A. The potential for loss due to fluctuations in the exchange rate
B. The potential for loss due to fluctuations in commodity prices
C. The potential for loss due to fluctuations in interest rate levels
D. The potential for loss due to fluctuations in inflation rates
Interest rate risk is the risk of loss due to changes in interest rates, impacting the value of assets and liabilities.
2. How is the degree of sensitivity to interest rate risk typically measured?
A. Using market value
B. Using liquidity ratio
C. Using the interest rate spread
D. Using duration
Duration is the classic method used to measure the sensitivity of assets and liabilities to interest rate changes.
3. What was the primary goal of Savings and Loans (S&Ls) during the 1980s?
A. To capture the spread between the rate paid for short-term deposits and the rate received on long-term loans
B. To minimize interest rates on long-term mortgages
C. To increase the amount of short-term loans given
D. To avoid lending on long-term loans
S&Ls aimed to maximize the interest spread between short-term deposits (liabilities) and long-term loans (assets).
4. What caused the savings and loan (S&L) crisis in the 1980s?
A. Low short-term interest rates
B. Inflation leading to higher interest rates and weakening profit margins
C. A sudden decrease in long-term mortgage rates
D. A sudden increase in demand for mortgages
The S&L crisis was caused by inflation and rising interest rates, which weakened the lending margins for S&Ls.
5. Which of the following is a tool used to manage interest rate risk?
A. Hedging with commodity futures
B. Changing the interest rate spread
C. Matching the duration of assets and liabilities
D. Limiting the number of loans given
One way to manage interest rate risk is by matching the duration of assets and liabilities to offset movements in interest rates.
6. What was the outcome of the S&L crisis in terms of industry impact?
A. 35% of S&Ls went out of business
B. The entire S&L industry was nationalized
C. Interest rates were capped for all banks
D. The industry experienced no major losses
The crisis led to a $160 billion taxpayer bailout, with 35% of S&Ls going out of business due to their exposure to unmanaged interest rate risk.
7. How can banks hedge known interest rate risks?
A. By adjusting the interest rate spread on loans
B. By using derivatives like caps, floors, and swaps
C. By increasing the duration of their liabilities
D. By reducing the number of loans issued
Banks can hedge interest rate risk by using derivatives such as caps, floors, and swaps to protect against adverse rate changes.
8. What is the primary cause of liquidity risk?
A. Poor management of equity capital
B. Insufficient demand for loans
C. Mismanagement of short-term liabilities
D. The inability to meet short-term cash requirements
Liquidity risk arises when an entity is unable to meet short-term cash obligations due to inadequate assets or liabilities mismatch.
9. How did Lehman Brothers fund its long-term, illiquid assets?
A. By relying on customer deposits
B. By borrowing in the short-term repo markets
C. By using internal equity capital
D. By selling assets in the secondary market
Lehman Brothers used short-term borrowings in the repo market to fund long-term, illiquid securitized assets.
10. What leverage ratio did Lehman Brothers have by 2007?
A. 31:1
B. 10:1
C. 20:1
D. 50:1
By 2007, Lehman Brothers had a high leverage ratio of 31:1, which meant they had significantly more debt than equity.
11. What happened to Lehman Brothers in September 2008?
A. It merged with another investment bank
B. It was acquired by the U.S. government
C. It filed for bankruptcy due to liquidity risk
D. It restructured its debt and continued operations
Lehman Brothers filed for bankruptcy in September 2008 due to its inability to meet liquidity demands, despite being a 150-year-old company.
12. What caused investors to become unwilling to lend Lehman Brothers money in the short-term markets?
A. Declining stock prices of Lehman Brothers
B. The company's over-reliance on customer deposits
C. Lack of liquidity in the secondary market
D. The collapse of the housing market and increased uncertainty
As the housing market collapsed in 2007, investors became unwilling to lend money in the short-term markets due to rising uncertainty.
13. What caused Continental Illinois to face liquidity problems in the early 1980s?
A. Increased interest rates on commercial loans
B. Losses from Penn Square Bank-linked loans and reliance on short-term funding
C. Overreliance on customer deposits
D. Insolvency of its partners in oil and gas deals
Continental Illinois faced liquidity issues due to substantial losses from its exposure to Penn Square Bank-linked loans, combined with reliance on short-term funding sources.
14. What was the immediate impact when Continental Illinois could no longer borrow from foreign markets in 1984?
A. The bank's stock price soared due to high liquidity
B. Continental Illinois merged with a larger bank to remain solvent
C. Depositors withdrew 20% of the bank’s demand deposits in just 10 days
D. Continental Illinois was acquired by the Federal Reserve
When Continental Illinois couldn't borrow from foreign markets, it faced a bank run, with depositors withdrawing 20% of its demand deposits in just 10 days.
15. What was one of the primary reasons that led to the collapse of Continental Illinois in 1984?
A. The bank’s overexposure to commercial loans
B. Failure of its commercial property investments
C. Regulatory changes that limited its lending ability
D. The inability to secure necessary liquidity in both domestic and foreign markets
The primary reason for Continental Illinois' collapse was its inability to secure liquidity in both domestic and foreign markets after the failure of Penn Square Bank.
