01.

FRM1 –Risk Management -Golden Future 2018

QUESTIONS ANSWER
Unexpected volatility in an asset is called: D
Risk is described as unexpected volatility in asset prices or
A earnings.

Sud

Biased expectations

Asset price instability

Risk

1
In a case, a model operator input the wrong price for a security B

into an algorithm used for trading, which then caused the

algorithm to buy instead Of sell the security. This situation
2 would be an example of:

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 A

Market risk.

Operational risk.

Strategic risk.

Liquidity risk.

Which of the following is(are) unexpected loss? A

In the mean, the lending losses are covered with a spread, if
I.Loan defaults are increasing simultaneous while recovery
lending losses are covered with a spread, if that there is sufficient
rates are decreasing.
information to compare such a spread, then the losses would
II.Lending losses are covered by charging a spread between
likely be considered expected losses.
the cost of funds and the lending rate.

A
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 I only

II only

Both

Neither

04. Multiple choice collection have been favorites tag has been B
marked correction If the reward is high, the risk is high too.

Generally speaking, if the reward is high, the risk:

Is low.

Is high.
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 C

Constant.

Cannot be determined.

You are having lunch with a client who suddenly asks you, "I D
Risk is the variability (aka, volatility) of adverse outcomes (aka,
noticed that you studied risk. To me, risk is when bad stuff can
losses) that are unexpected. The general form of the statement is:
happen. Can you tell me, what is your definition of risk?" As far
risk is the variability of unexpected, adverse outcomes; this
as the financial risk Manager (FRM) is concerned--at least
incorporates non-financial risks (the client asked for a definition of
among the following potential responses to your client's
"risk" not "financial risk"). The equivalent form that is specific to
question--which of the following definitions of risk is best?
financial risk is: financial risk is the volatility (or variability) of
A unexpected losses.

Risk is the source or cause of a financial loss or cost

Risk is a condition that increases the probability of a

loss
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 C

Risk is the size of a loss or cost: if a cost is greater, then

its risk is greater

Risk is the variability of adverse outcomes that are

unexpected

Which of the following statements regarding risk and risk A

Risk management is more concerned with the variability of losses,
management is correct?
especially ones that could rise to unexpectedly high levels or ones
A that suddenly occur that were not anticipated (unexpected losses).

Risk management is more concerned with unexpected

losses versus expected losses.

There is a relationship between the amount of risk

taken and the size of the potential loss.

C
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 The final step of the risk management process relates
developing a risk mitigation strategy.

If executed properly, the risk management process may

allow for risk elimination within an economy.

Financial risk management: B

Financial risk management is the process of detecting, assessing,
A and managing financial risks.

Seeks to eliminate all financial risks.

Is the process of detecting, assessing, and managing

financial risks.

Only focuses on managing market-related financial

risks.
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 D

Is the process of reacting to financial losses in order to

minimize losses.

Volatility of total returns is most accurately described as: B

Absolute risk is the volatility of total returns
A

Relative risk

Absolute risk

Directional risk

Non-directional risk

8
Which of the following statements related to counterparty C
Having a clearinghouse can only reduce network risk, network risk
9 credit risk is most accurate?

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 can not be eliminated. CDOs, interest rate swaps are traded in the
A
over-the-counter market, they are not standardized products. As
evidenced in the recent global financial crisis, an increase in The
Having a clearinghouse can eliminate network risk.
counterparty risk can produce systemic effects.

Financial products, such as CDOs, interest rate swaps,

are standardized exchange-traded products.

Financial systems are a network of obligations

distributed in numerous places.

Even in the absence of a clearinghouse, because the

financial network is so big, it can absorb the
counterparty risk itself.

03. Multiple choice collection have been favorites tag has been A
marked correction The risk is that the liquidation value of the collateral is insufficient

Local Bank, Inc. (LBI) has loaned funds to a private to recover the full loss on default. The fact that the loan is secured
by land and the building is now worth less than the value of the
manufacturing company, named We Make It All (Make It). The
10 collateral is the collateral provided by the defaulting counterparty.

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 current balance of the loan is $1 million and it is secured by a The financial loss and the cash flow difficulties suggest that there
piece of land and the corresponding building owned In is increased default risk for LBI as well. Downgrade risk does not
Make,.,,,,,,,,, Appraised at only $800,000. Based only on the apply here because Make It's loan is not publicly traded and is
information provided, which of the following risks face by LBI unlikely to be rated by a recognized rating agency.Settlement risk

have increased? does not apply here either because there is no exchange of cash
flows at the end of the transaction that would be required to incur
A such risk. In this case, the loan is settled when Make It fully repays
the principal balance owed.
Bankruptcy risk and default risk

Bankruptcy risk and settlement risk

Default risk and downgrade risk

Default risk, downgrade risk, and settlement risk

There are both absolute risk (measured without reference to a B

Market risk is the risk of losses from movements in market prices.
benchmark) and relative risk (measured against a benchmark)
Absolute risk measures these changes in terms of the volatility of
measures of market risk. Which of the following is an absolute
11 total returns. Tracking error is a relative measure of market risk

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 measure of market risk? defined as the deviation from a benchmark index. Correlation
refers to a benchmark Deviation from the benchmark index is a
A
consideration in measuring relative risk.

Tracking error

Volatility of total returns

Correlation with a benchmark portfolio

Deviations from a benchmark index

John is asked to evaluate the existing risk management system D

Insufficient training lead to misuse of order management system
of a bank. She is asked to match the following events to the
is an example in operational risk. An option writer not honoring
corresponding type of risk.
the obligation in a contract is a credit risk event. When a contract
Event:
is originated in multiple Jurisdicts leading to problems with
2.Credit
enforceability, there is legal risk.
spreads widen following recent bankruptcies.
12 3.Option writer does not have the resources required to honor

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 a contract.
4.Credit swaps with counterparty cannot be netted because
they originated in multiple Jurisdictions.

1: legal risk, 2: credit risk, 3: operational risk, 4: credit

risk

1: operational risk, 2: credit risk, 3: operational risk, 4:

legal risk

1: operational risk, 2: market risk, 3: operational risk, 4:

legal risk

1: operational risk, 2: market risk, 3: credit risk, 4: legal

risk

Match the following events to the corresponding risk type. C

13 "A rogue trader within an institution" is an example of operational

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 1. A rogue trader within an institution. risk. "Stock XYZ decreases in price due to a market crisis" is an
2. Stock XYZ decreases in price due to a market crisis. example of equity price risk. "Using a put option to hedge an
3. Using a put option to hedge an equity exposure. equity exposure" is an example of basis risk. "Counterparty sues
4. Counterparty sues bank to avoid meeting its obligations. bank to avoid meeting its obligations" is an example of legal risk.

1: legal risk; 2: credit risk; 3: strategic risk; 4: credit risk.

1: business risk; 2: market risk; 3: market risk; 4:

settlement risk.

1: operational risk; 2: equity price risk; 3: basis risk; 4:

legal risk.

1: reputation risk; 2: basis risk; 3: credit risk; 4: legal risk.

Funding liquidity risk referring to the risk: C

Funding liquidity risk refers to the risk that an institution will not
14 be able to: raise cash necessary to make debt payments; fulfill

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 cash, margin, and collateral requirements of counterparties; meet
A
capital withdrawals resulting in a loss.

That a counterparty to a financial transaction will

default.

That the government will decide to terminate a

government-funded program.

That an institution will not be able to raise cash

necessary to make debt payments.

Result from a large position size in an asset relative to

the asset's typical trading lot size.

The risk that a counterparty will fail to deliver its obligation is: C
Settlement risk is the risk that a counterparty will fail to deliver its
A obligation.
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 People risk

Market risk

Settlement risk

Model risk

Mark is estimating the existing risk management system of a B

I is market risk, II is liquidity risk.
company and identified the following two risks.
I.Credit spreads widen following recent bankruptcies
II.The bid-ask spread of an asset suddenly widens
Which one can be classified as liquidity risk?

I only
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 B

II only

I and II

Neither

Regarding the following statements, which one is correct? A

People risk relates to the risk associated with fraud perpetrated by
A internal employees and/or external individuals. It does not relate
to incompetence and lack of suitable training. Non-directional
Options are examples of financial instruments with non- risks have non-linear exposures to changes in economic or
directional risks. financial variables which are clearly The case with options. Asset-
liquidity risk (not funding liquidity risk) results from a large
B position size forcing transactions to influence the price of
securities.
Between two counterparties, default risk is always
higher than settlement risk.
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 C

Funding liquidity risk results from a large position size

forcing transactions to influence the price of securities.

People risk incorporates the risk associated with

incompetence and lack of suitable training of internal
employees and/or external individuals.

John Diamond is evaluating the existing risk management D

I is a model failure and II is an internal operational failure. These
system of Rome Asset Management and identifying the
are types of operational risks.
following two risks.
Ⅰ . Rome Asset Management's derivative Consistently
undervalues Call Options Pricing Model.
II .Swaps with counterparties exceed counterparty credit limit.
These two risks are most likely to be classified as:

Market risk

B
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 Credit risk

Liquidity risk

Operational risk

The risk that a country will not repay its debt is: C
Sovereign risk is country specific risk relating to a country's
A actions; therefore, the risk that a country will not repay its debt is
a sovereign risk.
Transfer risk

Repayment risk

Sovereign
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 D

Market risk

There are many reasons why risk management increases D

The first three are examples of where risk management can
shareholder wealth. Which of the following risk management
increase firm value. The last one is invalid because eliminate
policies is least likely to increase shareholder wealth?
projects with high volatility may eliminate projects with extremely
high payoffs.
A

Hedging strategies to lower the probability of financial

distress and bankruptcy.

Risk management policies designed to reduce the

probability of debt overhang.

Well-designed compensation structure for managers

that sets incentives for managers to take appropriate
risks.
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 D

Risk management policies to eliminate projects with

high volatility.

Melody Li is a junior risk analyst who has recently prepared a B

The complexity of derivatives pricing means the pricing may not
report on the advantages and disadvantages of hedging risk
always be as accurate as possible so it will not always reflect all of
exposures. An excerpt from her report contains four
the relevant risk factors. As a result, in practice, hedging with
statements. Which of Li’s statements is correct?
derivatives may not be a zero-sum game of transferring risk
between periods or between participants. Choice A is not correct
A
because hedging involves the use of financial derivatives and
insuring involves the use of insurance policies; an insurance policy
Purchasing an insurance policy is an example of
is not considered a financial instrument in the same sense as a
hedging.
derivatives instrument. Choice C is not correct because the
existence of significant costs of financial distress and bankruptcy
B
is contrary to the assumption of perfect capital markets. Choice D
is not correct because hedging with derivatives will require
In practice, hedging with derivatives is not likely to be a
disclosure, including some operational information that the firm
zero-sum game.
may otherwise prefer to keep private.

21 The existence of significant costs of financial distress

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 and bankruptcy is considered within the assumption of
perfect capital markets.

Hedging with derivatives is advantageous in the sense

that there is often the ability to avoid numerous
disclosure requirements compared with other financial
instruments.

Which of the following statements regarding the D

While it is accurate that the CRO is responsible for top-level risk
responsibilities of the chief risk officer (CRO) is least accurate?
management, he is also responsible for the analytical or systems
capabilities for risk management.
A

The CRO should provide the vision for the

organization’s risk management.

The CRO may have a solid line reporting to the CEO or a

dotted line reporting to the CEO and the board.

C
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 In addition to providing overall leadership for risk, the
CRO should communicate the organization’s risk
profile to stakeholders.

Although the CRO is responsible for top-level risk

management, he is not responsible for the analytical or
systems capabilities for risk management.

A growing regional bank has added a risk committee to its D

A risk appetite statement states a broad level of risk across the
board. One of the first recommendations of the risk committee
organization the firm is willing to accept in order to pursue value
is that the bank should develop a risk appetite statement.
creation. The statement is typically broadly articulated and can be
What best represents a primary function of a risk appetite
communicated across the organization, and helps to allocate
statement?
resources to specific objectives at the firm.

To quantify the level of variability for each risk metric

that a firm is willing to accept.

23 To state specific new business opportunities that a firm

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 is willing to pursue.

To assign risk management responsibilities to specific

internal staff members.

To state a broad level of acceptable risk to guide the

allocation of the firm’s resources.

Which of the following statements regarding corporate risk B

The Board of Directors is ultimately responsible for risk oversight.
governance is correct?
Effective risk governance simply requires clear accountability,
authority, and methods of communication; it is not necessary to
A
have multiple levels. The point of risk governance is to consider
the methods in which risk-taking is permitted, optimized, and
Management of the organization is ultimately
monitored; it is not necessarily to minimize the amount of risk
responsible for risk oversight.
taken. The real point of risk governance is to increase the value of
the organization from the perspective of the shareholders and/or
B
stakeholders.

A risk committee is useful for enforcing the firm’s risk

governance principles.
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 C

Effective risk governance requires multiple levels of

accountability and authority.

The point of risk governance is to minimize the amount

of risk taken by the organization.

Which of the following statements regarding risk appetite and A

Risk appetite directly impacts the allocation of resources. Risk
risk tolerance is correct?
tolerance is a measure of an organization's willingness to take risk.
I.Risk appetite directly impacts the allocation of resources.

II.Risk tolerance is a measure of an organization's ability to

take risk.

I only

B
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 II only

Both I and II

Neither I nor II

According to the IFC, Risk Treatment is the third step in a risk B

management process. In this Risk Treatment step, “All risks

that are identified, estimated, and evaluated are subject to a
risk treatment decision. There are four potential outcomes of
the decision: 1. Risk Avoidance; 2. Risk Transfer; 3. Risk
Reduction; and 4. Risk Retention.” Each of the following
summarizes the essence of the outcome (strategy) except
which does not?

