar assets (e.g., all heavily in residential mortgages pre-2008), an adverse shock hits all simultaneously. All banks deleverage together → fire sale → price collapse → more losses → more deleveraging. Macroprudential tools (CCyB, sectoral capital buffers, large exposure limits) try to address this by building buffers during periods of excessive sector growth.
Question 395
IAS 39 incurred loss provisioning contributed to 2008 crisis pro-cyclicality because:
Select an option first.
Correct answer: B — Provisions only when losses were incurred — massive provisions recognised all at once during the downturn, amplifying capital erosion at the worst time.
Explanation: Incurred loss cliff-effect: banks reported low provisions through 2007 (no evidence of impairment yet) then suddenly recognised massive losses in 2008 when defaults materialised. This simultaneous provision recognition eroded capital, restricted lending, and amplified the credit crunch. IFRS 9's expected loss model requires earlier, more gradual provisioning.
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Question 396
Primary residual risk after CDS hedging of a bond portfolio is:
Select an option first.
Correct answer: B — Basis risk — CDS spread may not move exactly with the bond's physical spread, leaving imperfect hedge P&L.
Explanation: Bond-CDS basis risk: physical bond spreads and CDS spreads for the same reference entity can diverge due to: (1) bond-specific factors (coupon, maturity, callability), (2) repo market dynamics (CTD for CDS delivery), (3) supply/demand imbalances in each market, (4) different legal definitions of credit events. The basis can be positive or negative and can widen significantly in stress.
Question 397
Basel III leverage ratio requires:
Select an option first.
Correct answer: B — Tier 1 capital ≥ 3% of total exposure (on- and off-balance-sheet).
Explanation: Leverage ratio: Tier 1 / Total exposure ≥ 3%. Total exposure = on-balance-sheet assets + derivatives + SFTs + off-balance-sheet. Non-risk-sensitive: treats all assets equally regardless of risk weight. Acts as a backstop preventing banks from gaming risk weights to achieve extremely low RWA while carrying high actual leverage. A, C, D describe risk-weighted capital requirements.
Question 398
Downturn LGD differs from long-run average LGD because:
Select an option first.
Correct answer: B — Downturn LGD reflects severe economic conditions where collateral falls and recovery is harder — typically higher than long-run average LGD, and used for regulatory capital calculation.
Explanation: Basel A-IRB requires: (1) long-run average LGD — used for expected loss calculation and pricing; (2) downturn LGD — calibrated to recession conditions, used for capital calculation. Downturn LGD > long-run LGD because: (a) collateral values fall in recessions, (b) insolvency procedures take longer when courts are overwhelmed, (c) distressed sales yield lower prices. A, C, D are wrong.
Question 399
A systemic stress test differs from a firm-specific stress test in that:
Select an option first.
Correct answer: B — Systemic tests assess financial system resilience including second-round effects, fire sale dynamics, and interbank contagion — not just individual firm impact.
Explanation: Systemic stress testing (e.g., FSB resilience assessments): models how stress at one or more institutions spreads through the financial system via direct bilateral exposures, asset price fire sales, and market confidence effects. Individual firm stress tests miss these network amplification channels. A, C, D are all incorrect.
Question 400
Credit cycle peak loan origination leads to higher losses later because:
Select an option first.
Correct answer: B — Lax underwriting standards, inflated collateral values, and optimistic PD estimates at cycle peaks mean these loans perform poorly when the cycle turns.
Explanation: Peak origination vintage risk: (1) competition drives down standards — covenant-lite, high LTV; (2) collateral values are inflated (property at peak); (3) PD estimates calibrated to benign conditions. When the cycle turns, these vintages experience elevated defaults (PD higher than estimated) and high LGDs (collateral falls). The 2006-07 US and European mortgage vintages exemplified all three factors.
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