16. How did the Federal Reserve respond to the failure of Continental Illinois in 1984?
A. It intervened with a rescue effort, making it the largest bank rescue in its history at the time
B. It imposed strict regulatory restrictions on large banks
C. It allowed the bank to fail without any intervention
D. It provided loans to other banks to offset the failure's effects
The Federal Reserve responded to Continental Illinois' failure by orchestrating the largest bank rescue effort in its history up to that time.
17. What concept did the failure of Continental Illinois contribute to in the banking industry?
A. The importance of diversified loan portfolios
B. The necessity of increasing bank capital reserves
C. The creation of the term "too big to fail"
D. The need for stricter loan classification standards
The failure of Continental Illinois contributed to the creation of the term "too big to fail," reflecting the concept that some banks are too large to allow to fail.
18. What was the primary business model of Northern Rock leading up to the financial crisis of 2007-2009?
A. To hold and manage long-term mortgage loans for investors
B. To source loans with the goal of repackaging and selling them (originate-to-distribute model)
C. To directly fund mortgages through customer deposits
D. To offer government-backed mortgage securities
Northern Rock followed the originate-to-distribute (OTD) model, sourcing loans to repackage and sell them, rather than holding the loans long-term.
19. What was the key factor behind the liquidity problems faced by Northern Rock in 2007?
A. Excessive borrowing in long-term markets
B. A significant reduction in the bank's dividend payouts
C. Its dependence on short-term borrowed funds and rising defaults in securitized mortgages
D. A rapid increase in deposit withdrawals following the Bank of England’s initial refusal to provide support
Northern Rock’s liquidity crisis was mainly due to its reliance on short-term borrowed funds and the rising defaults in the global mortgage market in 2007.
20. What event triggered a "run on the bank" at Northern Rock in 2007?
A. Leaked news of financial support from the Bank of England
B. A sudden and dramatic rise in mortgage rates
C. The announcement of a dividend cut to shareholders
D. Warnings from the British government about economic instability
The "run on the bank" was triggered when news of the Bank of England’s support for Northern Rock leaked to the public, causing depositors to rush to withdraw their funds.
21. What action did British regulators take to reassure the public during the run on Northern Rock in 2007?
A. They imposed a freeze on all withdrawals from the bank
B. They allowed Northern Rock to be acquired by a larger bank
C. They announced a complete suspension of dividend payments
D. They guaranteed 100% of all deposits at Northern Rock
In response to the bank run, British regulators guaranteed 100% of all deposits at Northern Rock, which helped calm the situation.
22. What was the outcome for Northern Rock following the liquidity crisis and bank run in 2007?
A. It turned into a public-owned entity
B. It was acquired by a foreign bank
C. It was split into two separate banks
D. It was allowed to continue operations without intervention
After the liquidity crisis, Northern Rock was nationalized, making it a public-owned entity.
23. What key action did the Federal Reserve require banks to undertake following the 2007-2009 financial crisis?
A. Increased their reserve capital holdings
B. Reduced their interest rate exposure
C. Conducted periodic stress testing for large banks
D. Focused on reducing loan default rates
Following the financial crisis, the Federal Reserve required large U.S.-based banks to undergo periodic stress testing to assess their ability to withstand financial shocks.
24. What is one of the key tradeoffs inherent in the asset/liability management (ALM) process for banks?
A. Reducing liquidity risk while minimizing interest rate risk by matching asset and liability durations
B. Reducing interest rate risk while accepting higher liquidity risk by using shorter-term funding sources
C. Increasing liquidity risk by lowering costs of funding sources
D. Balancing asset growth with regulatory capital requirements
One of the key tradeoffs in ALM is reducing interest rate risk by using shorter-term funding sources, which increases liquidity risk.
25. What is one consequence of banks trying to minimize liquidity risk by using longer-term, more expensive funding sources?
A. Decreased regulatory oversight
B. A higher default rate on loans
C. Increased costs of capital due to longer-term liabilities
D. Reduced loan tenure flexibility
Using longer-term, more expensive funding sources increases the costs of capital for banks, even as it reduces liquidity risk.
26. What is a potential downside of reducing the maturity on a bank’s assets (e.g., loans) to mitigate liquidity risk?
A. It may not be realistic due to borrower needs and market forces
B. It may lead to higher long-term loan default rates
C. It may increase capital reserve requirements
D. It will automatically reduce the bank’s cost of capital
Reducing the maturity on assets may not be feasible due to borrower needs and market conditions, making it an unrealistic solution for liquidity risk mitigation.
27. What is one strategy that banks can use to mitigate liquidity risk when they cannot perfectly match the durations of their assets and liabilities?