Risk Avoidance includes risks that cannot be hedged.

Because all retained risks should be hedge-able, risks
which cannot be hedged should be avoided.
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 B

Risk Transfer includes risks passed along to a third-

party typically via capital structure, insurance policy of
financial derivatives.

Risk Reduction can be pursued via portfolio

diversification.

Risk Retention includes risks both expressly retained

due to strategy and inadvertent due to neglect or
ignorance; retained risks must be monitored.

The involvement of the board of directors is important within A

Risk appetite may be conveyed in a qualitative and/or quantitative
the context of a firm’s decision to hedge specific risk factors.
manner, therefore, qualitative alone may be acceptable.
Which of the following statements regarding the setting of risk
appetite is correct?
I.Risk appetite may be conveyed strictly in a qualitative
manner.
27 II.Debtholders and shareholders are both likely to desire

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 minimizing the firm’s risk appetite.

I only.

II only.

Both I and II.

Neither I nor II.

Which of the following statements regarding the role of the B

The audit committee consists primarily of non-management
firm’s audit committee is most accurate?
members but there may be some management members. (e.g.,
chief financial officer).
A

The audit committee is meant to work dependently with

management.
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 B

The audit committee may consist of some members of

the management team.

The audit committee is only responsible for the

accuracy of the financial statements.

At least one member of the audit committee must

possess sufficient financial knowledge.

Which of the following tasks regarding risk appetite would be B

Developing the organization's risk appetite statement is the
reasonably performed by an organization's Board of Directors?
responsibility of management. It is the Board's role to review and
I.Develop the organization's risk appetite statement. provide appropriate feedback on management's work with regard
to the risk appetite statement. Determining if the risk appetite
II.Determine if the risk appetite may cause risks in other areas
may cause risks in other areas of the organization is consistent
of the organization. with the Board's oversight role.

A
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 I only

II only

Both I and II

Neither I nor II

The board of directors of a growing insurance company has B

Implementation of ERM requires integration. Establishing a
recommended the firm establish an enterprise risk
centralized risk management unit, infusion of a wholistic risk
management (ERM) framework. Which of the following
management approach into business processes and applying
represents a key benefit for the firm that it will likely attain
coordinated risk transfer strategies bring increased efficiency and
after establishing an ERM framework?
better performance in various bank practices including risk
reporting.
A

Increasing the organization's risk appetite and its

expected return on new projects
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 B

Improving the firm’s risk reporting practices

Allowing the board of directors to validate risk models

to ensure their accuracy

Increasing the expected correlation between risk factors

where there is exposure across the enterprise

Which of the following is a component of an ERM program? D

There are seven components of an ERM program: 1) Corporate
I Corporate governance governance; 2) line management; 3) portfolio management; 4) risk
II line management transfer; 5) risk analytics; 6) data and technology resources, and 7)
III portfolio management stakeholder management.
IV risk transfer

I and II
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 B

I, II and III

II and III

I, II, III and IV

A board of directors is evaluating the implementation of a new D

An effective ERM program should be integrated at several levels,
ERM program at an asset management company. Which
across the company as a whole and integrated with the
statement below is consistent across the various current
operational side of the company.
definitions of an ERM program and most appropriate to be
included in the company's ERM definition and goals?

The ERM program should reduce costs by transferring

or insuring most of the company's major risk exposures.

B
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 The major goal of the new ERM program should be to
reduce earnings volatility.

The ERM program should be managed separately from

the operational side of the company.

The ERM program should provide an integrated

strategy to manage risk across the company as a whole.

What’s the basis of enterprise risk management (ERM)? D

The basis of enterprise risk management (ERM) is that risks are
managed within each risk unit but centralized at the senior
A
management level. The traditional approach to risk management
was the silo approach, under which each firm unit was responsible
Risks should be managed and centralized within each
for managing its own risks, setting its own policies and standards,
risk unit.
without coordination between the risk units. ERM is a superior
approach because management benefits from an integrated
B
approach to handling all risks (for example, management can see
risks within the firm that cancel out and, therefore, do not need to
It is necessary to appoint a chief risk officer to oversee
be separately hedged). It is common, but not necessary, to
most risks.
33 appoint a chief risk officer to oversee all risks under ERM.

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 C

The silo approach to risk management is the optimal

risk management strategy.

Risks are managed within each risk unit but centralized

at the senior management level.

Which of the following statements most accurately describe A

ERM takes an integrated, big-picture approach to the risk
enterprise risk management (ERM)? ERM:
management process, which is a departure from separately
managing individual risks within an organization. Decisions are
A
made on an overall basis and therefore, it positively impacts
decision-making throughout the organization. ERM is defined as
decisions are made on an overall basis.
the discipline by which an organization in any industry assesses,
controls, exploits, finances, and monitors risks from all sources for
B
the purpose of increasing the organization’s short- and long-
term value to its stakeholders.
takes an integrated approach to the total return
process.

C
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 separately manages individual risks within an
organization.

monitors risks from all sources for the purpose of

increasing the organization’s long-term value.

General points to consider for ERM implementation include all A

General points to consider for ERM implementation include:
of the following except:
appointing an appropriate ERM leader; integrating ERM into an
organization’s culture; researching and gathering all potential
A
risks in the organization; quantifying operational and strategic
risks; determining interrelationships between various risks;
developing ERM immediately.
incomplete risk transfer options; ongoing monitoring of ERM; and
developing ERM gradually.
B

quantifying operational and strategic risks.

determining interrelationships between various risks.

D
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 integrating ERM into an organization’s culture.

Krista Skujins, FRM, is the CFO of a manufacturing firm. She is D

Diversification is a risk reduction technique.
currently in the process of diversifying the firm’s investment
portfolio by varying the correlations and asset classes among
securities. Diversification is best characterized as which of the
following risk treatments?

Risk avoidance

Risk transfer

Risk retention

Risk reduction

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 The Association of Insurance and Risk Managers’ (AIRMIC) C
Identification of Risk Management and Enterprise Objectives →
process of risk management requires an analysis carried out in
Risk Assessment → Risk Treatment → Risk Monitoring.
four stages: 1) Identification of Risk Objectives; 2) ________; 3)
Risk Treatment; 4) Risk Monitoring. Which of the following is
the second stage?

Risk Appetite

Risk Mapping

Risk Assessment

Risk Definition

37
Which of the following statements is most accurate regarding D
Risk transfer is one of seven components of a strong ERM
the implementation of enterprise risk management (ERM)?
38 framework. Derivatives , insurance, and hybrid products can be

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 ERM: incorporated into the risk transfer process to reduce risk. ERM is a
centralized and integrated approach to managing risk that is more

A effective in managing a company's overall risk compared co the

traditional silo approach of managing risks within each business

requires business units within an organization to unit. It should be used to manage risks within a firms risk appetite.

measure risks
independently.

relies on unique qualitative methodologies to manage

risks facing each
business unit.

is an integrated process designed to manage risks

outside of a firms risk appetite.

can use derivatives and insurance products to transfer

risks to third parties.

39 Which of the following statements regarding the D

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 responsibilities of the chief risk officer (CRO) is least accurate? While it is accurate that the CRO is responsible for top-level risk
management, he is also responsible for the analytical or systems

A capabilities for risk management.

The CRO should provide the vision for the

organization’s risk management.

The CRO may have a solid line reporting to the CEO or a

dotted line reporting to the CEO and the board.

In addition to providing overall leadership for risk, the

CRO should communicate the organization’s risk
profile to stakeholders.

Although the CRO is responsible for top-level risk

management, he is not responsible for the analytical or
systems capabilities for risk management.

40 Jimmy is a member of the senior management team at a bank A

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and is assisting with the development of a risk appetite In terms of communicating the RAF with the bank’s employees,
framework (RAF). With regard to the RAF, which of the additional information on the firm’s risk capacity versus current
following recommendations would Jimmy most likely take? amount of risk undertaken should be provided to assist
employees with understanding the RAF.
Ⅰ.In communicating the RAF to the bank’s employees,
information on the bank’s risk capacity versus current An effective RAF must go beyond the mere setting of risk limits.
amount of risk undertaken should be provided. The best practice would be to educate the employees who must
comply with those limits. Those employees should understand the
Ⅱ.An effective RAF should focus primarily on setting
background and reasons for the limits together with their impact
appropriate risk limits within the bank and its respective
on the firm’s revenue/profits, client service, and total risk.
business units.

I only

II only

Both I and II

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 Neither I nor II

Bob, a bank supervisor, has requested as part of a bank C

There are several benefits that accrue to banks that have effective
examination, that ABC bank, improve its aggregation and
risk data aggregation and reporting systems in place. These
reporting of risk data. ABC has experienced significant losses
benefits include an increased ability to anticipate problems. Also,
resulting from multiple causes, ranging from poor lending
in times of severe financial stress, effective risk data aggregation
decisions to bad decisions regarding the use of derivatives. The
enhanced a bank’s ability to identify alternative routes to restore
bank is now undercapitalized because of losses. Bob refers
financial health. Regulatory authorities should have access to
ABC’s risk managers to the Basel Committee’s
aggregated risk data to resolve issues related to bank health and
recommendations for effective risk data aggregation. He
viability. This aids regulators in resolving problems in the event of
informs risk committee members and senior management that
financial stress. By strengthening a bank’s risk function, the bank
one of the potential direct benefits of effective risk data
is better able to make strategic decisions, increase efficiency,
aggregation, particularly in light of ABC’s current troubles, is: reduce the probability of loss and ultimately increase profitability.
In this case, the bank appears to be in financial stress, so the most
A relevant benefit is improved resolvability.

increased bank efficiency.

more effective IT architecture.

C
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 improved resolvability of bank problems.

a clear definition of the bank’s risk appetite.

Which of the following is not a reason that Senior B

It is important for the board and senior management to have
management and the board of directors should receive
accurate and timely risk reports to oversee the bank’s risk-taking
accurate and timely aggregated risk data reports?
activities. The bank’s risk tolerance/appetite is monitored by the
board. The board and senior managers should be prepared to
A
make decisions in times of financial stress and crisis. The board
does not provide reports to regulators. Information requests from
Senior management and board members use risk
supervisors would be made at the bank level, not the board level.
reports to make decisions regarding bank risks.

Bank supervisors request risk reports from board

members, who should be prepared to provide this
information during bank examinations.

42 Senior management and board members should react

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 in times of financial stress and/or crisis and need
reliable risk reports to make good decisions.

The board should ensure that the bank is operating

within its risk tolerance/appetite and should therefore
make sure that it receives relevant risk information.

Assume the expected return on stocks is 18% (represented by A

Since the return to W is the nearest to Z (stocks), it is logical to
Z in the figure), and the expected return on bonds is 8%
assume that point W represents an allocation of 90% stocks and
(represented by point Y on the graph). The graph shows the
10% bonds. The return for W is lower than Z, but it also represents
portfolio possibilities curve for stocks and bonds. The point on
a reduction in Risk.
the graph that most likely represents a 90% allocation in stocks
and a 10% allocation in bonds is portfolio:
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A

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 Y

Given a set of risky assets, a Markowitz efficient frontier: D

The Markowitz efficient frontier is the set of possible portfolios
that provide the highest return for each level of risk, or the lowest
A
risk for each level of return. To generate an efficient frontier we
need to know the expected returns and standard deviations for
can be calculated from the assets’ expected returns
each asset, as well as the returns correlations for each pair of
and the correlations of returns for each pair of assets.
assets.

includes all portfolios that reduce the risk level

compared to holding a single asset.

cannot be generated unless one of the assets has a beta

of zero.

D
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 consists of the portfolios that provide the lowest risk for
every level of expected return.

Assume the following information for stocks A and B. A

*Standard deviation of returns on Stock A = 40%

*Standard deviation of returns on Stock B = 50%

*Expected return on Stock A = 18%

*Expected return on Stock B = 23%

*Correlation between returns of Stock A and Stock B = 0.10

The expected return and standard deviation of an equally

weighted portfolio of stocks A and B are closest to:

Expected return (%)：20.5 Standard deviation

(%)：33.54

45 Expected return (%)：20.5 Standard deviation

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 (%)：11.22

Expected return (%)：33.5 Standard deviation

(%)：11.22

Expected return (%)：33.5 Standard deviation

(%)：33.54

An investment manager is looking at ten possible stocks to C

The most efficient portfolio will be the one that lies on the
include in a client’s portfolio. In order to achieve the
efficient frontier. It will offer the highest expected return at a
maximum efficiency of the portfolio, the manager must:
given level of risk compared to all other possible portfolios.

include all ten stocks in the portfolio in equal amounts.

include only the stocks that have the lowest volatility at

a given expected rate of return.
46

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 C

find the combination of stocks that produces a portfolio

with the maximum expected rate of return at a given
level of risk.

exclude any of the stocks that are negatively correlated

with each other.

On a graph of risk, measured by standard deviation, and B

The efficient set is the set of portfolios that dominate all other
expected return, the efficient frontier represents:
portfolios as to risk and return. That is, they have highest
expected return at each level of risk.
A

all portfolios plotted in the northeast quadrant that

maximize return.

the set of portfolios that dominate all others as to risk

and return.
47

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 C

all portfolios plotted to the left of the graph that

maximize either risk or return.

the group of portfolios that have extreme values and

therefore are “efficient” in their allocation.

There are two assets X and Y, which line is not likely the
efficient frontier for X and Y?

A
48

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 B

Which one of the following portfolios does not lie on the B

Portfolio B has a lower expected return than Portfolio C with a
efficient frontier?
higher standard deviation.

