[ 2009 FRM ] Medium Practice Exam 2 Q31-35

31. A situation where the existence of insurance changes the behavior of economic agents is referred to as:

A. Asymmetric information

B. Externalities

C. Moral hazard

D. Regulatory arbitrage

Correct answer is C

The question is a definition of moral hazard:  fficeffice" />

A is incorrect.  Asymmetric information describes the situation in which two parties have different amounts of information.  For example, one party in a negotiation is not in the same position as another party, being ignorant of, or unable to observe, some information, which is essential to the contracting and decision making process.

B is incorrect.  An externality occurs when the action of one party affects the payoffs of other parties.

C is correct.  The presence of a safety net, such as insurance, encourages adverse or careless behavior.  For example, once insurance is bought, the purchaser has less incentives to control his/her loss.

D is incorrect.  Regulatory arbitrage attempts to defeat onerous capital requirements mandated by bank regulators.

Reference: Understanding Market, Credit, and Operational Risk, Allen, Boudoukh and Saunders, 2004 (pg. 186).

32. ABC Life Company acts as the fund manager for a number of defined-benefit pension plans. Its specialty is to construct portfolios such that the surplus of the plan has low volatility. To do that, ABC must construct portfolios that behave most like

A. a long position in a fixed-rate bond.

B. a short position in a floating-rate bond.

C. a long position in a floating-rate bond.

D. a short position in a fixed-rate bond.

Correct answer is D

'A defined benefit obligation for a life company behaves very much like a short position in a fixed rate bond' ? quote from the chapter.

Type of Question: Risk Management and Investment Management (risk management issues of pension funds)

33. The Big Bucks Hedge fund has the following description of its activities. It uses simultaneous long and short positions in equity with a net beta close to zero.

Which of the following statements about Big Bucks are correct?

i) It uses a directional strategy.

ii) It is a relative value hedge fund.

iii) This fund is exposed to idiosyncratic risks.

A. i and ii

B. ii and iii

C. i and iii

D. ii only

Correct answer is B

The fund is an equity market neutral hedge fund.

This type of fund is nondirectional and is exposed to idiosyncratic, stock specific risks.

Type of Question: Risk Management and Investment Management (risks of specific strategies)

34. Which of the following statements about the Treynor ratio is correct?

A. The Treynor ratio considers both systematic and unsystematic risk of a portfolio.

B. The Treynor ratio is equal to the excess return of a portfolio over the risk-free rate divided by the total risk of the portfolio.

C. The Treynor ratio can be used to appraise the performance of well-diversified portfolios.

D. The Treynor ratio is derived from portfolio theory since it assesses a portfolio's excess return relative to its risk.

Correct answer is C

A.  is incorrect ? Treynor ratio considers only systematic risk of a well-diversified portfolio

B.   is incorrect ? Treynor ratio denominator is beta of the portfolio

C.   is correct ? this statement is correct

D.   is incorrect ? Treynor ratio is derived from CAPM and not portfolio theory

Reference: Portfolio Theory and Performance Analysis Chapter 4

Type of Question: Risk Management and Investment Management (return metrics)

35. Which of the following statements about the Sharpe ratio is false?

A. The Sharpe ratio considers both the systematic and unsystematic risks of a portfolio.

B. The Sharpe ratio is equal to the excess return of a portfolio over the risk-free rate divided by the total risk of the portfolio.

C. The Sharpe ratio cannot be used to evaluate relative performance of undiversified portfolios.

D. The Sharpe ratio is derived from the Capital Market Line.

Correct answer is C

A is incorrect ? this statement is true.  Sharpe ratio considers the total risk of an undiversified portfolio

B is incorrect ? this statement is true

C is correct ? this statement is false.  Sharpe ratio can evaluate relative performance of an undiversified portfolio