A. Increase the interest rates on assets
B. Secure emergency liquidity access through credit lines with designated lenders
C. Sell assets in the secondary market
D. Rely on long-term customer deposits
One way for banks to manage liquidity risk is by securing emergency liquidity access through credit lines with designated lenders, although this can be costly.
28. What is the key characteristic of a static hedging strategy?
A. Frequent rebalancing of the hedged position to adjust to market conditions
B. Constant supervision and frequent adjustments to the hedge
C. Buying a hedging instrument that matches the position at the time of deployment without adjustments
D. Focus on updating the hedging strategy every few months
A static hedging strategy involves buying a hedging instrument that closely matches the position to be hedged and does not involve any adjustments during the strategy’s life.
29. Which of the following is a disadvantage of using a static hedging strategy?
A. Requires constant supervision and frequent transactions
B. Involves high transaction costs due to rebalancing
C. It does not adjust the hedge for changes in the underlying exposure
D. Involves model risk and ongoing updates
A static hedging strategy does not adjust for changes in the underlying exposure, meaning the hedge could become less effective as market conditions change.
30. What is a characteristic of a dynamic hedging strategy?
A. It requires low supervision and incurs low transaction costs
B. It involves frequent rebalancing of the hedged position to adjust to changing market conditions
C. It does not need any adjustments once deployed
D. It only involves buying a single hedging instrument
A dynamic hedging strategy requires frequent rebalancing of the hedged position to adjust to market changes, which makes it more responsive to market forces.
31. What is one of the risks associated with a dynamic hedging strategy?
A. Lack of flexibility in adjusting to market changes
B. Model risk and the costs of frequent transactions
C. Reduced supervision due to minimal updates
D. No need for periodic updates of the hedging exposures
A dynamic hedging strategy involves frequent transactions and model risk, as it requires frequent adjustments to the hedge based on market movements.
32. What is a rolling hedge strategy in dynamic hedging?
A. A one-time hedge applied for the entire investment horizon
B. A strategy where assets are sold immediately to lock in profits
C. A strategy where short-term hedging instruments are repeatedly bought and rolled forward to match a long-term exposure
D. A strategy where hedges are only adjusted on an annual basis
A rolling hedge strategy involves buying short-term hedging instruments, such as futures contracts, and rolling them forward as time progresses to maintain a long-term hedge.
33. What type of hedging strategy did Metallgesellschaft Refining and Marketing (MGRM) use to manage its exposure to rising energy prices?
A. Static hedging strategy using long-term forward contracts
B. Dynamic hedging strategy using a stack-and-roll approach with short-term futures contracts
C. Dynamic hedging strategy using a fixed-price contract with customers
D. Static hedging strategy with periodic adjustments using options
MGRM used a dynamic hedging strategy, specifically the stack-and-roll approach, where it hedged long-term exposures with short-term futures contracts, rolling them over each month.
34. Why did MGRM use short-term futures contracts for hedging instead of long-term futures contracts or forward contracts?
A. Long-term futures contracts were too liquid
B. Alternatives in the forward market were unavailable, and long-term futures contracts were highly illiquid
C. Short-term futures were too expensive to use for hedging
D. The company had access to a large pool of long-term forward contracts
MGRM used short-term futures contracts because alternatives in the forward market were unavailable and long-term futures contracts were highly illiquid, making them unsuitable for hedging.
35. What risk did MGRM face in offering fixed-price contracts to customers?
A. Risk of falling oil prices below the contract price
B. Risk of rising energy prices, as the contracts gave them a short position in long-term forward contracts
C. Risk of being unable to hedge the exposure due to liquidity in the futures market
D. Risk of customers defaulting on the contracts
MGRM faced the risk of rising energy prices, as the customer contracts effectively gave them a short position in long-term forward contracts.
36. How often did MGRM need to adjust its hedge using the stack-and-roll strategy?
A. Annually, after the customer contracts expired
B. Monthly, by selling the current contracts and buying new one-month futures contracts
C. Quarterly, based on the energy market forecast
D. Every five years, to match the contract duration
MGRM adjusted its hedge monthly by selling its current contracts before expiration and buying new one-month futures contracts, as part of its stack-and-roll strategy.
37. In MGRM’s case, how were gains and losses on the customer contracts realized?
A. Immediately upon entering the contract
B. As and when the customers took delivery, which occurred over a 5- to 10-year period
C. On a quarterly basis as the contracts were rolled forward
D. At the expiration of the futures contracts used for hedging
Gains and losses on MGRM's customer contracts were realized when customers took delivery, which occurred over the 5- to 10-year contract period, as opposed to futures contracts, which were marked to market daily.
38. What happens in a rolling hedge strategy when the futures market is in backwardation?
A. The company faces a margin call due to unrealized profits.
B. The company sells futures contracts at a loss relative to the cost of buying the next month’s hedge.
C. The company can sell existing futures contracts at a profit.
D. The futures price is lower than the spot price.
In backwardation, the spot price is higher than future prices, allowing the company to sell futures contracts at a profit.