A
49

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 B

Which of the following inputs is least likely required for the C

The level of risk aversion in the market is not a required input. The
Markowitz efficient frontier?
model requires that investors know the expected return and
variance of each security as well as the covariance between all
A
securities.

The expected return of all securities.

The covariation between all securities.

C
50

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 The level of risk aversion in the market.

The variance of all securities.

Assume the expected return on stocks is 18% (represented by C

The efficient frontier consists of portfolios that have the maximum
Z in the figure), and the expected return on bonds is 8%
expected return for any given level of risk (standard deviation or
(represented by point Y on the graph). The efficient frontier
variance). The efficient frontier starts at the global minimum-
consists of the portfolios between and including:
variance portfolio and continues above it. Any portfolio below the
efficient frontier is dominated by a portfolio on the efficient
frontier. This is because efficient portfolios have higher expected
51 returns for the same level of risk.

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A

X and W

Y and Z

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 C

X and Z

Y and X

Which of the following portfolios falls below the Markowitz B

Portfolio B is inefficient (falls below the efficient frontier) because
efficient frontier?
for the same risk level (8.7%), you could have portfolio C with a
higher expected return (15.1% versus 14.2%).

Portfolio A

Portfolio B
52

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 C

Portfolio C

Portfolio D

A risk manager is analyzing the characteristics of a portfolio B

The correlation of -1 makes it possible to create a portfolio that
created by combining two stocks with standard deviations of
has a standard deviation of returns of 0%.
returns of 14% and 19%, and a correlation coefficient of -1
between their returns. Assume no borrowing and no short
selling is allowed, which of the following statements about
potential portfolios created from only these two stocks is
correct?

It is possible to create a portfolio that has a standard

deviation of returns greater than 19%.

53 It is possible to create a portfolio that has a standard

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 deviation of returns of 0%.

All possible portfolios will lie on the efficient frontier in

standard deviation/return space.

All possible portfolios will lie on a single straight line in

standard deviation/return space.

Assume the following information for stocks A and B. Expected A

return on Stock A = 18% Expected return on Stock B = 23%

Correlation between returns of Stock A and Stock B = 0.10
Standard deviation of returns on Stock A = 40% Standard
deviation of returns on Stock B = 50% The expected return and
standard deviation of an equally weighted portfolio of stocks A
and B are closest to:

Expected return (%)20.5,Standard deviation (%)33.54

54

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 B

Expected return (%)20.5,Standard deviation (%)11.22

Expected return (%)33.5,Standard deviation (%)11.22

Expected return (%)33.5,Standard deviation (%)33.54

Assume a two-asset portfolio. Asset A has volatility of 20% and C

Asset B has volatility of 30%. The returns of the two assets have
a correlation of 0.4. If each asset is weighted 50% (equally
weighted portfolio), what is the portfolio volatility?

19.4%

20.1%
55

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 C

21.1%

25.9%

In a two-asset portfolio, reducing the correlation between the C

Reducing correlation between the two assets results in the
two assets moves the efficient frontier in which direction?
efficient frontier expanding to the left and possibly slightly
upward. This reflects the influence of correlation on reducing
A
portfolio risk.

The efficient frontier is stable unless return expectations

change. If expectations change, the efficient frontier will
extend to the upper right with little or no change in risk.

The efficient frontier tends to move down and to the

left, representing increased risk from negative
correlation.

C
56

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 The frontier extends to the left, or northwest quadrant
representing a reduction in risk while maintaining or
enhancing portfolio returns.

The efficient frontier is stable unless the asset’s

expected volatility changes. This depends on each
asset’s standard deviation.

The market portfolio in the Capital Market Theory contains D

The market portfolio contains all risky assets in existence. It does
which types of investments?
not contain any risk-free assets.

All stocks in existence.

All stocks and bonds in existence.

All risky and risk-free assets in existence.

57

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 D

All risky assets in existence.

Consider the expected returns and standard deviations for the A

Portfolio 1 is not efficient because it has a lower expected return
following portfolios:
and higher risk than Portfolios 2, 3 and 4.

Relative to the other portfolios, the portfolio that is not mean

variance efficient is:

Portfolio 1

Portfolio 2

Portfolio 3
58

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 D

Portfolio 4

To describe the shape of the portfolio possibilities curve, which D

The portfolio possibilities curve is concave above the minimum
one of the following is best?
variance portfolio and convex below the minimum variance
portfolio.
A

The curve is strictly convex.

The curve is strictly concave.

The curve is convex above the minimum variance

portfolio and concave below the minimum variance
portfolio.

59 The curve is concave above the minimum variance

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 portfolio and convex below the minimum variance
portfolio.

A portfolio to the right of the market portfolio on the capital market A

line (CML) is created by:
Portfolios that lie to the right of the market portfolio on the
A
Holding more than 100% of the risky asset. capital market line are created by borrowing funds to own more
B than 100% of the market portfolio (M). Both the statement,
Fully diversifying.
"holding both the risk-free asset and the market portfolio "and
C
Buying the risk-free asset. "buying the risk-free asset" refer to portfolios that lie to the left of
D the market portfolio. Portfolios that lie to the left of point M are
Holding both the risk-free asset and the market portfolio.
created by lending funds (or buying the risk free-asset). Less than
100% of both the market portfolio and more than 100% of the
risk-free asset. The portfolio at point Rf (intersection of the CML
and the y-axis) is created by holding 100% of the risk-free asset.
The statement, "fully diversifying" is incorrect because the market
60 portfolio is fully diversified.
The intercept and slope of the capital market line are: D
A The quotation of CML is
R M and [E(R P ) - R F ] / σ P , respectively.
B
R F and [E(R P ) - R F ] / σ M , respectively. ,
C
R M and [E(R M ) - R P ] / σ M , respectively. Thus, the intercept is and the slope is
D
R F and [E(R M ) - R F ] / σ M , respectively.
61
The market portfolio in Capital Market Theory is determined by: C
62 A The Capital Market Line is a straight line drawn from the risk-free

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 a line tangent to the efficient frontier, drawn from any point on the rate of return (on the Y axis) through the market portfolio. The
expected return axis.
market portfolio is determined as where that straight line is
B
a straight line drawn to any efficient portfolio. exactly tangent to the efficient frontier.
C
a line tangent to the efficient frontier, drawn from the risk-free rate of
return.
D
The intersection of the efficient frontier and the investor's highest
utility curve.

Which of the following statements about the security market line D

(SML) is least accurate? Securities that fall on the SML are properly priced. They have
A
value to an investor in that they still earn a return.
The market portfolio consists of all risky assets.
B
Securities that plot above the SML are undervalued.
C
The risk-free rate defines where the SML intersects the vertical axis.
D
Securities that plot on the SML have no intrinsic value to the investor.
63
The market portfolio (M) contains the optimal allocation of only risky D
assets and no risky assets. Let the S 1 be the Sharpe ratio of this market The ability to borrowing or lend morphs the concave/convex
portfolio. There exists a risk-free asset. Initially, an investor is fully
(100%) Investment in M with a portfolio Sharpe ratio of S 1 .,, investor efficient frontier into the linear CML; ie, the leveraged portfolio is
borrows 30% at the risk-free rate, such that she is 130% invested in the efficient with higher risk and higher return.
market portfolio (M) where this leverage portfolio has a Sharpe ratio of
All portfolios on the CML have the same Sharpe ratio: the slope of
S 2. After the leverage (ie, borrowing at the risk-free rate to invest 30%
in M, is the investor still on the efficient frontier and how do the the CML.
Sharpe ratios?
A
No (no longer efficient), and S 2 < S 1 .
64 B

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 No, but S 2 = S 1 .
C
Yes(still efficient), but S 2 < S 1 .
D
Yes, and S 2 = S 1 .

The efficient frontier is defined by the set of portfolios that for each A
volatility level, maximizes the expected return. According to the capital The capital market line connects the risk-free asset with the
asset pricing model (CAPM), which of the following statements is
market portfolio, which is the efficient portfolio at which the
correct with respect to the efficient frontier?
A capital market line is tangent to the efficient frontier.
The capital market line always has a positive slope and its steepness
depends on the market risk premium and the volatility of the market
portfolio.
B
The capital market line is the straight line connecting the risk-free asset
with the zero beta minimum variance portfolio.
C
Investors with the lowest risk aversion will typically hold the portfolio
of risky assets that has the lowest standard deviation on the efficient
frontier.
D
The efficient frontier allows different individuals to have different
portfolios of risky assets based upon their individual forecasts for asset
returns.
65
In the context of the CML, the market portfolio includes: B
A The market portfolio has to contain all the stocks, bonds, and risky
12-18 stocks needed to provide maximum diversification
assets in existence. Because this portfolio has all risky assets in it,
B
All existing risky assets it represents the ultimate or completely diversified portfolio.
C
Risky stocks and bonds only
66 D

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 The risk-free asset

Portfolios that represent combinations of the risk-free asset and the C

market portfolio are plotted on the: The introduction of a risk-free asset changes the Markowitz efficient
A frontier into a straight line. This straight efficient frontier line is called the
Utility curve capital market line (CML). Investors at point Rf have 100 percent of their
B funds invested in the risk-free asset Investors at point M have 100 percent
Capital asset pricing line of their funds invested in market portfolio M. Between Rf and M, investors
C hold both the risk-free asset and portfolio M. To the right of M, investors
Capital market line hold more than 100 percent of portfolio M. All investors have to do to get
D the risk and return combination that suits them is to simply vary the
Characteristic line proportion of their investment in the risky portfolio M and the risk-free
asset. The term "characteristic line" refers to Beta, used to form the
67 Security market line (SML). Utility curve reflect individual preferences.
Portfolio P in the mean variance analysis represents the tangency point C
between the capital market line and the portfolio possibilities curve. In The CML is the line connecting T-bills and Portfolio P. The market
this analysis, the market price of risk would be the:
price of risk is the slope of the CML. Had risk been measured on
the graph with beta, the graph would represent the SML. The
market price of risk would still be The slope of the line.

A
Standard deviation of Portfolio P
B
Expected return on the minimum-variance portfolio
C
Slope of the line connecting T-bills and Portfolio P
68 D

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 Point at which the straight line intersects the expected return axis

For an investor to move further up the Capital Market Line than the C
market portfolio, the investor must: Portfolios that lie to the right of the market portfolio on the
A
capital market line ("up" the capital market line) are created by
Reduce the portfolio's risk below that of the market.
B borrowing funds to own more than 100% of the market portfolio
Continue to invest only in common stocks. (M). The statement, "diversify the portfolio Even more" is incorrect
C
because the market portfolio is fully diversified.
Borrow and invest in the market portfolio.
D
Diversify the portfolio even more.
69
Jim manages a well-diversified portfolio containing forty stocks. The A
portfolio has a beta of 1.05. Jim is considering adding the stock of ABC Since the portfolio is well diversified, the assumed level of
Inc. to the portfolio, and would fund the purchase with cash already in
unsystematic risk is zero. The addition of ABC Inc will increase the
the portfolio. ABC Inc. has a beta of 1.20, and is currently not part of
the portfolio. Which statement about the resulting portfolio is TRUE? portfolio beta, and, hence, the level of systematic risk.
A
Systematic risk would increase, but the unsystematic risk would be
unchanged.
B
Systematic risk would decrease, but the unsystematic risk would be
unchanged.
C
Both systematic risk and unsystematic risk would be unchanged.
D
Both systematic risk and unsystematic risk would both increase.
70
A security’s systematic risk is proportional to： A
A The measure of systematic risk is beta, and beta is proportional to
the covariance of its return with the return on the market portfolio.
the covariance of a security’s return with the return on the
B
71 the standard deviation of its return. market portfolio.

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 C
the variance of its return.
D
its diversifiable risk.

Which of the following statements about risk is FALSE? B

A Total risk = systematic risk + unsystematic risk
The market portfolio consists only of systematic risk.
B
Total risk = systematic risk - unsystematic risk.
C
Unsystematic risk is diversifiable risk.
D
Systematic risk is undiversifiable risk.
72
Which of the following statements about portfolio risk and C
diversification is least accurate? Systematic risk cannot be eliminated by diversification.
A
Unsystematic risk can be reduced by diversification. Diversification
Not all risk is diversifiable.
B benefits will occur any time security returns have less than perfect
Unsystematic risk can be substantially reduced by diversification. positive correlations.
C
Systematic risk can be eliminated by holding securities in a well-
diversified international stock portfolio.
D
None of above.
73
Which of the following statements about systematic and unsystematic A
risk is least accurate? This statement should read, "The unsystematic risk for a specific
A
firm is not similar to the unsystematic risk for other firms in the
The unsystematic risk for a specific firm is similar to the unsystematic
risk for other firms in the same industry. same industry." Thus, other terms for this risk are firm-specific, or
B unique, risk. Systematic risk is not diversifiable. As an investor
74 As an investor increases the number of stocks in a portfolio, the

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 systematic risk will remain constant. increases the number of stocks in a portfolio the unsystematic risk
C
will decrease at a decreasing rate. Total risk equals systematic
Total risk equals market risk plus firm-specific risk.
D (market) plus unsystematic (firm-specific) risk.
As compared to a less-diversified portfolio, a well-diversified portfolio
has lower unsystematic risk.

