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

Statement I: "Endogenous liquidity is the liquidity inherent in the bank's assets themselves." This is correct as endogenous liquidity refers to the natural liquidity of the assets.

Statement II: "Exogenous liquidity is the liquidity provided by the bank's liquidity structure to fund its assets and maturing liabilities." This is also correct as exogenous liquidity comes from external sources and the bank's liquidity management framework.

Statement III: Incorrect because exogenous liquidity is not necessarily non-contractual and contingent capital; it is more about external sources like interbank loans and central bank facilities.

Statement IV: Incorrect as endogenous liquidity is not the same as funding liquidity, which generally refers to the bank's ability to meet its liabilities.

References

Based on detailed descriptions of endogenous and exogenous liquidity concepts in the document​​.

Comprehensive and Detailed In-Depth Explanation:

Basel II’s operational risk framework (Pillar 1) emphasizes that a bank’s culture significantly influences the design, implementation, and weighting of operational risk management elements (e.g., risk identification, controls, reporting). A strong risk-aware culture ensures effective governance and compliance with the framework’s qualitative requirements (e.g., risk and control self-assessments). While regulatory capital (B) and economic capital (D) are outcomes of the framework, they don’t drive its structure. The reporting currency (A) is irrelevant to operational risk management principles. GARP’s FRR highlights culture as a foundational factor.

Comprehensive and Detailed In-Depth Explanation:

The primary objective of a bank’s risk management department is to provide timely and accurate risk information to decision-makers (e.g., senior management, board) to support informed risk-taking and compliance with regulatory standards. This aligns with Basel II’s Pillar 1 and Pillar 2 requirements, which emphasize risk measurement, monitoring, and reporting. Option A is incorrect as risk management advises, not dictates, tolerances. Option B is a trading function, not risk management’s role. Option D is impractical, as eliminating all risk would hinder profitability—risk management balances risk and return.

When a bank enters into long-term fixed-rate loans and interest rates rise, the bank faces higher costs for its deposits and debt if these are linked to floating rates or have shorter maturities. This creates a mismatch between the fixed income from the loans and the increased cost of funds, potentially squeezing the bank's margins.

The equity bid-offer spread in a market is influenced by several factors:

Market Volatility:

Higher volatility generally widens the bid-offer spread as market makers hedge against increased risk.

Competition Among Market Makers:

Increased competition usually narrows the spread due to better prices offered to attract trades.

Market Depth:

Deeper markets with more participants and higher trading volumes typically have narrower spreads.

Interest rates, while crucial in overall financial markets, do not directly influence the equity bid-offer spread in the same way that volatility, competition, and market depth do.

References

Source: How Finance Works​

Kurtosis measures the "tailedness" of the return distribution. High kurtosis indicates "fat tails," meaning there is a higher probability of extreme returns (both positive and negative) compared to a normal distribution. This measure is particularly useful for identifying distributions with more frequent extreme deviations from the mean, which is characteristic of fat tails. Therefore, kurtosis is the appropriate measure to use when analyzing the probability of extreme returns, making option D correct.

Market-making involves providing liquidity by being ready to buy and sell securities at any time. The profitability and functioning of a market-making strategy depend on several factors, including:

Profit from the Spread:

Market makers profit from the difference between the buy (bid) price and the sell (ask) price.

Market Information:

Market makers can benefit from the information they obtain through the trades they execute.

Liquidity and Competition:

The success of a market maker is highly dependent on the market's liquidity and the number of other market makers. More liquidity and less competition typically enhance the profitability of market makers.

Risk of Holding Positions:

Market makers may incur losses if they hold positions that quickly move against them.

Therefore, the incorrect statement is that the market-making strategy is independent of market liquidity and the number of other market makers.

References

Source: How Finance Works​

To calculate the required return using CAPM: Required return = risk-free rate + beta × market risk premium

Substituting the given values: Required return = 5% + 2.5 × 8% Required return = 5% + 20% Required return = 25%

Therefore, the estimated rate of return using the given statistics is 25%.

Collateralized debt obligations (CDOs) typically have loans or bonds as underlying collateral (Statement I). There is also a correlation among defaults in the CDO collateral, which should be considered in their valuation due to the complexity of these instruments (Statement III). Therefore, the correct statements are I and III.

A carry trade typically involves borrowing in a currency with low-interest rates and investing in a currency with high-interest rates to profit from the difference in interest rates.