39. Which of the following occurs when a rolling hedge strategy is implemented in a contango market?
A. The company incurs losses due to futures prices being higher than the spot price.
B. The company can profit from the futures contracts.
C. The company experiences no change in its financial position.
D. The company sells futures contracts at a lower price.
In contango, future delivery prices are higher than spot prices, which leads to losses when implementing a rolling hedge strategy.
40. What was the result of the company’s hedge strategy in late 1993 when spot oil prices declined sharply?
A. The company made a profit by closing out all hedging positions.
B. The company faced a $1.3 billion margin call to offset unrealized losses.
C. The company was able to secure short-term funding and avoided any losses.
D. The company entered a period of continuous gains in the futures market.
The company faced a $1.3 billion margin call to cover unrealized losses when spot oil prices declined sharply in late 1993.
41. What was the key issue that led to the company’s undoing in the rolling hedge strategy case study?
A. The company failed to diversify its investment portfolio.
B. The company’s customer contracts were all short-term.
C. The company faced a liquidity problem, preventing it from covering margin calls.
D. The company’s hedging strategy was not properly constructed.
The company’s key issue was a liquidity problem, which constrained its ability to cover margin calls during adverse market conditions.
42. What is a primary concern when implementing a rolling hedge strategy, according to accounting rules?
A. The company will incur additional taxes from hedging instruments.
B. Hedging positions must be unwound quickly to minimize losses.
C. Gains from customer contracts can be reported while futures contract losses cannot.
D. The company is required to report futures contract losses but not gains from customer contracts.
According to German accounting rules (IFRS), the company must report losses on futures contracts but cannot report the daily gains from customer contracts.
43. When unwinding a large futures position, what is one significant challenge faced by a company?
A. The company can easily sell contracts without affecting the market.
B. The company may face a loss due to rising spot prices.
C. The company may take several days to sell contracts while minimizing market impact.
D. The company may need to secure long-term funding sources to avoid market impact.
Unwinding a large futures position can take several days, and the company must minimize market impact to avoid worsening the situation.
44. What is the impact of tax treatment on hedging instruments in different jurisdictions?
A. The tax treatment is identical across all jurisdictions, and does not affect the strategy.
B. The after-tax impact can be very different from the pretax outcomes, depending on jurisdiction.
C. Tax treatment has no effect on the rolling hedge strategy.
D. Tax treatment is more favorable for futures contracts than for customer contracts.
Tax treatment on hedging instruments can vary between jurisdictions, leading to different after-tax impacts on the strategy.
45. What is the potential consequence of using the wrong model for estimating the value of a financial product?
A. Increased accuracy in valuation
B. No impact on the valuation process
C. Model risk leading to incorrect estimations
D. More reliable risk metrics
Using the wrong model can lead to incorrect estimations, which exposes the firm to model risk.
46. Which of the following is an example of model risk in financial estimation?
A. Using a reliable model with complete data
B. Incorrectly specifying a model or making wrong assumptions
C. Using a model based on historical market data
D. Using a stress-testing model that forecasts all market conditions
Incorrectly specifying a model or making wrong assumptions can lead to model risk and affect the financial estimation.
47. In the context of model risk, what does the use of incomplete data potentially lead to?
A. Accurate risk metrics
B. Improved assumptions
C. A better risk management approach
D. Incorrect model outputs and potential financial losses
Using incomplete data can result in inaccurate model outputs, leading to incorrect financial estimations and model risk.
48. Which of the following is a lesson from the Long-Term Capital Management (LTCM) case related to model risk?
A. The need to plan for risk metrics beyond 10-day Value at Risk (VaR)
B. The importance of using only theoretical models without real-world testing
C. Ignoring stress testing of models is acceptable
D. Risk models only need to be based on historical data
The LTCM case highlighted the need for risk metrics beyond the traditional 10-day VaR and the importance of stress testing.
49. What is a key takeaway from the London Whale case regarding model risk management?
A. Risk limits should always be adjusted to avoid losses
B. Adjusting assumptions and models to make bad decisions look better is acceptable
C. Risk managers should never adjust models or assumptions to justify unprofitable decisions
D. Models should be ignored when risk limits are breached
The London Whale case showed that risk managers should not adjust models or assumptions to justify unprofitable trades or decisions.
50. What is one of the primary sources of model risk in financial product valuation?
A. Using a validated and well-tested model
B. Making incorrect assumptions and using wrong estimators
C. Using complete data for model input
D. Using a model that is based on market conditions
Model risk arises from incorrect assumptions, wrong estimators, and other model-related errors in financial product valuation.
51. What was Victor Niederhoffer’s strategy in writing put options on the S&P 500 Index?
A. Write short call options on the S&P 500
B. Write long put options on the S&P 500
C. Write deeply out-of-the-money put options on the S&P 500
D. Buy deeply in-the-money call options on the S&P 500
Niederhoffer's strategy was to write deeply out-of-the-money put options on the S&P 500 to capture small premiums.