A portfolio manager is analyzing an equity portfolio and has been given

the following information from the management group: B
*Annual standard deviation of portfolio returns 16.0%
*Correlation of portfolio returns to market returns 0.825
*Expected annual market return 7.0%
*Annual standard deviation of market returns 12.0%
*Annual risk free rate 1.8%
According to the capital asset pricing model, what is the expected
annual return of the portfolio?
A
5.0%
B
7.5%
C
8.7%
D
75 9.5%
Suppose that the correlation of the return of a portfolio with the A
return of its benchmark is 0.8, the volatility of the return of the The following equation is used to calculate beta:
portfolio is 5%, and the volatility of the return of the benchmark is 4%.
What is the beta of the portfolio?
A
1.00
B
0.80
C
76 0.64

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 D
-1.00

An equity analyst is estimating the return of a stock using the CAPM. B

The analyst compiles the following information and correctly calculates
the expected return for stock as 7.2%. Risk-free rate 3.0% Beta of stock
1.4 Correlation between the stock return and market return 0.7
Standard deviation of stock return 5.0% The risk team reviews the
analyst’s work and discovers that analyst has input an incorrect
correlation estimate; the proper correlation is 0.6. Assuming all other
input are unchanged and correct, what is the correct expected return
for stock using the CAPM?
A
6.2%
B
6.6%
C
7.9%
D
8.4%
77
You are analyzing a portfolio that has a Jensen’s alpha of 4.75% and B
78 an actual return of 14.2%. The risk-free rate is 4.25% and the equity 1. Jensen’s alpha = actual return - expected return using CAPM

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 risk premium is 6%. Based on the information provided, the beta of the 2. CAPM E(R) = risk-free rate + beta × (return on the market -
portfolio is closest to:
risk-free rate Use Jensen’s alpha of 4.75% and the actual return
A
0.77 of 14.2%. The expected return from CAPM must be 14.2% - 4.75%
B = 9.45%. Use this value in the CAPM to find the beta of the
0.87
portfolio. expected return = risk-free rate + beta × equity risk
C
0.97 premium 9.45% = 4.25% + β × 6%, therefore β = approximately
D 0.87.
1.07

An analyst is considering an investment in stock DKR and has gathered A

the following information: Expected return of DKR 8.00% Risk-free rate
2.50% Standard deviation of DKR returns 14.75% Standard deviation of
market returns 13.50% Correlation of DKR return and market returns
0.76 The analyst believes DKR is fairly valued according to the CAPM.
Based on this information, what is the expected return of the market
portfolio?
A
9.12%
B
10.43%
C
12.19%
D
15.12%
79
Which of the following statements about a stock's beta is TRUE? A beta B
greater than one is: Beta is a measure of the volatility of a stock. The overall market's
A
beta is one. A stock with higher systematic risk than the market
risky, while a beta less than one is risk-free.
B will have a beta greater than one, while a stock that has a lower
is riskier than the market, while a beta less than one is less risky than systematic risk will have a beta less than one.
80 the market.

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 C
overvalued, while a beta less than one is undervalued.
D
undervalued, while a beta less than one is overvalued.

An analyst gathered the following data about three stocks: D

Stock A =8 % + 1.5(7%)=18.5%. Because the estimated return of
15.0% is less than the required return of 18.5%, Stock A is
overvalued. Stock C = 8 % + 0.6(7%) =12.2%. Because the
estimated return of 14.2% is greater than the required return of 1
2 .2 %. Stock C is undervalued.

If the risk-free rate is 8 % and the risk-premium on the market is

7%，are Stock A and Stock C undervalued, properly valued, or
overvalued, according to the security market line (SML)?
A
(Stock A)Undervalued (Stock C)Undervalued
B
(Stock A)Overvalued (Stock C)Overvalued
C
(Stock A)Undervalued (Stock C)Overvalued
D
(Stock A)Overvalued (Stock C)Undervalued
81
An analyst has developed the following data for two companies: PNS C
Manufacturing (PNS) and ABC Travel (ABC). PNS has an expected
return of 15 percent and a standard deviation of 18 percent. ABC has
an expected return of 11 percent and a standard deviation of 17
percent. PNS's correlation with the market is 75 percent, while ABC's
correlation with the market is 85 percent. If the market standard
deviation is 22%, which of the following are the betas for PNS and
82 ABC?

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 A
Beta of PNS:0.66 Beta of ABC: 0.61
B
Beta of PNS:0.92 Beta of ABC: 1.10
C
Beta of PNS:0.61 Beta of ABC: 0.66
D
Beta of PNS:1.10 Beta of ABC: 0.92

James Tulsma, FRM, is analyzing a publicly traded firm and is using the C
company’s beta, the risk-free rate of return, and the expected return The capital asset pricing model (CAPM) assumes the following:
on the market to estimate the company’s required rate of return. He
Investors desire to maximize their expected utility of wealth at the
is somewhat concerned that the underlying assumptions of this
technique are not realistic. Which of the following statements is an end of next period. Investors are risk averse. Investors are only
assumption of the capital asset pricing model (CAPM)? concerned with the mean and standard deviation of returns.
A
Assets are fully divisible.
Investors minimize their expected utility of wealth at the end of the
period.
B
Investors are risk-neutral.
C
Investors are only concerned with the mean and standard deviation of
returns.
D
Assets are not divisible.
83
An investment advisor is analyzing the range of potential expected C
returns of a new fund designed to replicate the directional moves of If the CAPM holds, then , which is maximized at the greatest
the BSE Sensex Index but with twice the volatility of the index. The
possible beta value which implies a correlation of 1 between the
Sensex has an expected annual return of 12.3% and volatility of 19.0%,
and the risk free rate is 2.5% per year. Assuming the correlation fund’s return and the index return. Since the volatility of the
between the fund’s returns and that of the index is 1, what is the fund is twice that of the index, a correlation of 1 implies a
expected return of the fund using the capital asset pricing model?
maximum beta βi of 2. Therefore: Ri (max) = 2.5% + 2 * (12.3% -
84 A

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 18.5% 2.5%) = 22.1%.
B
19.0%
C
22.1%
D
24.6%

According to the CAPM, which of the following is not wrong with A

respect to the efficient frontier? Within modern portfolio theory, the efficient frontier is a
I. The capital market line is the straight line connecting the risk-free
combination of assets that has the best possible expected level of
asset with the zero beta minimum variance portfolio.
II. The capital market line always has a positive slope and its steepness return for its level of risk. The efficient frontier is the positively
depends on the market risk premium and the volatility of the market sloped portion of the opportunity set that offers the highest
portfolio.
expected return for a given risk level. The efficient frontier is at the
III. The complete efficient frontier without a risk-free asset can be
obtained by combining the minimum variance portfolio and the market top of the feasible set of portfolio combinations. II, III and V are
portfolio. correct statements. The capital market line connects the risk-free
IV. The efficient frontier assumes no transaction costs, no taxes, a
common investment horizon for all investors, and that the return asset and the market portfolio. The efficient frontier does allow
distribution has no skewness. investors to have different risk aversions, but assumes that they all
V. The efficient frontier allows different individuals to have different have the same forecast for asset returns.
portfolios of risky assets based upon their own risk aversion and
forecast for asset returns.
A
II, III and IV
B
II, III and V
C
I, II and III
D
I, IV and V
85
86 The risk-free rate is 5% and the expected market risk premium is 10%. A

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 A portfolio manager is projecting a return of 12%. The portfolio has a Based on the CAPM, the portfolio should earn: E(R) = 0.05 +
beta of 0.7，and the market beta is 1.0. After adjusting for risk, this
0.7(0.10) = 12%. On a risk-adjusted basis, this portfolio lies on the
portfolio is expected to:
A security market line (SML) and thus is earning the proper risk-
equal the performance predicted by the CAPM. adjusted rate of return.
B
outperform the CAPM return.
C
underperform the CAPM return.
D
unable to determine based on the information provided.

All of the following are assumptions of the Capital Asset Pricing Model D
except:
A The CAPM assumes that investors all have the same horizon (as
Each investor seeks to maximize the expected utility of wealth at the
well as expectations). This means that the distribution of the
end of that investor’s horizon.
B horizons is not normal because normality implies a bell-shaped
Investors can borrow and lend at the same risk-free rate. curve distribution, which would have a positive variance and,
C
hence, dispersion.
Investors have the same expectations concerning returns.
D
The time horizons of investors are normally distributed.
87
Patricia Franklin makes buy and sell stock recommendations using the B
capital asset pricing model. Franklin has derived the following
information for the broad market and for the stock of the CostSave The CAPM equation is:
Company (CS):

Franklin forecasts the beta for CostSave as follows:

beta forecast = 0.80 + 0.20 × historical beta = 0.80 + 0.20 × 1.50

= 1.10
88 Franklin believes that historical betas do not provide good forecasts of

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 future beta, and therefore uses the following formula to forecast beta: The CAPM required return for CostSave Company is: 0.05 + 1.1
forecasted beta = 0.80 0.20*historical beta
After conducting a thorough examination of market trends and the CS (0.08) = 13.8%
financial statements, Franklin predicts that the CS return will equal
10%. Franklin should derive the following required return for CS along Note that the market premium, E(RM) - RF, is provided in the
with the following valuation decision (undervalued or overvalued): question (8%).
A
Valuation：overvalued，CAPM required return：8.3%
Franklin should decide that the stock is overvalued because she
B
Valuation：overvalued，CAPM required return：13.8% forecasts that the CostSave return will equal only 10%, whereas
C the required return (minimum acceptable return) is 13.8%.
Valuation：undervalued，CAPM required return：8.3%
D
Valuation：undervalued，CAPM required return：13.8%

Assume the riskfree rate is 4% and the expected (overall) market B

return is 12% with 20% volatility. Our portfolio (P) has volatility of 30%
and a correlation with the market of 0.4. According to CAPM, what is
the portfolio’s expected return?
A
6.0%
B
8.8%
C
11.2%
D
12.0%

89
Suppose the S&P 500 has an expected annual return of 7.6% and C
volatility of 10.8%. Suppose the Atlantis Fund has an expected annual Since the correlation or covariance between the Atlantis Fund and
return of 8.3% and volatility of 8.8% and is benchmarked against the
the S&P 500 is not known, CAPM must be used to back out the
90 S&P 500. If the risk free rate is 2.0% per year, what is the beta of the

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 Atlantis Fund according to the Capital Asset Pricing Model? beta.
A
0.81
B
0.89
C
1.13
D
1.23

An analyst at CAPM Research Inc. is projecting a return of 21% on A

portfolio A. The market risk premium is 11%, the volatility of the According to the CAPM, the required return of Portfolio A is:
market portfolio is 14%, and the risk-free rate is 4.5%. Portfolio A has a
beta of 1.5. According to the capital asset pricing model, which of the
following statements is true?
A
The expected return of portfolio A is greater than the expected return While the expected return on the market is:
of the market portfolio.
B market risk premium+Rf=11%+4.5%=15.5%
The expected return of portfolio A is equal to the expected return of
Therefore, the expected return of portfolio A is greater than the
the market portfolio.
C expected return of the market portfolio.
The expected return of portfolio A is less than the expected return of
the market portfolio.
D
The return of Portfolio A has lower volatility than the market portfolio.
91
The expected rate of return is twice the 12% expected rate of return B
from the market. What is the beta if the risk-free rate is 6%?
A
4
B
3
92 C

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 2
D
5

Given a beta of 1.10 and a risk-free rate of 5%, what is the expected D
rate of return assuming a 10% market return?
A
15.5%
B
21.5%
C
5.5%
D
10.5%
93
The beta of stock D is -0.5. If the expected return of Stock D is 8%, and B
the risk-free rate of return is 5%, what is the expected return of the
market?
A
3.0%
B
-1.0%
C
3.5%
D
-4.0%
94
A risk manager is analyzing the expected performance of a group of D
assets which are all benchmarked to the same market index. For the Given that the returns on the market index are greater than risk-
analysis, the risk manager assumes that the returns on the market
index are greater than the risk-free rate and that the assumptions of free rate, we can conclude: E(RM) > RF. E(RM) – RF > 0
the CAPM hold. Holding all other things constant, which of the
following statements is correct?
95 A

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 The expected return on an asset increases when its correlation with
the market return decreases.
B
For an asset with a negative correlation of return to the market, an
increase in the risk-free rate will decrease its expected return.
C
An asset with a beta of 2.5 will always have a higher standard deviation
of return than an asset with a beta of 0.5.
D
When comparing two assets, the asset with the higher beta will always
have the higher expected return.

According to the CAPM, over a single time period, investors seek to D

maximize their: CAPM assumes investors seek to maximize the expected utility of
A
their wealth at the end of the period, and that when choosing
wealth and are concerned about the tails of return distributions.
B their portfolios, investors only consider the first two moments of
wealth and are not concerned about the tails of return distributions. return distribution: the expected return and the variance. Hence,
C
investors are not concerned with the tails of the return
expected utility and are concerned about the tails of return
distributions. distribution.
D
expected utility and are not concerned about the tails of return
distributions.
96
Given the following data, what is the correlation coefficient between C
the two stocks and the Beta of stock A?
Standard deviation of returns of Stock A is 10.04%
Standard deviation of returns of Stock B is 2.05%
Standard deviation of the market is 3.01%
Covariance between the two stocks is 0.00109
Covariance between the market and stock A is 0.002
A
97 Correlation Coefficient：0.5296 Beta (stock A):0.06

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 B
Correlation Coefficient：0.6556 Beta (stock A):2.21
C
Correlation Coefficient：0.5296 Beta (stock A):2.21
D
Correlation Coefficient：0.6556 Beta (stock A):0.06

Which of the following statements regarding the Capital Asset Pricing D

Model is least accurate? The CML plots expected return versus standard deviation risk. The
A
SML plots expected return versus beta risk. Therefore, they are
It relies on the existence of a risk-free asset.
B lines that are plotted in different two-dimensional spaces and will
It is useful for determining an appropriate discount rate. not converge.
C
Its accuracy depends upon the accuracy of the beta estimates.
D
It is when the security market line (SML) and capital market line (CML)
converge.
98
XYZ Inc. has a beta of 1.15. If the expected return on the market is 12 B
percent, and the risk-free rate is 6 percent, what is the expected return
for XYZ?
A
10.15%
B
12.90%
C
11.69%
D
14.00%
99
Assuming a positive market risk premium and holding all other things A
equal, which of the following statements about the CAPM is correct?
100 A

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 The expected return on a security decreases when its correlation with
the market return decreases. According to the CAPM,
B
For a security with a beta greater than 1.0, an increase in the risk-free A. The expected return on a security decreases when its
rate will increase its expected return.
correlation with the market return decreases. A is correct.
C
A stock with a beta of 2.0 will always have a higher standard deviation
than a stock with a beta of 0.5. B. , for a security with a beta
D
greater than 1.0, 1-β<0, so an increase in the risk-free rate will
The expected return on a security will increase when the standard
deviation of the market return increases. decrease its expected return. B is incorrect.