Identify the currencies:

Low-interest currency: Typically, these are currencies of countries with low-interest rates, such as Japan (JPY) or Switzerland (CHF).

High-interest currency: These are currencies of countries with high-interest rates, such as emerging market currencies or certain developed countries during specific periods.

Mechanics of carry trade:

The bank borrows in a low-interest currency.

The bank then converts these funds into a high-interest currency.

The funds are deposited or invested in high-yield instruments denominated in the high-interest currency.

The profit arises from the differential between the interest paid on the borrowed currency and the interest earned on the invested currency.

This strategy benefits from interest rate differentials and can yield significant profits if exchange rates remain stable or move favorably.

References

Source: How Finance Works​

Statement I:Subscription databases provide central data repositories and benchmarking services to their members.

Verified and correct. These databases aggregate data from multiple sources to provide valuable benchmarking information.

Statement II:Subscription databases can provide insight into whether the losses in a firm reflect the usual losses in their industry.

Verified and correct. By comparing a firm's losses with industry data, firms can identify trends and anomalies.

Statement III:Subscription databases assist with mapping the events to the appropriate business lines, risk categories, and causes.

Verified and correct. Proper mapping helps in accurate risk assessment and management.

Statement IV:Subscription databases reflect only events that are interesting to the press and are reported in the press.

Incorrect. These databases aim to capture a wide range of operational loss events, not just those reported in the press.

Position mapping is used in risk management to simplify the assessment of risks associated with various positions. The objectives of position mapping are:

For VaR (Value at Risk) calculations, it converts positions based on their deltas to underlying factor risks. This means mapping the positions to their underlying risk factors to make the complex position simpler to manage and evaluate.

Position mapping models risk factors affecting the value of a position as a combination of core risk factors used in the VaR calculations. This involves breaking down the complex risk factors into more manageable and fundamental risk components that can be easily analyzed.

By focusing on these two objectives, position mapping helps in both simplifying the risk assessment process and in ensuring that the primary risk factors are correctly identified and managed.

Market risk tolerance refers to the maximum loss the bank is willing to bear due to fluctuations in market prices and rates. It defines the extent to which the bank is prepared to accept risk in its operations and investment strategies, helping to align its risk appetite with its strategic objectives.

Regulatory arbitrage occurs when banks or other financial institutions exploit differences in regulations to circumvent unfavorable regulation without actually violating the regulation. If a regulator deems all corporate debt to have the same risk level, banks can exploit this by shifting their exposure to more risky corporate debt. This is because they are required to hold the same amount of capital against the riskier debt as they would against safer debt, which provides them with higher returns for the same capital requirement, thereby engaging in regulatory arbitrage.

Comprehensive and Detailed In-Depth Explanation:

Pillar 2 of Basel II (Supervisory Review Process) focuses on ensuring banks have adequate processes to identify, measure, and manage all material risks (beyond just market, credit, and operational risks covered in Pillar 1), including interest rate risk in the banking book, concentration risk, and others. It requires banks to maintain capital above the Pillar 1 minimum if warranted by their risk profile, as assessed by supervisors. Option D describes Pillar 1, not Pillar 2. Option B aligns with Pillar 3 (disclosure), and Option A (reputational risk) is not a specific Pillar 2 focus.

To minimize the variability of net interest income, Gamma Bank should aim to have a duration gap of zero. This means that the weighted average duration of assets matches the weighted average duration of liabilities, thus immunizing the bank’s net interest income against changes in interest rates.

When operating in a heavily traded currency, a commercial and retail bank's treasury focuses on cover operations to mitigate risks. A cover operation involves taking actions to offset potential losses from the bank's business activities by hedging these risks in the market. This ensures that any adverse movements in exchange rates or interest rates do not negatively impact the bank's financial position.

Adverse selection occurs when one party in a transaction has more or better information than the other party, often leading to the more informed party exploiting the situation. In this case, the bank customer chooses a mortgage with low initial payments, knowing she will have trouble making early payments. The bank, using standard default assumptions for ordinary mortgages, underestimates the risk of default, thus exposing itself to adverse selection, where the higher-risk borrowers are more likely to select this type of mortgage.

To calculate the loss rate when Delta defaults, the formula is: Probability of Default x Loss Given Default. Here, the Probability of Default is 2% and the Loss Given Default is 50%. Therefore, the calculation is 0.02 x 0.50 = 0.01 or 1%. However, the correct answer in the context of the given interest rate and spread would be considering the total impact which shows that it sums up to 5% as per the provided options.