52. What was the assumed risk threshold in Niederhoffer’s strategy for the S&P 500 Index?
A. A 10% daily drop in the S&P 500
B. A 3% daily drop in the S&P 500
C. A 5% daily drop in the S&P 500
D. A 7% daily drop in the S&P 500
Niederhoffer assumed that a daily drop of more than 5% in the S&P 500 was highly improbable.
53. What caused the $50 million margin call in Niederhoffer’s hedge fund?
A. A 5% drop in the S&P 500
B. A sudden market crash in October 1997
C. A 7% drop in a single trading session of the S&P 500
D. A liquidity crisis in the global market
The margin call was triggered by a 7% drop in the S&P 500 in a single session, which exceeded Niederhoffer’s risk threshold.
54. What happened when Niederhoffer’s fund could not meet the $50 million margin call?
A. The fund’s brokers doubled the margin requirement
B. The fund’s brokers liquidated the fund's equity position
C. The fund was merged with another hedge fund
D. The fund’s brokers took ownership of the contracts
The brokers liquidated all the put contracts, locking in substantial losses and wiping out the entire fund's equity position.
55. What is the primary lesson to be learned from Niederhoffer’s hedge fund failure?
A. Rely on historical data without questioning assumptions
B. Always diversify your portfolio to avoid concentrated risk
C. Assumptions can be flawed, and markets do not offer a free lunch
D. Never take large positions in out-of-the-money options
The key lesson is that assumptions can be flawed, and competitive markets do not offer easy, risk-free opportunities.
56. What was the leverage ratio of Long-Term Capital Management (LTCM) at its peak?
A. 10:1
B. 26:1
C. 50:1
D. 100:1
LTCM had a leverage ratio of 26:1, meaning they had $125 billion in assets with only $4.8 billion in equity.
57. What was LTCM's core strategy?
A. Arbitrage trading in emerging markets
B. High-frequency trading in equities
C. Relative value play
D. Options trading
LTCM’s core strategy was a relative value play, which involved buying one asset and selling another to capture perceived mispricing.
58. What did LTCM's relative value strategy aim to reduce?
A. Volatility and systematic risk
B. Credit risk
C. Market risk
D. Operational risk
The relative value strategy aimed to reduce both volatility and systematic (market-linked) risk.
59. What was the total notional value of LTCM’s assets?
A. $100 billion
B. $500 billion
C. $800 billion
D. Over $1 trillion
The notional value of LTCM’s assets was over $1 trillion during its peak, despite the balance sheet showing only $125 billion in assets.
60. What was the leverage ratio of LTCM in terms of its equity to assets?
A. 10:1
B. 15:1
C. 26:1
D. 50:1
LTCM's leverage ratio was 26:1, meaning for every $1 of equity, it controlled $26 in assets.
61. Why was LTCM able to take on such high levels of leverage?
A. They had a reputation for high-risk trading.
B. Financial institutions waived initial margin requirements due to their reputation.
C. They used government bonds as collateral.
D. They were backed by the U.S. government.
LTCM was able to take on high leverage because financial institutions waived initial margin requirements based on the reputation of its principals.
62. What was the primary risk of LTCM’s relative value strategy?
A. A sudden and unexpected change in market conditions
B. Currency fluctuations
C. Inflationary pressures
D. Increased transaction costs
The primary risk for LTCM’s strategy was a sudden and unexpected change in market conditions, which could lead to severe losses.
63. What was the primary strategy employed by Long-Term Capital Management (LTCM)?
A. Investing solely in U.S. Treasuries
B. Betting on short-term interest rates
C. Playing perceived spread differentials between sovereign and corporate bonds
D. Investing in international equities
LTCM primarily focused on exploiting perceived spread differentials between sovereign and corporate bonds, such as buying corporate bonds and shorting sovereign debt.
64. What event triggered Long-Term Capital Management's (LTCM) downfall?
A. A sudden increase in U.S. Treasury yields
B. A stock market crash in the United States
C. The Russian government's default on its debt in 1998
D. A major recession in the European Union
The downfall of LTCM was triggered by the Russian government's default on its debt in August 1998, which led to a flight to quality.
65. What was the result of LTCM’s significant losses in 1998?
A. The Federal Reserve Bank of New York bailed out LTCM with a loan
B. LTCM was forced to shut down without any external help
C. A group of banks injected $3.5 billion in exchange for control of LTCM
D. LTCM filed for bankruptcy and liquidated its assets
The Federal Reserve brokered a deal where a group of banks injected $3.5 billion into LTCM in exchange for 90% of the firm's shares and complete control of management.
66. What was the similarity between the Long-Term Capital Management (LTCM) case and the Metallgesellschaft case?
A. Both firms were involved in aggressive equity trading strategies
B. Both firms collapsed due to market volatility
C. Both cases were triggered by a lack of short-term liquidity
D. Both firms had large exposure to foreign exchange risk
The downfall of both LTCM and Metallgesellschaft was due to a lack of short-term liquidity, which caused them to reach a breaking point during times of financial stress.
