2016-FRR GARP Financial Risk and Regulation (FRR) Series Free Practice Exam Questions (2025 Updated)

Explanation:

Convexity measures the sensitivity of the duration of a bond to changes in interest rates. It is a measure of the curvature in the relationship between bond prices and yields, indicating how the duration of a bond changes as the yield changes.

ReferencesExplanation based on financial risk management principles.

Option A:The loss data entry must include the actual loss amount.

Correct as it ensures accurate financial impact recording.

Option B:The loss data program must comprehensively capture all material activities.

Correct, necessary for a thorough risk management program.

Option C:The loss data entry should only include the date when the event was reported.

Incorrect, as it is essential to capture both the event date and the report date to understand the timeline of the incident.

Option D:The loss data entry may include descriptive information about the drivers or causes of the loss event.

Correct, as it provides context and insights into the root causes, aiding in risk analysis and prevention.

To perform foreign exchange matched position trading, Alpha Bank should match the customer's transaction to eliminate currency risk. Here’s the breakdown:

Customer transaction: The customer buys AUD 1,010,000 at a rate of 101 for BRL 100 million.

Market transaction: To cover this, Alpha Bank should buy BRL at the market rate of 100, paying AUD 1,000,000 (BRL 100 million / 100 = AUD 1,000,000).

This ensures that the bank is not exposed to fluctuations in the BRL/AUD exchange rate.

References

Source: How Finance Works​

Most exchange-traded equity options in the U.S. typically have the American exercise feature. This feature allows the holder to exercise the option at any time before and including the expiration date, providing greater flexibility compared to the European exercise feature, which only allows exercise at expiration. The Asian and shout option features are less common and not typically associated with exchange-traded equity options.

Comprehensive and Detailed In-Depth Explanation:

Scenario analysis assesses rare, high-severity operational loss events (e.g., major fraud, natural disasters) to estimate potential capital needs under Basel II’s AMA. Option A is correct. Option B is false—scenario analysis targets severe events, unlike RCSA, which identifies frequent risks. Option C is incorrect—external data is often used (Basel II, para. 671). Option D is wrong—scenarios include hypothetical events beyond current experience.

Exact Extract from Official Source:

BCBS, "Basel II: International Convergence of Capital Measurement and Capital Standards," June 2006, para. 672: "Scenario analysis is used to evaluate exposure to high-severity events… It complements historical loss data by considering rare but plausible loss scenarios."

GARP FRR Study Notes, Operational Risk Section: "Scenario analysis focuses on tail events—high-impact, low-frequency losses—distinguishing it from RCSA’s focus on routine risks."

Regulatory standards impose formulaic capital calculations for all of the bank's activities to ensure:

Comparability Across Banks: Different models used by banks would make it difficult for regulators to compare results across banks.

Comprehensive Risk Assessment: Standardized calculations help ensure that banks are not missing key risks in their calculations.

Avoiding Gaming of the System: Standardized calculations prevent banks from using capital calculations to game the banking regulation system, ensuring consistency and fairness.

References

Source: How Finance Works​

A $10,000,000 loan to IBM worth $9,800,000 would most likely not be included in the trading book. Loans held to maturity are generally part of the banking book rather than the trading book, which typically includes assets intended for trading and short-term profit.

US-based Alpha Bank holding European corporate bonds and US inflation-indexed Treasury notes in its investment portfolio would not be exposed to changes inequity values. This is because the investment portfolio consists of bonds and notes, which are fixed income securities and not related to equity market movements.

The modified duration of a bond portfolio is calculated as the value-weighted average of the modified durations of the component bonds. This approach accounts for the proportion of the total portfolio value that each bond represents, providing a more accurate measure of the portfolio's sensitivity to changes in interest rates.

According to Basel II Accord's operational risk categories, Business Continuity Planning (BCP) activities that fall within operational risk include:

Damage to Physical Assets: This covers risks related to the physical destruction or damage to bank assets.

Business Disruption and System Failures: This includes risks associated with operational disruptions and failures in systems that support business activities.