D. , so
the expected return on a security will decrease when the standard
deviation of the market return increases. D is incorrect.

You are interested in constructing a portfolio benchmarked to the S&P A

500 with a standard deviation of returns less than or equal to 10% per
year. Assume the CAPM holds, if the risk-free rate is 2% per year and
the expected return on the S&P 500 is 8% per year with a standard
deviation of 25% per year, what is the highest expected return you
could achieve on your portfolio?
A
4.4% per year
B
5.2% per year
C
6.0% per year
D
6.8% per year
101

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 A risk analysis is attempting to estimate the market sensitivity of the K- C
50 Fund, a diversified fund that is benchmarked to the KOSPI index.
The annualized data is given below:

If the covariance of the K-50 Fund with the KOSPI is 0.00945, what is its
beta?
A
0.53
B
0.62
C
0.74
D
1.18
102
A portfolio with a volatility of 30.0% has a Treynor measure of 0.080. B
The portfolio has a correlation of 0.50 with the market index which
The beta(P,M) = correlation(P,M)*volatility(P)/volatility(M) =
itself has a volatility of 20.0%. What is the portfolio's Sharpe measure?
A 0.50*30%/20% = 0.750. Because Treynor = (Portfolio's excess
0.095 return)/beta, the portfolio's excess return = 0.080*0.750 = 6.0%
B
and its Sharpe measure = 6.0%/30.0% = 0.20.
0.200
C
0.330
D
0.475
103

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 A fund manager recently received a report on the performance of his B
portfolio over the last year. According to the report, the portfolio Sharp ratio = (9.3% - 3.2%) / 13.5% = 0.4519 Sortino ratio = (9.3%
return is 9.3%, with a standard deviation of 13.5%, and beta of 0.83.
- 3.2%) / 8.4% = 0.7262 Sortino ratio - Sharp ratio = 0.274
The risk-free rate is 3.2 %, the semi-standard deviation of portfolio is
8.4%, and the tracking error of the portfolio to the benchmark index is
2.8%. What is the difference between the value of the fund's Sortino
ratio (computed relative to the risk-free rate) And its Sharpe ratio?
A
1.727
B
0.274
C
-0.378
D
0.653
104
An analyst is evaluating the performance of a portfolio of Mexican C
equities that is benchmarked to the IPC Index. The analyst collects the The Sharpe ratio for the portfolio is (6.6% - 1.5%) / 13.1% = 0.389.
information about the portfolio and the benchmark index shown in the
table below:
* Expected return on the portfolio 6.6%
*Volatility of returns on the portfolio 13.1%
* Expected return on the IPC Index 4.0%
* Volatility of returns on the IPC Index 8.7%
* Risk-free rate of return 1.5%
* Beta of portfolio relative to IPC Index 1.4
What is the Sharpe ratio for this portfolio?
A
0.036
B
0.047
C
0.389
105 D

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 0.504

Which of the following statements about the Sortino ratio are valid? D
I.The Sortino ratio is more appropriate for asymmetrical return The information ratio, not the Sortino ratio, compares the
distributions.
portfolio return to the return of a benchmark portfolio. The
II .The Sortino ratio compares the portfolio return to the return of a
benchmark portfolio. Sortino ratio allows one to evaluate portfolios obtained through
III.The Sortino ratio allows one to evaluate portfolios obtained through an optimization algorithm that uses semi-variance, not variance,
an optimization algorithm that uses variance as a risk metric.
as a risk metric. Sortino ratio uses the notion of semi-variance, it is
The Sorting ratio is defined on the same principles as the Sharpe ratio,
but the Sorting ratio replaces the risk free rate with the minimum more appropriate for asymmetric return distributions than any
acceptable return and the standard deviation of returns with the metric that uses standard deviation (such as the Sharpe ratio). The
standard deviation of returns below the minimum acceptable return.
A Sortino ratio is similar to the Sharpe ratio, except the risk free rate
II and III is replaced With the minimum acceptable return in the numerator
B and the standard deviation of the returns is replaced with the
I, III and IV
C standard deviation of the returns below the minimum acceptable
I and III return in the denominator.
D
I and IV
106
The ST Fund is a mutual fund that is benchmarked to the S&P 500 C
index. It contains equally weighted holdings of 10 stocks from the
index, with an average annual portfolio return of 11% and a volatility The sharp ratio of ST Fund is:
of returns of 16%. Over the same time Period, the average annual
return on the S&P 500 has been 12%, with a volatility of returns of 9%.
The annual risk-free rate is 3%. ST Fund's portfolio manager is planning The sharp ratio of S&P 500 is:
to diversify the fund by increasing its holdings to 100 Stocks in the S&P When ST Fund's portfolio manager is planning to diversify the
500, all equally weighted. Because of this change, ST Fund's Sharpe
fund by increasing its holdings to 100 stocks in the S&P 500, the
ratio will most likely:
A ST Fund's Sharpe ratio will most likely increase to the sharp ratio
Decrease toward 0 of S&P 500.
107 B

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 Decrease toward 1
C
Increase toward 1
D
Increase above 1

Which of the following statements about the Sharpe Ratio is false? C

A The SR considers total risk, which includes systematic and
The Sharpe Ratio considers both the systematic and unsystematic risks
unsystematic risks, so A and B are correct statements, and
of a portfolio.
B incorrect answers. similar, the SR is derived from the CML, which
The Sharpe Ratio is equal to the excess return of a portfolio over the states that the market is mean-variance efficient and hence has
risk-free rate divided by the total risk of the portfolio.
the highest Sharpe Ratio of any feasible portfolio. Finally, the SR
C
The Sharpe Ratio cannot be used to evaluate relative performance of can be used to evaluate undiversified portfolios precisely, because
undiversified portfolios. it includes idiosyncratic risk.
D
The Sharpe Ratio is derived from the Capital Market Line.
108
Consider the following already-annualized statistics for portfolio (P): C
*Riskfree rate = 2.00% Sharpe = excess return/volatility = 0.0750/0.1470 = 0.510;
*Realized portfolio (P) return (average) = 9.50%
Sortino = [return above MAR]/downside deviation = (9.50% -
*Portfolio (P) excess return = 9.50% - 2.00% = 7.50%
* Standard deviation of portfolio (P) returns = 14.70% 6.00%)/5.60% = 0.6250
* Minimum acceptable return (MAR) = 6.00%
*Downside deviation of portfolio (P) returns = 5.60%
Which are nearest, respectively, to the Sharpe measure and Sortino
ratio?
A
0.280 (Sharpe) and 0.100 (Sortino)
B
0.350 (Sharpe) and 0.433 (Sortino)
C
109 0.510 (Sharpe) and 0.625 (Sortino)

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 D
0.740 (Sharpe) and 1.290 (Sortino)

An analyst has compiled the following information on a portfolio: D

*Sortino Ratio: 0.82
*Beta: 1.15
*Expected return: 12.75%
*Standard deviation: 11.9%
*Risk-free rate: 4.75%
What is the semi-standard deviation of the portfolio return? Semi-standard deviation = 9.76%
A
0.4%
B
8.2%
C
14.9%
D
9.76%
110
For a given portfolio, the expected return is 10% with a standard D
deviation of 15%. The expected return of the market is 11% with a
standard deviation of 18%. The risk-free rate is 4%. The portfolio's
Treynor measure is closest to:
A
0.0075
B
0.0120
C
0.0400
D
0.0800
111
Market portfolio's sharp ratio is 40%, the correlation between the B
112 market portfolio and the stock is 0.7, the stock's sharp ratio is:

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 A
12%
B
28%
C
32%
D
30%

For a given portfolio, the expected return is 10% with a standard D

deviation of 15%. The expected return of the market is 11% with a
standard deviation of 18%. The risk-free rate is 2.5%. The portfolio's
Treynor measure is closest to:
A
0.0075
B
0.0120
C
0.0800
D
0.1000
113
An analyst has compiled the following information on a portfolio: D

What is the semi-standard deviation of the portfolio return?

A
0.4%
114 B

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 8.2%
C
14.9%
D
9.09%

Gregory is analyzing the historical performance of two commodity B

funds tracking the Reuters/Jefferies - CRB Index as benchmark. He
collated the data on the monthly returns and decided to use the
information ratio (IR) to assess which fund achieved higher returns
more efficiently and presented his findings.

What is the information ratio for each fund and what conclusion can
be drawn?
A
IR for Fund I = 0.212, IR for Fund II = 0.155, Fund II performs better as it
has a lower IR.
B
IR for Fund I = 0.212, IR for Fund II = 0.155, Fund I performs better as it
has a higher IR.
C
IR for Fund I = 0.248, IR for Fund II = 0.224, Fund I performs better as it
has a higher IR.
D
IR for Fund I = 0.248, IR for Fund II = 0.224, Fund II performs better as it
has a lower IR.
115

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 You are reviewing the performance of a portfolio and have compiled B
the following information. Sortino ratio = (13.75% - 5.35%)/13.72% = 0.612 Information ratio
= (13.75% - 12.36%)/7.21% = 0.192 Sharp ratio = (13.75% -
5.35%)/16.90% = 0.497

In relation to the portfolio’s performance, which of the following

statements is (are) correct?
I.The Sortino ratio for the portfolio is 0.497.
II.The information ratio for the portfolio is 0.192.
III.The Sharpe ratio yields a result lower than the Sortino ratio but
higher than the information ratio.
A
I and II
B
II and III
C
III only
D
I, II and III
116
Portfolio A has an expected return of 8%, volatility of 20%, and beta of A
0.5. Assume that the market has an expected return of 10% and
volatility of 25%. Also assume a risk-free rate of 5%. What is Jensen’s
alpha for portfolio A?
A
117 0.5%

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 B
1.0%
C
10%
D
15%

Donaldson Capital Management, a regional money management firm, B

manages nearly $400 million allocated among three investment The Treynor measure is most appropriate for comparing well-
managers. All portfolios have the same objective, which is to produce
diversified portfolios. That is, the Treynor measure is the best to
superior risk-adjusted returns (by beating the market) for their clients.
You have been hired as a consultant to measure the performance of compare the excess returns per unit of systematic risk earned by
the portfolio managers. You have collected the following information portfolio managers, provided all portfolios are well-diversified. All
based on the last ten years of returns.
three portfolios managed by Donaldson Capital Management are
clearly less diversified than the market portfolio. Standard
deviation of returns for each of the three portfolios is higher than
the standard deviation of the market portfolio, reflecting a low
level of diversification. Jensen’s alpha is the most appropriate
measure for comparing portfolios that have the same beta. The
During the same time period the average annual rate of return on the Sharpe measure can be applied to all portfolios because it uses
market portfolio was 13% with a standard deviation of 19%. In order to total risk and it is more widely used than the other two measures.
assess the portfolio performance of the above managers, you should
use: Also, the Sharpe ratio evaluates the portfolio performance based
A on realized returns and diversification. A less-diversified portfolio
The Treynor measure of performance will have higher total risk and vice versa.
B
The Sharpe measure of performance
C
The Jensen measure of performance
D
The Sortino measure of performance
118

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 Tim is evaluating 4 funds run by 4 independent managers relative to a D
benchmark portfolio that has an expected return of 7.4% and volatility Expected residual return = rF - rB Information ratio = (rF -
of 14%. He is interested in investing in the fund with the highest
rB)/residual risk Expected residual returnA = 9.3% - 7.4% = 1.9%
information ratio that also meets the following conditions in his
investment guidelines: Expected residual returnB = 0.9 × 2.4% = 2.16% Expected residual
Expected residual return must be at least 2%. returnC = 1.3 × 1.5% = 1.95% Expected residual returnD = 9.4% -
Residual risk relative to the benchmark portfolio must be less than
7.4% = 2% Information ratioD = 2% / 1.8% = 1.1 Both Fund B and
2.5%.
Based on the following information which fund should he choose? D meet the requirements while Fund D has higher information
ratio.