67. What impact did the Russian default in 1998 have on LTCM’s positions?
A. It led to an increase in the value of LTCM's bonds
B. It caused LTCM to increase its leverage significantly
C. It created a flight to quality, hurting LTCM's short positions
D. It had no impact on LTCM’s investment strategy
The Russian default triggered a flight to quality, where investors rushed to buy the assets that LTCM had been shorting, such as U.S. Treasuries and German bunds.
68. What was the amount of equity lost by LTCM in the month following the Russian debt default?
A. $1 billion
B. $3 billion
C. $2 billion
D. $4 billion
LTCM lost over $2 billion in equity (approximately 40% of its total equity) in just one month due to the aftermath of the Russian debt default.
69. What was a major cause of LTCM's failure?
A. Insufficient market exposure
B. Lack of liquidity in global markets
C. Model error, particularly in forecasting correlations and volatility
D. Over-reliance on government bailout
LTCM's failure was primarily caused by model errors, such as underestimating correlation spikes and volatility during a global crisis.
70. What did LTCM fail to properly anticipate that contributed to its collapse?
A. A decrease in global correlations
B. A spike in correlations during a global crisis
C. A drop in liquidity levels due to market intervention
D. A steady market volatility during the crisis
LTCM failed to anticipate a sharp rise in correlations between assets, particularly during a global economic crisis.
71. Which of the following risk types did LTCM primarily face during its collapse?
A. Market risk
B. Credit risk
C. Operational risk
D. Liquidity risk
LTCM’s collapse was triggered by liquidity risk, as they faced margin calls that they couldn’t meet due to their inability to liquidate assets quickly enough.
72. What was one of the lessons from the LTCM case study regarding diversification?
A. Geographic diversification failed due to rising correlations during a crisis
B. Diversification between asset classes does not matter during a crisis
C. Bonds and stocks became uncorrelated during a period of external shock
D. Diversification works well only when markets are stable
The LTCM case demonstrated that geographic diversification failed due to the rise in correlations between asset classes during a crisis.
73. What type of model did LTCM primarily rely on for risk assessment?
A. Black-Scholes model
B. Monte Carlo simulation
C. Value-at-risk (VaR) model
D. Stress testing models
LTCM used a Value-at-risk (VaR) model to measure potential losses, but its assumptions did not account for extreme market shocks.
74. What is one of the lessons from the LTCM crisis regarding margin requirements?
A. Margin requirements were too high
B. Margin requirements were too low
C. No margin requirements were needed
D. Initial margin posting should have been required without exception
If LTCM's lenders had required initial margin posting consistently, it could have buffered the short-term liquidity crisis.
75. What risk management approach is now advocated as a result of the LTCM failure?
A. Stress testing
B. Value-at-risk (VaR) modeling
C. Leveraged positions
D. Geographic diversification
The LTCM crisis led to the adoption of stress testing over VaR models, as it better accounts for extreme market events.
76. What was the primary reason for JP Morgan’s $6.2 billion loss in 2012?
A. The bank’s excessive exposure to equity derivatives.
B. A sudden market crash that affected synthetic credit derivatives.
C. Massive bets on synthetic credit derivatives that exceeded market capacity.
D. Poor management of excess demand deposits by the Chief Investment Officer (CIO).
JP Morgan lost $6.2 billion due to excessive and poorly managed bets on synthetic credit derivatives, particularly by the CIO's London office.
77. What was the role of Bruno Iksil, also known as “The Whale,” in the London Whale trade?
A. He was responsible for placing huge trades that disrupted the market.
B. He managed the valuation methodology of synthetic derivatives.
C. He adjusted the bank’s risk management strategies to increase profit.
D. He managed the bank’s global risk exposure.
Bruno Iksil was known for placing massive trades, making him infamous as "The Whale" due to his outsized impact on the market.
78. How did JP Morgan’s leadership respond to early 2012 losses in their trading strategy?
A. They decided to downsize their positions and reduce risk exposure.
B. They chose to double down with long bets, expanding risk exposure.
C. They closed all synthetic derivative positions to minimize losses.
D. They transferred the risk management responsibility to an external firm.
Rather than reducing risk, the leadership opted to increase exposure by taking long positions to offset their short holdings, which worsened the situation.
79. What did JP Morgan’s CIO do when they realized their positions were losing money in early 2012?
A. They closed all positions and recognized the losses immediately.
B. They raised risk limits to accommodate the increasing losses.
C. They adjusted the valuation methodology to make positions appear less risky.
D. They asked an external auditor to assess the true risk of their positions.
To mitigate the apparent impact, the CIO adjusted the valuation methodology, effectively "cherry-picking" prices to make the trades appear less risky.
80. What did the U.S. Senate find regarding JP Morgan’s risk management in the London Whale trade?
A. The risk management strategies were well-implemented and successful.
B. The CIO consistently adhered to the risk limits and policies.
C. The CIO ignored numerous risk limits and raised the limits instead of managing risks.
D. The CIO implemented an effective hedging strategy to minimize losses.
The U.S. Senate’s review found that the CIO ignored over 300 breaches of risk limits and even raised those limits to avoid dealing with the actual risks.
