Free Practice Questions for GARP 2016-FRR Exam

Beta measures the responsiveness of a particular equity or equity portfolio to the overall market.

It captures the correlation between the returns of the equity portfolio and the market returns, indicating how much the portfolio's value changes in response to market movements.

When a proprietary trading desk hedges an Arab light OTC forward position with Brent crude oil forwards, they face basis risk. This is because the underlying commodities (Arab light and Brent crude oil) are different and may not move perfectly in sync, leading to a potential mismatch in the hedge.

References

Verified based on the discussion of basis risk in commodity trading provided in the book "How Finance Works"​​.

Collateralized mortgage obligations (CMOs) are a type of asset-backed security that pools together mortgages and then issues tranches with different maturities and levels of risk. They do not have CDOs as their underlying collateral; instead, they are backed by mortgage loans. Therefore, the statement that CMOs have pools of CDOs as underlying collateral is incorrect.

Option A:A company can have differing operational loss data collection and reporting thresholds for different departments.

Verified and correct. Different departments might have various risk exposures and thresholds based on their specific operational risk profiles.

Option B:The operational loss data collection program has to capture all losses regardless of their size.

Incorrect. A minimal loss threshold is usually set to avoid the administrative burden of capturing immaterial losses. Companies typically set thresholds based on risk appetite and regulatory requirements.

Option C:Setting an operational loss data collection threshold depends on the risk appetite of the firm and regulatory requirements it needs to meet.

Verified and correct. Thresholds are set based on the company's risk appetite and regulatory expectations to ensure effective and efficient loss data collection.

Option D:The operational loss data collection program must include all material losses that are above the minimal gross loss threshold.

Verified and correct. Only losses above the set threshold are required to be captured to maintain a focus on material risks.

Derivatives have several advantages over cash instruments in hedging transactions. These include:

Lower Credit Risk:

Derivatives, especially exchange-traded ones, often have lower credit risk because the clearinghouse guarantees the performance of the contract.

Lower Funding Requirements:

Derivatives typically require lower upfront capital than buying or selling the underlying cash instruments directly. This is due to the leverage they offer, where only a margin is required instead of the full value of the position.

Lower Dealing Costs:

Trading derivatives can be cheaper in terms of transaction costs compared to trading the underlying cash instruments. This is especially true for large positions or frequent trading.

Lower Capital Charges:

Regulatory capital requirements for derivatives can be lower compared to cash instruments because derivatives can be used to hedge and reduce overall portfolio risk, thereby reducing capital charges under regulatory frameworks.

References

Source: How Finance Works​

Comprehensive and Detailed In-Depth Explanation:

PV01 (Present Value of a 1 basis point change) measures the change in a portfolio’s value for a 1 bp (0.01%) shift in interest rates, assuming a linear relationship. Its weakness is that it fails to capture non-linear effects (e.g., convexity) for large interest rate changes, where the actual value change deviates from the linear approximation. Option A is incorrect as PV01 ignores convexity, not overestimates it. Option C is false as PV01 is accurate for small changes. Option D is incorrect as PV01 is computationally simple. GARP’s FRR confirms this limitation in interest rate risk analysis.

Net Interest Income Calculation:

As previously calculated, the net interest income is $9 million per year.

Present Value of Perpetuity Formula:

Present Value (PV) = Net Interest Income / Discount Rate

PV = $9 million / 0.05 = $180 million

Correction:

The net interest income was stated as $9 million earlier, but here, let's verify this calculation:

Interest income from $120 million at 10% = $12 million

Interest expense on $100 million at 3% = $3 million

Net interest income = $12 million - $3 million = $9 million

Correct Present Value Calculation:

PV = $9 million / 0.05 = $180 million

Final Verification:

The previous net interest income used is correct and the final PV calculation should stand corrected as per the perpetual formula:

PV = $9 million / 0.05 = $180 million, confirming the right choice should be $180 million.

References

Source: How Finance Works​

Initial Margin Calculation: The bank takes a long position requiring a 2% margin. For futures contracts priced at $50 per barrel, the margin required per barrel is 0.02×50=10.02 \times 50 = 10.02×50=1 dollar.

Profit Calculation: The price rises from $50 to $55 per barrel, making a profit of 55−50=555 - 50 = 555−50=5 dollars per barrel.

Return Calculation:

Return on Investment (ROI) without considering risk: 51=5\frac{5}{1} = 515​=5 or 500%.

Risk-Adjusted Return:

VaR (Value at Risk) on the position is estimated to be $10.

Risk-adjusted return formula: ProfitVaR=510=0.5\frac{Profit}{VaR} = \frac{5}{10} = 0.5VaRProfit​=105​=0.5 or 50%.

References

Source: How Finance Works​

James is managing a loans portfolio and must evaluate which loans to keep or sell. The most likely loan to be sold is one made to a highly risky borrower, even if it is fully collateralized by the customer's deposits. This is because, despite the collateral, the high risk associated with the borrower could lead to potential problems and higher costs for the bank in the future. Selling this loan transfers the risk to another bank and frees up resources for potentially more profitable and less risky loans.

Skewness measures the asymmetry of the return distribution. Positive skewness indicates a distribution with a longer or fatter right tail, while negative skewness indicates a distribution with a longer or fatter left tail. It is the correct measure for describing the symmetry of a statistical distribution.