A
Fund A
B
Fund B
C
Fund C
D
Fund D
119
You are evaluating the historical performance of four equity funds B
benchmarked to the BSE SENSEX Index, as shown in the table below: IR = Average Excess Return / Tracking Error Fund B has the
highest information ratio

120

Page 88 of 122
 Which fund has the highest information ratio?
A
Fund A
B
Fund B
C
Fund C
D
Fund D

For the past four years, the returns on a portfolio were 6%，9% ，4%, B
and 12%. The corresponding returns of the benchmark were 7%, 10%, The benchmark returns are not important here. The average of the
4%, and 14%. The risk-free rate of return is 7%, and the mean squared
portfolio returns is(6 %+ 9% + 4% + 12%) / 4 = 31 %/ 4 = 7.75%.
deviation from the minimum return is 2.5. The portfolios Sortino ratio
is closest to:
A Sortino ratio=（7.75%-7%）/SQRT（2.5）
0.3000
B If the minimum acceptable return is not provided, it is reasonable
0.4743
to use the riskfree rate instead.
C
0.7000
D
1.1068
121
Assume that you are only concerned with systematic risk. Which of the A
following would be the best measure to use to rank order funds with Systematic risk of a portfolio is that risk which is inherent in the
different betas based on their risk-return relationship with the market
portfolio? market and thus cannot be diversified away. In this situation you
A should seek a measure which ranks funds based on systematic risk
Treynor ratio
only, which is reflected in the beta as defined below:
B
Sharpe ratio
C
122 Jensen’s alpha where is the correlation coefficient between the portfolio and the

Page 89 of 122
 D market, represents the standard deviation of the portfolio and
Sortino ratio
represents the standard deviation of the market. In a well-
diversified portfolio (where one is normally only concerned with
systematic risk), it can be assumed that the correlation coefficient
is close to 1, therefore beta can be approximated to an even

simpler equation:

In either case, beta explains the volatility of the portfolio

compared to the volatility of the market, which captures only
systematic risk. The Treynor ratio is the correct ratio to use in this
case. The formula is: which describes the difference between the
expected return of the portfolio, E(Rp) and the risk free rate Rf
divided by the portfolio beta β. Therefore, it plots excess return
over systematic risk.

A portfolio has an expected return of 11.0% with volatility of 24.0%. A

The benchmark has an expected return of 5.0% with volatility of 15%. Tracking error = SQRT(24%^2 + 15%^2 - 2*24%*15%*0.80) =
The expected returns correlation is 0.80. What is the expected (ex
15.0% Information ration = E[R(P) - R(B)]/TE = (11%-5%)/15% =
ante) information ratio (IR)?
A 0.40
0.40
B
0.55
C
0.69
D
0.80
123

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 A portfolio has an average return over the last year of 13.2%. Its C
benchmark has provided an average return over the same period of
12.3%. The portfolio’s standard deviation is 15.3%, beta is 1.15,
tracking error volatility is 6.5% and semi-standard deviation is 9.4%.
The lastly risk free rate is 4.5%. Calculate the portfolio’s Information
Ratio (IR).
A
0.489
B
0.396
C
0.138
D
0.106
124
A portfolio manager returns 10% with a volatility of 20%. The D
benchmark returns 8% with a volatility of 14%. The correlation
between the two is 0.98. The risk-free rate is 3%. Which of the
following statements is correct?
A
The portfolio has higher SR than the benchmark.
B
The portfolio has negative IR.
C
The IR is 0.35.
D
The IR is 0.29.
125
The information ratio of the Sterol US Fund for 2006 against the D
S&P500, its benchmark index is 1. For the same time period, the fund’s
Sharpe ratio is 2, the fund has tracking error volatility of 7% against the
S&P 500, and the standard deviation of fund returns is 5%. The risk-
free rate in the US is 4%. Calculate the return for the S&P 500 during
126 the time period.

Page 91 of 122
 A
15%
B
11%
C
9%
D
7%

Portfolio Q has a beta of 0.7 and an expected return of 12.8%. The D

market risk premium is 5.25%. The risk-free rate is 4.85%. Calculate
Jensen’s Alpha measure for Portfolio Q.
A
8.32%
B
6.70%
C
5.97%
D
4.27%
127
An analyst in CAPM Research Inc. is projecting a return of 21% on B
portfolio A. Portfolio A has a beta of 1.5.The market risk premium is According to the CAPM, the required return of Portfolio A is:
11%, the volatility of the market portfolio is 14%, and the risk-free rate
is 4.5%. According to the CAPM, which of the following statements is
not wrong?
A
The expected return of portfolio A is equal to the expected return of While the expected return on the market is:
128 the market portfolio.

Page 92 of 122
 B
The expected return of portfolio A is greater than the expected return
of the market portfolio.
Therefore, the expected return of portfolio A is greater than the
C
The expected return of portfolio A is less than the expected return of expected return of the market portfolio.
the market portfolio.
D
The return of Portfolio A has lower volatility than the market portfolio.

A high net worth investor is monitoring the performance of an index C

tracking fund in which she has invested. The following table shows the Relative risk measures risk relative to a benchmark index, and
performance figures of the fund and the benchmark portfolio:
measures it in terms of tracking error or deviation from the index.
We need to calculate the standard deviation of the series: {0.08,
0.04, 0.02, 0.01, 0.005} Perform the calculation by computing the
difference of each data point from the mean, square the result of
each, take the average of those values, and then take the square
root. This is equal to 3.04%.

What is the tracking error volatility of the fund over this period?
A
0.13%
B
1.26%
C
3.05%
D
4.59%
129
130 While the risk-free rate was 4.0%, a portfolio's realized a return of D

Page 93 of 122
 14.0% exactly matched the return of its benchmark, the market index, Beta (P, M) = Cov(P,M)/Variance(M) = 0.01440/0.20^2 = 0.36.
which also returned 14.0%. The portfolio's covariance (of returns) with
Jensen's alpha = 14% - 4% - 0.36*(14%-4%) = 6.4%.
the market index was 0.01440 and the market's volatility was 20.0%.
What was the Jensen's alpha of the portfolio?
A
-1.6%
B
Zero
C
3.2%
D
6.4%

Which concept gives a measure of historical value added per unit of C

risk taken and can be useful, among other tools, to risk managers? Information ratio is a measure of historical value added per unit of
A
risk. Tracking error is an estimate of how much risk a manager
Tracking error
B takes as a measure of the deviation from a benchmark.
Jensen’s alpha
C
Information ratio
D
Heteroscedasticity
131
A risk manager is evaluating a portfolio of equities with an annual D
volatility of 12.1% per year that is benchmarked to the Straits Times The Jensen's alpha is equal to the y-intercept, or the excess return
Index. If the risk-free rate is 2.5% per year, based on the regression
of the portfolio when the excess market return is zero. Therefore it
results given in the chart below, what is the Jensen's alpha of the
132 portfolio? is 3.7069%.

Page 94 of 122
 A
0.4936%
B
0.5387%
C
1.2069%
D
3.7069%

An analyst is estimating the sensitivity of the return of stock A to B

different macroeconomic factors. He has the following estimates for The expected return for Stock A equals the expected return for
the factor betas:
βindustrial production = 1.3 βinterest rate = -0.75 the stock under the baseline scenario, plus the impact of
When industrial production has a growth of 3% and an interest rate of “shocks”, or excess returns of, both factors. Since the baseline
1.5%, the expected return for Stock A is supposed to be 5%. scenario incorporates 3% industrial production growth and a 1.5%
The economic research department is forecasting an acceleration of
economic activity for the following year, with GDP forecast to grow interest rate, the “shocks” are 1.2% for the GDP factor and
4.2% and interest rates increasing 25 basis points to 1.75%. 0.25% for the interest rate factor.
What return of Stock A can be expected for next year according to this
forecast?
133 Therefore the expected return for the new scenario = Baseline

Page 95 of 122
 A scenario expected return + βindustrial production * industrial production
5.8%
B shock + βinterest rate * Interest rate shock = 5% + (1.3 * 1.2%) + (-
6.4% 0.75*0.25%) = 6.37%
C
6.9%
D
7.6%

Suppose three factors have been identified for the U.S. economy: the B
growth rate of industrial production (IP), the inflation rate (IR), and the 9.20% = 9.0% + [0.8 * (5.0% - 4.0%)] + [0.6 * (2.0% - 3.0%)] + [0.5
excess return of 30-year Treasury bonds over T-bills (TB). IP is expected
* (2.0% - 2.0%)]
to be 4.0%, IR is expected to be 3.0%, and TB is expected to be 2.0%. A
stock that is expected to provide a rate of return of 9.0% has a beta of
0.8 on IP, a beta of 0.6 on IR, and a beta of 0.5 on TB. If industrial
production (IP) actually grows by 5.0%, the inflation rate (IR) turns out
to be 2.0%, and the excess long-term Treasury bond (TB) is realized as
2.0%, what is the revised estimate of the expected rate of return on
the stock?
A
8.80%
B
9.20%
C
10.30%
D
11.50%
134
An investor believes there are three important factors that determine B
the expected return for a common stock. The investor uses the E(R) = 0.03 + 0.7(0.015) + 1.2(0.04) - 0.1(0.05) E(R) = 0.03 + 0.0105
following factor betas and factor risk premiums.
135 + 0.048 - 0.005 E(R) = 0.0835

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 If the risk-free rate is 3%, what is the expected return for this stock
using the arbitrage pricing theory (APT) model?

A
5.35%
B
8.35%
C
9.50%.
D
10.37%.

Suppose an analyst examines expected return for the Broad Band C

Company (BBC) base on a 2-factor model. Initially, the expected return
for BBC equals 10%. The analyst identifies GDP and 10-year interest
rates as the two factors for the factor model. Assume the following
data is used:
*GDP growth consensus forecast = 6%
*Interest rate consensus forecast = 3%
*GDP factor beta for BBC = 1.5
*Interest rate factor beta for BBC = -1.00
Suppose GDP ends up growing 5% and the 10-year interest rate ends
up equaling 4%. Also assume that during the period, the Broad Band
Company unexpectedly experiences shortage of key inputs, causing its
revenues to be less than originally expected. Consequently, the firm-
specific return is -2% during the period. Using the 2-factor model with
the revised data, which of the following expected returns for BBC is
136 correct?

Page 97 of 122
 A
1.5%
B
3.5%
C
5.5%
D
6.5%

Which of the following assumptions is not the assumptions of the D

single-factor model?
A
Security returns are described by a factor model.
B
Idiosyncratic risk is diversified
C
Well-diversified portfolio can be formed.
D
Arbitrage opportunities exist.

137
Which of the following is a common attribute of the collapse at both A
Metallgesellschaft and Long-term Capital Management (LTCM)? Metallgesellschaft and Long Term Capital Management (LTCM)
A
dealt in the derivatives market in huge quantities and both
Cash flow problems caused by large mark to market losses.
B experienced a cash flow crisis due to the change in economic
High leverage. conditions. This led to huge mark-to-market losses and margin
C
calls.
Fraud.
D
138 There are no similarities between the causes of the collapse at

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 Metallgesellschaft and LTCM.

Which of the following statements is correct regarding the factors that A

led to the financial crisis at Metallgesellschaft Refining and Marketing? Metallgesellschaft implemented a stack-and-roll hedging strategy,
A
which uses short-term futures contracts to hedge long-term risk
There was a cash flow problem that constrained the company’s
ability to fully execute the hedge already in place. exposure. The stack-and-roll hedge strategy proved ineffective
B due to interim funding cash outflows created by margin calls and
The maturity mismatch between its short and long positions is widely
other factors. No offsetting interim cash inflows were available on
believed to have contributed to the problems.
C their long-term customer contracts, creating a liquidity crisis that
The shifting of prices so that the petroleum spot prices were greater was exacerbated by their size of their futures positions in relation
than petroleum futures prices created a significant cash flow problem.
to the liquidity of the market. However, many economists believe
D
Gains and losses on customer contracts were realized when customers that such a hedging strategy is fundamentally Gains and losses on
entered into the contracts. its customer contracts were realized if and when the customers
139 took delivery, which would occur over a 5 to 10-year period.
Which of the choices below was least influential in the A
Metallgesellschaft debacle? The fundamental problem at Metallgesellschaft was that the
A
timing of the marked to market losses and margin calls on its
Fraud.
B futures contracts were mismatched with the cash flows on the
Financial reporting requirements. future contracts it was trying to hedge. The problem was
C
compounded by the enormous size of the positions, Which made
Timing differences in the cash flows of its long and short positions.
D liquidation costly, and by conservative financial reporting
The size of its positions influenced market prices. requirements that did not recognize the gains on the forward
contracts. Neither fraud nor deception is central to the
140 Metallgesellschaft case.
Consider three potential statements about Metallgesellschaft (MG): D
I.MG employed a stack-and-roll hedge because liquidity was highest All three (high liquidity favored the stack; the stack has greater
for short-dated oil futures contracts.
141 basis risk; the shift to contango caused dramatic roll return losses

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 II.MG employed a stack-and-roll hedge, and a stack hedge has greater and associated, substantial margin calls)
basis risk than a strip hedge.
III.The roll return in MG’s stack-and-roll hedge was profitable under
oil backwardation but losing under oil contango.
Which of the statements is TRUE?
A
I only
B
II only
C
I and II only
D
All three

Which of the following choices is an example of operational risk in the D

collapse of Barings? The failure to supervise the actions of its trader is an example of
A
operational risk.
The Nikkei collapsed due to an earthquake.
B
Much of a company’s assets were in illiquid derivative products.
C
The default of Japanese industrial firms.
D
Failure to supervise the actions of its trader.
142
Between 1993 and 1995, Nick Leeson’s actions resulted in losses of C
approximately $1.25 billion and forced Barings into bankruptcy. Which
of the following actions would least likely have prevented the All of the statements are correct except for the one relating to
bankruptcy of Barings’ Bank?
SIMEX. Nick Leeson was eligible to trade on the SIMEX.
A
Information on account gains and losses being more transparent.
B
Management being more suspicious of huge reported profits.
143 C

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 All traders being required to meet SIMEX (Singapore International
Monetary Exchange) standards.
D
A system of checks and balances being established to detect wildly
speculative positions.