81. What was the key action taken by Nick Leeson that led to the collapse of Barings Bank?
A. He manipulated the Nikkei futures prices.
B. He took large directional positions without offsetting short positions.
C. He controlled both the back-office accounting and the reporting of his trades.
D. He defrauded customers by selling fake securities.
Leeson took speculative positions without offsetting short positions, controlled his trade reporting, and concealed the true losses from his trades.
82. What did the risk managers at Barings Bank fail to do when they grew suspicious of Nick Leeson’s profits?
A. They immediately dismissed Leeson’s supervisors.
B. They did not have the authority to override Leeson’s supervisors who were comfortable with his actions.
C. They chose to ignore the profits entirely.
D. They decided to cover up the situation for fear of reputational damage.
The risk managers were unable to intervene due to their lack of authority over Leeson's supervisors, who were influenced by the profits.
83. What major event occurred as a result of Nick Leeson’s unauthorized trading activities?
A. Barings Bank became the most profitable bank in the world.
B. Barings Bank was sold to a rival bank for a premium.
C. Barings Bank collapsed, and ING acquired it for £1.
D. Barings Bank merged with another bank to recover from the losses.
As a result of Nick Leeson’s rogue trading, Barings Bank suffered catastrophic losses and was acquired by ING for just £1.
84. Which of the following is a key lesson from the Barings Bank rogue trading incident?
A. Always verify profits independently and ensure proper internal controls.
B. Trust in front-office traders to manage risk effectively.
C. Ignore any concerns raised by back-office staff about unusual trading activity.
D. Allow front-office traders to also manage risk oversight to streamline operations.
The key lesson is to verify profits and ensure strong internal controls, especially preventing back-office manipulation by front-office traders.
85. How did Nick Leeson conceal the true losses from his trades at Barings Bank?
A. By falsifying customer trade records.
B. By managing the back-office accounting and hiding losses in a reconciliation account.
C. By using complex derivatives to mask losses.
D. By reporting the losses as gains in other departments.
Leeson controlled the back-office accounting, hiding the actual losses through a hidden reconciliation account.
86. Which of the following is a primary building block for financial engineering?
A. Stock Options
B. Bonds
C. Mutual Funds
D. Forwards, Futures, Swaps, Options, and Securitized Products
The primary building blocks for financial engineering are forwards, futures, swaps, options, and securitized products.
87. A U.S.-based mutual fund investing in Japanese fixed income instruments is exposed to which risks?
A. Only Currency Risk
B. Only Interest Rate Risk
C. Both Japanese Interest Rate Risk and Currency Risk
D. Neither Interest Rate Risk nor Currency Risk
The U.S.-based mutual fund is exposed to both Japanese interest rate risk and currency risk when investing in Japanese fixed income instruments.
88. Which of the following instruments can be used by a risk manager to hedge both interest rate risk and currency risk?
A. Forwards
B. Quanto Swaps
C. Stock Options
D. Bonds
A quanto swap is a multicurrency interest rate swap, which can hedge both interest rate risk and currency risk.
89. In the context of hedging strategies, what is the primary goal of a pure hedging strategy?
A. To enhance returns by taking more risk
B. To speculate on market movements
C. To mitigate risk exposures
D. To diversify the investment portfolio
The primary goal of a pure hedging strategy is to mitigate risk exposures, not to enhance returns or take on additional risk.
90. What is a potential risk of using a hedging strategy to enhance returns?
A. It reduces risk exposures significantly
B. It may add more layers of risk
C. It always leads to higher returns
D. It ensures risk-free returns
Using a hedging strategy to enhance returns may add more layers of risk, instead of mitigating the current exposures.
91. What caused Bankers Trust’s client, P&G, to incur substantial losses in 1994?
A. P&G used simple interest rate swaps to hedge its risk.
B. P&G was highly leveraged in a series of swaps, and the Federal Reserve raised interest rates unexpectedly.
C. P&G made conservative investments and failed to benefit from the market downturn.
D. P&G reduced its leverage when interest rates increased.
P&G incurred significant losses due to high leverage in swaps and an unexpected interest rate hike by the Federal Reserve.
92. What was the primary reason for Bankers Trust’s downfall after its dealings with Procter & Gamble?
A. Bankers Trust failed to manage liquidity risks effectively.
B. Bankers Trust focused on conservative hedging and lost out on potential profits.
C. Bankers Trust’s reputation suffered due to multiple firms losing money with their leveraged products.
D. Bankers Trust refused to work with high-leverage clients like P&G.
The reputational damage caused by multiple firms losing money through leveraged products resulted in Bankers Trust's eventual acquisition by Deutsche Bank.
