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FRM Updated
How do cross-currency swaps actually work, and why is the notional exchanged unlike regular interest rate swaps?
Cross-currency swaps are fundamentally different from plain IRS because they involve two different currencies, so netting the notional makes no sense. At inception, parties exchange notionals at the spot rate and re-exchange them at maturity at the original rate.
How is factor-based VaR used in stress testing and scenario analysis?
Factor-based stress testing applies extreme scenario shocks to portfolio factor sensitivities, producing estimated P&L impacts. Historical scenarios replay actual crises, while hypothetical scenarios design specific shocks. Multi-factor consistency is critical — factor correlations typically spike during stress.
What is wrong-way risk and how do you measure it?
Wrong-way risk occurs when exposure to a counterparty increases simultaneously with their default probability. Specific WWR involves a direct causal link; general WWR arises from broad economic factors. It is measured through exposure-default correlation, alpha multipliers, or conditional exposure analysis.
What is cointegration and how is it used in pairs trading?
Cointegration means two non-stationary series have a stationary linear combination — they share a long-term equilibrium. Unlike correlation (short-term co-movement), cointegration implies the spread is mean-reverting, enabling pairs trading strategies.
How are credit-linked notes (CLNs) structured and who benefits from them?
A credit-linked note (CLN) is a funded credit derivative where the investor buys a bond with an embedded CDS. The investor receives enhanced coupons but absorbs credit losses if the reference entity defaults. CLNs reduce counterparty risk compared to unfunded CDS.
How are recovery rates modeled in practice and what factors affect LGD estimation?
Recovery rate modeling is crucial because Loss Given Default directly scales expected and unexpected credit losses. Key factors include seniority of the claim, industry sector, economic conditions at default, and the legal framework of the jurisdiction.
What is model calibration in risk management and how do you avoid overfitting?
Model calibration adjusts parameters to match current market data, while estimation fits to historical data. Overfitting occurs when the model memorizes noise rather than capturing real patterns, leading to poor out-of-sample performance. Key defenses include parsimony, cross-validation, and economic constraints.
How do catastrophe bonds and insurance derivatives transfer risk to capital markets?
Catastrophe bonds allow insurers to transfer tail risk to capital markets through an SPV structure. Investors receive high coupons (SOFR + 700-1200bps) in exchange for bearing the risk of losing principal if a qualifying catastrophic event occurs.
How is Basel III regulatory capital structured, and what is the loss-absorption waterfall?
Basel III regulatory capital is structured in a loss-absorption waterfall: CET1 (common equity) absorbs losses first, followed by CET1 buffers, AT1 contingent convertibles, Tier 2 subordinated debt, and TLAC-eligible senior debt. Each layer has specific instruments, minimum requirements, and triggers.
Why is Expected Shortfall considered superior to VaR, and what makes a risk measure 'coherent'?
Expected Shortfall (ES) is superior to VaR because it satisfies all four properties of a coherent risk measure, including subadditivity — meaning diversification always reduces or maintains risk. VaR can violate subadditivity, telling you diversification increases risk, which is economically nonsensical.
What is Liquidity-Adjusted VaR (LVaR), and how do funding liquidity risk and market liquidity risk interact?
Liquidity risk is one of the most practically important topics in FRM Part II. Market liquidity risk is the inability to sell an asset at fair value without price impact; funding liquidity risk is the inability to meet cash obligations. Liquidity-Adjusted VaR corrects standard VaR by adding a spread-based liquidity cost component.
How do banks design an operational risk appetite statement?
An operational risk appetite statement articulates the type and amount of operational risk a bank is willing to accept in pursuit of its strategic objectives...
How do you measure and manage pension surplus volatility?
Surplus volatility combines asset variance, liability variance, and their covariance — LDI matching drives it down dramatically.
What are the supervisory LGD values under Foundation IRB?
F-IRB uses supervisory LGD: 45% senior unsecured, 75% subordinated, 11.25% covered bonds. Secured uses LGD* formula blending unsecured and collateral LGD. Maturity fixed at 2.5 years...
How does a repurchase agreement (repo) transaction work step by step, and what are the risks involved?
A repurchase agreement is economically a collateralized loan structured as a sale and repurchase of securities. The cash borrower sells bonds to the lender at a haircut, receives cash, and repurchases the bonds at maturity plus repo interest. Key risks include counterparty, collateral, rollover, and fire-sale risk.
How do duration and convexity work together to estimate bond price changes, and when does duration alone fail?
Duration provides a linear approximation of bond price sensitivity to yield changes, while convexity adds the curvature correction. For yield changes beyond 50 bps, duration alone significantly overestimates price declines and underestimates price gains. The full formula is: change in price ≈ -duration × yield change + half × convexity × yield change squared.
What are the core components of an Enterprise Risk Management (ERM) framework, and how does it differ from siloed risk management?
This is a foundational topic that sets the stage for everything else in the FRM curriculum. Before the 2008 crisis, many institutions managed risks in silos — credit, market, and operational risk teams worked independently. ERM exists to aggregate and correlate risks across the entire enterprise, preventing blind spots where interconnected exposures fall through the cracks.
What are the different levels of external review for green bonds, and how do they affect investor confidence?
Green bond external review ranges from second-party opinions (moderate assurance, most common) to CBI certification (highest assurance, most rigorous). Each type differs in scope, depth, ongoing monitoring, and cost, with certification providing the strongest defense against greenwashing.
What are spectral risk measures, and how do they generalize expected shortfall through risk aversion weighting?
Spectral risk measures generalize expected shortfall by applying a risk-aversion-weighted function across quantiles of the loss distribution. While ES weights all tail losses equally, spectral measures assign increasing weight to more extreme losses, making them consistent with expected utility for risk-averse agents.
What is the difference between portfolio margining and product margining, and how does portfolio margining improve capital efficiency?
Product margining calculates requirements per product with no offsets, while portfolio margining recognizes risk-reducing correlations across products. Portfolio margining typically reduces total margin by 30-70% but relies on correlation assumptions that may break down under stress.
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