In 1997, equity derivative losses at the Union Bank of Switzerland B

(UBS) appeared to be related to four different factors. Which one of Statement I resembles factors that affected UBS as well as its
factors shown below is the most unique (i.e., did not impact
competitors. The bank warrant positions may have been larger
competitors)?
I.British law tax changes and large Japanese bank warrants. than its competitors, but they were not unique to UBS. Statement
II.Incorrect valuation of long-dated options on equity baskets and II resembles factors that were unique to UBS.
inappropriate modeling of other long-dated options.
A
I only
B
II only
C
Neither I nor II
D
Both I and II
144
Hedging models at Long-Term Capital Management accounted for the: D
.spike in correlations among asset class prices during times of The models used by LTCM primarily relied on historical
economic crisis.
correlations to measure risk. In doing so, the firm failed to
.dependence of catastrophic events through time during global
economic shocks. account for the spike in correlations caused by economic shocks,
A such as Russia defaulting on its debt. The models also did not
I only.
consider that infrequent shocks Having been clustered in time,
B
II only. one causing another. As it happened, risk premiums rose across
C the globe, forcing LTCM to liquidate positions because its
Both I and II.
relatively miniscule equity basis was insufficient to withstand the
145 D

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 Neither I nor II. losses. The size of its positions aggravated negative price trends
that were Already set in motion.
The following is not a problem of having one employee perform A
trading functions and back office functions:
To minimize operational risk, trading and back office functions
A
The employee gets paid more because he performs two functions. should not be performed by the same employee. The risks of
B doing so include hiding trading mistakes and hiding the size of
The employee can hide trading mistakes when processing the trades.
exposures in the trading book. The extra direct compensation cost
C
The employee can hide the size of his book. of paying the same employee to Perform both functions is
D minimal compared to the potential operational risk costs.
The firm may not know its true exposure.
146
Barings was forced to declare bankruptcy after reporting over USD 1 B
billion in unauthorized trading losses by a single trader, Nick Leeson. Leeson was supposed to be running a low-risk, limited return
Which of the following statements concerning the collapse of Barings is
arbitrage business out of his Singapore office, but in actuality he
correct?
A was investing in large speculative positions in Japanese stocks and
Leeson avoided reporting the unauthorized trades by convincing the interest rate futures and options. When Leeson fraudulently
head of his back office that they did not need to be reported.
declared very substantial reported profits on His positions,
B
Management failed to investigate high levels of reported profits even management did not investigate the stream of large profits even
though they were associated with a low-risk trading strategy. thought it was supposed to be associated with a low-risk strategy.
C
Leeson traded primarily in OTC foreign currency swaps which allowed
Barings to delay cash payments on losing trades until the first payment
was due.
D
The loss at Barings was detected when several customers complained
of losses on trades that were booked to their accounts.
147
Which of the following actions would least likely have prevented the D
148 bankruptcy of Barings’ Bank? All of the statements are correct except for the one relating to

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 A SIMEX. Nick Leeson was eligible to trade on the SIMEX.
Management being more suspicious of huge reported profits.
B
Information on account gains and losses being more transparent.
C
A system of checks and balances being established to detect wildly
speculative positions.
D
All traders being required to meet SIMEX (Singapore International
Monetary Exchange) standards.

Nick Leeson’s now infamous trading strategies in 1994 and 1995 at B

Barings Bank focused on calculated bets on the Nikkei 225. Which of After incurring huge trading losses, Leeson made an effort to
the following trading strategies is not the reason for the staggering
recover those losses by abandoning his original hedged position
losses that ultimately forced Barings into bankruptcy?
I.Long-long futures arbitrage. in a long-short futures arbitrage strategy and initiated a long-long
II.Long straddle. futures position on two trading exchanges. As well, one of his
A
other trading strategies Was selling straddles on the Nikkei 225
I only
B (which would have been profitable had the underlying index
II only holding relatively unchanged).
C
Neither I nor II
D
Both I and II
149
Which of the following are examples of model risk illustrated in the B
Long-term Capital Management case? LTCM's models underestimated the extent to which securities
Ⅰ.Poor management oversight
prices would move together in times of economic crisis. The
Ⅱ.Financial reporting standards
Ⅲ.Ignoring autocorrelation of economic shocks models also failed to anticipate that multiple economic shocks
Ⅳ.Underestimating correlations among asset classes during economic might occur in clusters through time (ie, be positively auto-
crises correlated) as economic history suggests.
150

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 A
II, III, and IV only
B
III and IV only
C
I, II, III, and IV
D
I only

Which of the following statements is accurate about the issue between A

Bankers' Trust and Procter & Gamble (P&G)? The transaction at issue was a complex interest-rate derivative.
A
The "sheer complexity" of the transaction was at the heart of the
The transaction at issue was a complex interest-rate derivative.
B dispute and appears to generally not be in dispute. In regard to
P&G was a new client to Banker's Trust in 1994. (B), P&G "had been entered into such "In regard to (C), P&G was
C
seeking to REDUCE FUNDING COST (consequently that had
The intent of P&G was to implement a tailored hedge.
D directional exposure to a rise in interest rates) and "the derivatives
Banker's Trust asserted its fiduciary role with respect to P&G. were not tailored to any particular needs" Of P&G or Gibson". In
regard to (D), BT asserted that it was NOT acting in an advisory
(fiduciary) role to P&G, since the firm had retained its own outside
experts to create interest rate forecasts. Notice how this issue
resembles Goldman Sachs' position with respect to the ABACUS
151 transaction.
Long-Term Capital Management (LTCM) experienced financial difficulty B
in the late 1990s. Which of the following statements is false regarding LTCM required their investors to invest for three years, such
their troubles?
decreased (not increasing) funding. Although the risk of their
A
The amount of their positions in swaps was very large, but due to positions was quite small in theory, the size of their positions was
offsetting in selling at large discounts. Their repurchase agreements, but the
positions, the amount of their risk was in theory very small.
firm had high leverage which magnified the degree of their losses.
152 B

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 LTCM required their investors to invest for three years, thereby
increasing
funding risk.
C
LTCM obtained financing through repurchase agreements at very
favorable
terms.
D
Due to the size of their positions, LTCM could not liquidate their assets
without selling at large discounts.

Metallgesellschaft Refining and Marketing offered customers long- A

term contracts with fixed prices for petroleum contracts. Their strategy Metallgesellschaft implemented a stack-and-roll hedge strategy,
to hedge this exposure:
which uses short-term futures contracts to hedge long-term risk
A
did not account for funding risk created by a mismatch between the exposure. The stack-and-roll hedge strategy proved ineffective
timing of the hedge cash flows and the contract cash flows. due to interim funding cash outflows created by margin calls, a
B
shift in The market from backwards to contango, and other
failed because of improper internal controls.
C factors. No offsetting interim cash inflows were available on their
was based on fraudulent reporting. long-term customer contracts, creating a liquidity crisis that was
D
suffered from poor diversification. exacerbated by their size of their futures positions in relation to
the liquidity of the market. Themes were not diversification, fraud,
153 or operational controls.
What does Bankers' Trust’s financial disasters due to? C
A Disaster due to conduct of customer business. Miller: "The classic
Disaster due to large market moves.
case of this type [ie, disasters due to the conduct of customer
B
Disaster due to misleading reporting. business] is the Bankers Trust (BT) incident of 1994, when BT was
C sued by Procter & Gamble (P&G And Gibson Greetings. Both P&G
Disaster due to conduct of customer business.
and Gibson claimed that they had suffered large losses in
D
154 All of the above. derivatives trades they had entered into with BT due to being

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 misled by BT as to the nature of the positions. These were trades
on which BT had little market or credit Risk, since it had hedged
the market risk on them with other derivatives and there was no
credit issue of P&G or Gibson being unable to pay the amount
they owed. However, the evidence uncovered in the course of
legal discovery for these lawsuits was severely damaging To BT's
reputation for fair business dealing, led to the resignation of the
firm's CEO, and ultimately had such negative consequences for
the bank's ability to do business that it was forced into an
acquisition by Deutsche Bank, which essentially amounted to a
dismemberment of the firm."
Yasuo Hamanaka, the lead copper trader for Sumitomo, attempted to B
corner the copper market. Since the copper market was relatively Yasuo Hamanaka, the lead copper trader for Sumitomo,
small, Hamanaka had the potential to control and corner it. This trader
established a dominant long position in futures contracts and
did not use which of the following tactics to corner the copper market?
I.Establishing a long dominant position in physical copper. simultaneously purchased large quantities of physical copper. As
II.Establishing a short dominant position in copper futures. the future contracts approached delivery, the party with the short
A
position would find little physical copper available for delivery and
I only
B would be forced to either pay a large premium for physical copper
II only or unwind their short position at unfavorable prices by taking an
C
Both I and II offsetting long futures position. Either way, the price of copper
D and/or copper futures would rise and create handsome profits.
Neither I nor II
155
In late 1993, Metallgesellschaft reported losses of approximately USD A
1.5 billion. In 1992, the company had begun a new strategy to sell Oil prices fell in the fall of 1993 because of OPEC's problems
petroleum to independent retailers, on a monthly basis, at fixed prices
adhering to its producing quotas, so the market changed into one
156 above the prevailing market price for periods of up to 5 and even 10

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 years. At the same time, Metallgesellschaft implemented a hedging of contango so C and D are incorrect. In contango, the futures
strategy using a large number of short-term derivative contracts such
price is above the spot price and as a result Metallgesellchaft
as swaps and futures on crude oil, heating oil, and gasoline on several
exchanges and markets. Its approach was to buy on the derivatives incurred losses on its short-dated long futures contracts so B is
market exposure to one barrel of oil for each barrel it had committed incorrect and A is correct.
to deliver. Because of its choice of a hedge ratio, the company suffered
such large losses with its hedging strategy when oil market conditions
abruptly changed to:
A
Contango, which occurs when the futures price is above the spot price.
B
Contango, which occurs when the futures price is below the spot price.
C
Normal backwardation, which occurs when the futures price is below
the spot price
D
Normal backwardation, which occurs when the futures price is above
the spot price

The high degree of operational risk in the Sumitomo case was A

illustrated by which of the following? The lack of operational oversight gave Sumitomo’s copper
I.Model risk
trader the autonomy to execute large highly - levered transactions
II.Lack of informed supervisors to approve large trades
III.High degree of autonomy, allowing the trader to execute highly in the spot market. The large trades in the both the spot and
levered positions futures market should have required the approval of a supervisor
IV.The trader’s ability to keep two sets of trading books and hide
who was informed about the trader’s strategies and competent
trading losses
A to understand them. The trader’s broad authority allowed him to
II, III and IV manipulate the reporting system and thereby hide his huge
B
losses. Model risk is the risk that a hedging or pricing model is
I only
C flawed, which is not pertinent in this case.
I and IV only
157 D

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 II and III only

A stack-and-roll hedge as described in the Metallgesellschaft case is C

best described as:
A A stack is a bundle of futures contracts with the same expiration.
Buying futures contracts of different expirations and allowing them to
Over time, a firm may acquire stacks with various expiry dates. To
expire in sequence.
B hedge a long-term risk exposure, a firm would close out each
Buying futures contracts of different expirations and closing out the stack as it approaches expiry and enter into a contract with a
position shortly before expiration.
more distant delivery, known as a roll. This strategy is called a
C
Using short-term futures to hedge a long-term risk exposure by stack-and-roll hedge and is designed to hedge long-term risk
replacing them with longer-term contracts shortly before they expire. exposures with short-term contracts.
D
Using short-term futures contracts with a larger notional value than
the long-term risk they are meant to hedge.
158
Which of the following types of operational risk caused substantial B
losses to Barings Bank?
A
Political turmoil
B
Unauthorized trading
C
Massive technology failure
D
Inability to reconcile a new settlement system

159
All of the following are reasons that Nick Lesson engaged in aggressive D
160 speculative trading in the Barings Bank collapse except: The collapse of Barings Bank was not an instance of flawed

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 A hedging models, but one of poor operational control. Leeson had
Barings’ lack of risk management oversight.
previously incurred huge trading losses. In an effort to recover
B
Barings has attempted to recover previous trading losses. those losses, he speculated to recoup these losses. His influence
C and authority in back office operations allowed him to hide his
His authority over settlement operations allowed him to hide trading
speculative losses and report phantom profits. Senior
losses.
D management’s lack of understanding about Leeson’s role and
Barings’ risk management models were flawed. oversight allowed his schemes to go undetected.