Comprehensive and Detailed In-Depth Explanation:

Correlation measures the strength and direction of the linear relationship between two variables, typically expressed as a coefficient between -1 (perfect negative correlation) and +1 (perfect positive correlation), with 0 indicating no linear relationship. In financial risk management, correlation is critical for assessing portfolio diversification and systemic risk (e.g., in Basel’s credit risk models). Option B accurately describes this as the "association" and "strength of a possible statistical relationship." OptionA (symmetry) relates to distribution properties, not correlation. Option C (joint variability) is a consequence of correlation but not its definition. Option D (extreme returns) pertains to tail dependence, not general correlation. GARP’s FRR materials align with this statistical definition.

Risk and Control Self-Assessments (RCSA) distinguish themselves from other types of assessments because they include both a risk assessment and a control assessment. This combined approach allows for a comprehensive view of both the potential risks and the effectiveness of the controls in place to mitigate those risks.

Back testing VaR models involves comparing the predicted losses (VaR estimates) with the actual daily profits and losses to assess the accuracy and reliability of the VaR model. This process helps in validating whether the model is effective in predicting risk and in identifying any discrepancies between predicted and actual outcomes. Therefore, the correct statement about back testing the VaR models is option B.

Standard operational risk definitions typically include human errors (I), process failure (II), and systems failure (III). Unexpected events (IV) are generally considered in broader risk categories but are not standard elements of operational risk definitions.

When evaluating a diversified equity portfolio, an endowment asset manager should consider:

Company-specific projected earnings and earnings risk to understand the performance potential and variability of individual assets.

Aggregate earnings expectations to gauge the overall market outlook and economic conditions affecting the portfolio.

Individual asset volatility to assess the risk and potential fluctuations in the value of specific investments within the portfolio.

Market liquidity, while important, is not typically a primary concern for long/short equity strategies focused on diversified portfolios.

Activities typically used to develop an operational risk framework include planning, training, and auditing. Marketing is not typically used to develop an operational risk framework, as it is more relevant to the promotion of products and services rather than the establishment of risk management processes and structures.

Risk and control self-assessments (RCSA) have several advantages:

They provide insight into risks that exist in a firm but may not have occurred before (II).

They allow each department to take ownership of its own risks and controls (IV). However, RCSA may not always provide very accurate scoring of risks and controls due to its subjective nature (I), and while it can produce biased operational risk reporting, the primary advantage is the transparency it offers, not the bias (III).

To determine the VaR for the fully leveraged position, we need to understand how leverage affects VaR. Leverage magnifies both returns and risks, which means that the VaR for a leveraged position is greater than that of an unleveraged position.

Calculate the leverage ratio:

In a repurchase transaction with a 20% haircut, 20% of the asset's value must be provided as collateral, meaning 80% can be borrowed.

Leverage ratio LLL = 1Haircut\frac{1}{\text{Haircut}}Haircut1​ = 10.2\frac{1}{0.2}0.21​ = 5.

Calculate the leveraged position:

If the initial unleveraged position is $100, then the leveraged position is $100 \times 5 = $500.

Calculate the VaR for the leveraged position:

The unleveraged VaR is $30 on $100.

Therefore, the leveraged VaR will be magnified by the leverage ratio: Leveraged VaR=Unleveraged VaR×Leverage Ratio\text{Leveraged VaR} = \text{Unleveraged VaR} \times \text{Leverage Ratio}Leveraged VaR=Unleveraged VaR×Leverage Ratio = $30 \times 5 = $150.

References

Source: How Finance Works​

Identify the strategies for achieving leverage in long positions:

I. Securities may be purchased with borrowed funds using a bank loan from the broker.

This is a common method known as margin trading, where an investor borrows money from a broker to purchase securities.

II. Securities may be borrowed on margin by taking a loan from a broker.

This is another form of margin trading where the securities themselves are used as collateral for the loan.

III. Securities may be purchased and used in a repo transaction to generate cash for further security purchases.

In a repurchase agreement (repo), securities are sold with an agreement to buy them back at a later date, providing immediate liquidity for further investments.

IV. The bank may enter into a derivative transaction, such as a total return swap, that requires little to no collateral but mimics the performance of a long or short position in the underlying instrument.

Derivatives like total return swaps allow for exposure to the performance of an asset without owning it, often with minimal collateral requirements.

Explanation:

All the listed strategies (I, II, III, IV) are valid methods for a bank to achieve leverage in long positions. They involve different mechanisms of borrowing funds or utilizing existing assets to increase the potential return on investment.