Which of the following choices are the result of unauthorized or rogue B

trading except? LTCM was an example of strategies that were deliberately
A
undertaken and approved but that didn’t pay off. LTCM was
Daiwa
B subject to operational risks like model risk, but the trades that led
Long-Term Capital Management to the losses were not unauthorized. Allied Irish Bank involved a
C
rogue trader making foreign exchange trades. Sumitomo’s
Allied Irish Bank
D rogue trading in copper killed it. Daiwa had a fixed income rogue
Sumitomo doing unauthorized trades.
161
In the case of Barings Bank (Barings), Nick Leeson incurred huge D
trading losses. Which of the following statements correctly describes The basic problem at Barings was operation risk control. Nick
one of the factors that led to the bankruptcy of Barings?
Leeson was in charge of trading and settlement, This dual
A
Barings had insufficient liquidity to cover marked to market losses. responsibility allowed him to hide losses by crossing trades at
B fabricated prices. He then booked the profitable side of the trade
Leeson used a long straddle strategy on the Nikkei 225.
in accounts that were reported and the unprofitable side in an
C
Leeson held speculative double short positions in the market for Nikkei unreported account. The lack of supervision also permitted him to
225 futures contracts. shift from hedged trading strategies to speculative strategies in an
D
There was ambiguity concerning who was responsible for performing effort to hide previously incurred losses. Clearly his reporting to
162 specific oversight functions. multiple managers in a convoluted organizational structure led to

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 ambiguity concerning who was responsible for performing
specific oversight functions. Leeson used a short straddle strategy
on the Nikkei 225 and held speculative double long positions in
the market for Nikkei 225 futures contracts. Liquidity was an issue
in the Metallgesellschaft and LTCM cases, not Barings
Which of the following cases of losses was not the result of A
unauthorized or rogue trading? A. LTCM was an example of strategies that were deliberately
A
undertaken and approved but that didn’t pay off. LTCM was
Long-Term Capital Management
B subject to operational risks like model risk, but the trades that led
Allied Irish Bank to the losses were not unauthorized. B. Allied Irish Bank involved a
C
rogue trader making foreign exchange trades. C. Sumitomo’s
Sumitomo
D rogue trading in copper killed it.
Barings
163
Which of the following case stories is frequently associated with the A
inability to maintain hedges and forced liquidation of positions? Metallgesellschaft, a large German industrial company, used a
A
large number of short-term rolling hedges to hedge the cost of
Metallgesellschaft
B fuel and oil. When the cost of oil declined, they did not have the
Barings cash flow to meet the margin calls on the hedges and were forced
C
to liquidate at tremendous losses. Had they been able to meet the
LTCM
D margin calls they would have been vindicated by the rising oil
Daiwa prices in the following years.
164
All of the following are reasons that Nick Lesson engaged in aggressive C
speculative trading in the Barings Bank collapse except: The collapse of Barings Bank was not an instance of flawed
A
hedging models, but one of poor operational control. Leeson had
He has attempting to recover previous trading losses.
165 B previously incurred huge trading losses. In an effort to recover

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 Barings’ lack of risk management oversight. those losses, he speculated to recoup these losses. His influence
C
and authority in back office operations allowed him to hide his
Barings’ risk management models were flawed.
D speculative losses and report phantom profits. Senior
His authority over settlement operations allowed him to hide trading management’s lack of understanding about Leeson’s role and
losses.
oversight allowed his schemes to go undetected.

Which of the following statements is not a consequence of the A

securitization? Securitization transfers the default risk of borrowers to investors,
A
so the originating institutions do not have the incentive to be
Securitization makes originating banks approve and monitor loans
carefully. diligent on the borrowers’ creditworthiness. By tranching,
B securitization could provide low mortgage interest rates to more
Securitization transfers the default risk of the underlying assets to
risk-bearing investors. Securitization can help overcome
investors.
C regulatory hurdles.
Securitization enabled the originating institutions offer lower interest
rates on mortgages.
D
Securitization may allow institutional investors to indirectly hold assets
that they are prevented from holding directly.
166
Which of the following statements about asset-backed securities A
(ABSs) is least accurate? The senior tranche is the lowest-risk tranche but also is the lowest
A
expected return tranche (the equity tranche has the highest risk
The highest expected return, lowest-risk tranche is the senior tranche.
B but offers the highest expected return). All other statements are
The waterfall structure of an ABS alters the priority of principle and accurate.
interest cash flow.
C
A 5% overcollateralization indicates that for every $100 in an ABS
created, $105 in underlying mortgages is required.
D
167 The total cash flow of the underlying mortgages and the total cash flow

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 of the ABS are the same.

Which of the following is not considered as a failure of risk C

management? Failure to minimizing losses is not a failure of risk management.
A
Incorrect measurement of known risks.
B
Failure in communicating risk issues to top management.
C
Failure to minimize losses on credit portfolios.
D
Failure to use appropriate risk metrics.
168
Each of the following choices is a failure of risk management except: A
A Failure to minimizing losses is not a failure of risk management.
Ignore to minimize losses on credit portfolios.
B
Incorrect measurement of known risks.
C
Failure in communicating risk issues to top management.
D
Failure to use appropriate risk metrics.
169
Harriet Fields, an investment adviser specializing in selling municipal C
bonds, advertises on television explaining their safety and security. The Fields violated the Professional Integrity and Ethical Conduct
bonds she is currently selling are limited obligation bonds backed only
section of the Code of Conduct by misrepresenting the bonds as
by the revenue generated from the projects they fund, which include a
housing project and a golf course. Fields tells her prospective clients being safe and secure when in fact they were investing in risky
that the bonds are safe, secure, and offer generous interest payments. projects and backed only by the revenue generated from those
Which of the following statements is most correct regarding Fields’s
projects. According to the Code, GARP Members shall not
actions?
A knowingly misrepresent details relating to analysis,
Fields did not violate the GARP Code of Conduct because municipal recommendations, actions, or other professional activities.
170 bonds are generally regarded as being safe investments.

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 B
Fields violated the part of the GARP Code of Conduct dealing with
confidentiality.
C
Fields violated the GARP Code of Conduct when she misrepresented
the bonds by not explaining their inherent risks.
D
Fields has not violated any of the ethical responsibilities related to the
GARP Code of Conduct.

Bob Hatfield has his own money management firm with two clients. A
The accounts of the two clients are equal in value. It is Hatfields GARP Members shall make a distinction between fact and opinion
opinion that interest rates will fall in the near future. Based upon this,
in the presentation of analysis and recommendations. The analyst
Hatfield begins increasing the bond allocation of each portfolio. In
order to comply with Best Practices in the GARP Code of Conduct, the must inform the clients of the change and tell them it is based
analyst needs to: upon an opinion and not a fact.
A
inform the clients of the change and tell them it is based upon an
opinion and not a fact.
B
make sure that the change is identical for both clients.
C
file a report with the SEC of the new portfolio allocation.
D
perform all of these functions
171
Jack Schleifer, FRM, is an analyst for Brown Investment Managers D
(BIM). Schleifer has recently accepted an invitation to visit the facilities GARP members must not offer, solicit, or accept any gift, benefit,
of ChemCo, a producer of chemical compounds used in a variety of
compensation, or consideration that could be reasonably
industries. ChemCo offers to pay for Schleifer’s accommodations in a
penthouse suited at a luxury hotel and allow Schleifer to use the expected to compromise their own or another’s independence
firm’s private jet to travel to its three facilities located in New York, and objectivity. Schleifer has appropriately rejected the offer of
Hong Kong, and London. In addition. ChemCo offers two tickets to a
the hotel accommodation and the use of ChemCo’s jet.
172 formal high-society dinner in New York. Schleifer declines to use

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 ChemCo’s corporate jet or to allow the firm to pay for his However, Schleifer cannot accept the tickets to the dinner. Since it
accommodations but accepts the tickets to the dinner (which he
is a formal high-society dinner, the tickets are most likely
discloses to his employer) since he will be able to market his firm’s
mutual funds to other guests at the dinner. Has Schleifer violated the expensive or hard to come by. Even though he has disclosed the
GARP Code of Conduct? gift to his employer and he plans to use the dinner as a marketing
A
opportunity for his firm, the gift itself may influence Schliefer’s
No, since he is using the gifts accepted to benefit his employer’s
interests. future research in favor of ChemCo. Allowing such potential
B influence is a violation of Professional Integrity and Ethical
No, since the gift he accepted was fully disclosed in writing to his
Conduct.
employer.
C
No, since the gift he accepted is of nominal value and he declined to
accept the hotel accommodations and the use of ChemCo’s jet.
D
Yes.

When an analyst makes an investment recommendation, which of the D

following statements must be disclosed to clients? Standard VI (A), disclose of conflicts.
A
The firm is a market maker in the stock of the recommended company.
B
An employee of the firm holds a directorship with the recommended
company.
C
The analyst’s farther in law has a material ownership in the security.
D
All of these statements must be disclosed to clients.
173
Preservation of Confidentiality applies to the information that an B
analyst learns from: According to Standard 3.1 and 3.2, a member shall not make use
A
of confidential information for inappropriate and unless having
current clients and former clients only
174 B received prior consent shall maintain the confidentiality of their

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 current clients, former clients and prospects work, their employer or client.
C
former clients and prospects only
D
current clients and prospects only

Gail Stefano, FRM, an analyst for a U.S. brokerage firm that serves U.S. A
investors, researches public utilities in South American emerging Historical growth can be cited as a fact since it actually happened.
markets. Stefano makes the following statement in a recent report:
Stefano states that her firm expects further profitability which is
“Based on the fact that the South American utilities sector has seen
rapid growth in new service orders, we expect that most companies in an option. She does not claim that these are facts. Thus, she is not
the sector will be able to convert the revenue increases into significant in violation of standard 5.4. In addition, Stefano identifies relevant
profits. We also believe the trend will continue for the next three to
factors and highlights in particular the most significant risks of
five years.” The report goes on to describe the major risks of investing
in this market, in particular the political and exchange rate instability investing in South American utilities. She has fully complied with
associated with South American countries. Stefano: standard 5.3.
A
Has not violated the Code.
B
Violated the Code by failing to properly distinguish factual information
from opinions.
C
Violated the Code by recommending an investment which would not
be suitable for all of its clients.
D
Violated the Code by failing to properly identify details related to the
operations of South American utilities.
175
Will Lambert, FRM, is a financial risk analyst for Offshore Investment; A
he is preparing a purchase recommendation on Burch Corporation. GARP members should make full and fair disclosure of all matters
According to the GARP Code of Conduct, which of the following
that could reasonably be expected to impair independence and
statement about disclosure of conflicts is most correct? Lambert would
have to disclose that: objectivity or interfere with respective duties to their employer,
176 A clients, and prospective clients.

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 All of these choices require disclosure.
B
His wife owns 2000 shares of Burch Corporation.
C
Offshore is a an OTC market maker for Burch Corporation’s stock.
D
He has a material beneficial ownership of Burch Corporation through a
family trust.

A bank credit analyst concludes that, if specific pending legislation is A

enacted this year, defaults in the banking sector are likely to increase.
Alter publishing these findings, the analyst attends an industry
networking event and tells several colleagues that the banking sector
will soon experience rising defaults. Which aspect of the GARP Code of
Conduct has been violated?
A
GARP members shall be diligent about not overstating the accuracy or
certainty of results or conclusions.
B
GARP members must disclose any actual or potential conflict of
interest to all potential parties.
C
GARP members must not use confidential information to benefit
personally.
D
GARP members shall be familiar with current generally accepted risk
management practices.
177
Over the past two days, Lorraine Quigley, FRM, manager of a hedge D
fund, has been purchasing large quantities of Craeger Industrial Quigley’s trades are most likely an attempt to take advantage of
Products’ common stock while at the same time shorting put options
an arbitrage opportunity that exists between Craeger’s common
on the same stock. Quigley did not notify her clients of the trades
although they are aware of the fund’s general strategy to generate stock and its put options. She is not manipulating the prices of
178 returns. Which of the following statements is most likely correct? securities in an attempt to mislead market participants. She is

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 Quigley: pursuing a legitimate investment strategy. Participants in her
A
hedge fund are aware of the fund’s investment strategy, and
Violated the Code by manipulating the prices of publicly traded
securities. thus Quigley did not violate the Code by not disclosing this
B specific set of trades in advance of trading.
Violated the Code by failing to disclose the transactions to clients
before they occurred.
C
Violated the Code by failing to establish a reasonable and adequate
basis before making the trades.
D
Did not violate the Code.

Isabelle Burns, FRM, is an investment advisor for a firm whose client C

base is composed of high net worth individuals, in her personal Standards 2.1 and 2.2: Conflicts of Interest. Members and
portfolio, Burns has an investment in Torex, a company that has
candidates must act fairly in all situations and must fully disclose
developed software to speed up Internet browsing. Burns has
thoroughly researched Torex and believes the company is financially any actual or potential conflict to all affected parties. Sell-side
strong yet currently significantly undervalued. According to the GARP members and candidates should disclose to their clients any
Code of Conduct, Burns may:
ownership in a security that they are recommending.
A
Not recommend Torex as long as she has a personal investment in the
stock.
B
Not recommend Torex to a client unless her employer gives written
consent to do so.
C
Recommend Torex to a client, but she must disclose her investment in
Torex to the client.
D
Recommend Torex to a client without disclosure as long as it is a
suitable investment for the client.
179
180 WEB, an investment-banking firm, is the principal underwriter for A

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 MTEX’s upcoming debenture issue. Lynn Black, FRM, is an analyst Standards 3.1 and 3.2 relate to the preservation of confidentiality.
with WEB, and she learned from an employee in MTEX’s
The simplest, most conservative and most effective way to comply
programming department that a serious problem was recently
discovered in the software program of its major new product line. In with these Standards is to avoid disclosing any information
fact, the problem is so bad that many customers have canceled their received from a client, except to authorize fellow employees who
orders with MTEX. Black checked the debenture’s prospectus and are also working for the client. If the information concerns illegal
found no mention of this development. The red herring prospectus has
already been distributed. According to the GARP Code of Conduct, activities by MTEX, Black may be obligated to report activities to
Black’s best course of action is to: authorities.
A
Inform her immediate supervisor at WEB of her discovery.
B
Keep quiet because this is material nonpublic inside information.
C
Notify potential investors of the omission on a fair and equitable basis.
D
Report her discovery to the Division of Corporation Finance of the
Securities and Exchange Commission.

Which of the following are potential consequences of violating the B

GARP Code of Conduct once a formal determination that such a According to the GARP Code of Conduct, violation(s) of the Code
violation has occurred is made? I.Suspension of the GARP Member
may result in the temporary suspension or permanent removal of
from GARP’s member roles.
II.Suspension of the GARP Member’s right to work in the risk the GARP Member from GARP’s Membership roles, and may also
management profession. include temporarily or permanently removing from the violator
III.Removal of the GARP Member’s right to use the FRM designation
the right to use or refer to having earned the FRM destination or
or any other GARP granted designation.
IV.Required participation in ethical trading. any other GARP granted destination, following a formal
A determination that such a violation has occurred.
I and II only
B
I and III only
C
181 II and IV only

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 D
III and IV only

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