93. What was the nature of the agreement between Bankers Trust and Procter & Gamble?
A. Procter & Gamble agreed to hedge their market risks using stocks.
B. Procter & Gamble entered into fixed-rate agreements with Bankers Trust to avoid speculation.
C. Procter & Gamble used equity options to manage its risk exposures.
D. Procter & Gamble entered into leveraged swaps, betting on interest rate declines.
P&G entered into highly leveraged swaps, betting on interest rate declines, which led to significant losses when rates unexpectedly rose.
94. Which of the following was a consequence of Procter & Gamble’s involvement with Bankers Trust?
A. P&G sued Bankers Trust and won a judgment of $78 million.
B. P&G increased their use of interest rate derivatives after the incident.
C. Bankers Trust’s reputation improved, and it gained more clients.
D. Procter & Gamble halted all future derivative transactions with financial institutions.
P&G sued Bankers Trust and won a judgment of $78 million due to the losses incurred from their leveraged swaps.
95. What impact did the 1994 interest rate hikes have on Procter & Gamble's strategy with Bankers Trust?
A. The interest rate hikes boosted P&G’s profitability from the leveraged swaps.
B. The interest rate hikes caused significant losses for P&G as their leveraged positions became unfavorable.
C. The interest rate hikes had no effect on P&G’s positions with Bankers Trust.
D. P&G’s leveraged swaps became more profitable due to higher interest rates.
The increase in interest rates by the Federal Reserve resulted in significant losses for P&G due to their highly leveraged positions in swaps.
96. What was the key factor that led to the bankruptcy of Orange County in the 1990s?
A. Poor investment in stocks and bonds.
B. Reliance on long-term investments rather than short-term borrowing.
C. A reliance on short-term repos and complex inverse floating-rate notes which were misunderstood.
D. Over-reliance on a single investment in real estate.
The strategy relied on complex inverse floating-rate notes and the continued roll-over of repo contracts, which became unsustainable when interest rates rose sharply.
97. What happened to Orange County's strategy when the Federal Reserve raised interest rates by 250 basis points in 1994?
A. The interest rate on repos decreased significantly, benefiting Orange County.
B. The repo contracts were renewed without any issues.
C. The complex derivatives became more profitable.
D. The coupon rates dropped on the inverse floaters and investors did not roll forward the repo products.
The interest rate hike caused coupon rates to drop on the complex derivatives, and repo investors were unwilling to roll over contracts, leading to bankruptcy.
98. What was the nature of the securities that Orange County invested in under the leadership of Robert Citron?
A. High-risk stocks with potential for high returns.
B. Government bonds with fixed interest rates.
C. Complex inverse floating-rate notes whose coupon rates declined when interest rates rose.
D. Long-term bonds with guaranteed returns.
Citron invested in inverse floating-rate notes, which were complex securities that performed poorly when interest rates rose.
99. What lesson can be learned from the Orange County bankruptcy case?
A. Always invest in government bonds for safety.
B. High risk guarantees high returns in the long run.
C. Do not invest in anything you do not understand, as the losses can be catastrophic.
D. Short-term borrowing is always safer than long-term investments.
The main takeaway from this case is the importance of understanding the risks associated with investments before proceeding.
100. How did the use of repo contracts contribute to the financial troubles of Orange County?
A. Repo contracts provided fixed interest returns, which limited the county’s flexibility.
B. Repo contracts led to excessive borrowing at high rates, increasing the county's debt burden.
C. Repo contracts were used to invest in long-term, low-risk assets.
D. Repo contracts were rolled over repeatedly, and when the investors refused to roll forward, it led to liquidity problems.
The repo contracts were used as short-term borrowing mechanisms, and when investors stopped rolling over the contracts, liquidity issues emerged, leading to the bankruptcy.
101. What was the primary risk faced by Sachsen Landesbank during the financial crisis of 2007-2009?
A. Heavy losses due to investments in securitized subprime mortgage loans.
B. Losses from excessive lending to regional small firms in Germany.
C. Insufficient capital reserves to support its operations.
D. Operational inefficiencies caused by its off-balance sheet entities.
Sachsen Landesbank incurred significant losses from its investments in subprime mortgage assets, which led to its eventual sale during the financial crisis.
102. Why did Sachsen Landesbank establish an off-balance sheet entity in Dublin?
A. To expand its regional lending operations in Ireland.
B. To avoid taxes and regulatory restrictions in Germany.
C. To buy and hold securitized subprime mortgage loans from the U.S. market.
D. To create a hedge against market volatility in Germany.
Sachsen Landesbank created the off-balance sheet entity in Dublin to gain exposure to the lucrative U.S. subprime mortgage market without affecting its balance sheet directly.
103. What was the primary reason for Sachsen Landesbank’s failure during the financial crisis?
A. Poor management of its regional lending portfolio in Germany.
B. Excessive exposure to subprime mortgage assets and lack of diversification.
C. Its failure to adequately hedge against operational risk.
D. Insufficient liquidity in its international operations.
Sachsen Landesbank's failure was mainly due to its overexposure to subprime mortgage assets, which caused severe financial losses when the market collapsed.
104. How did the financial crisis of 2007-2009 impact Sachsen Landesbank?
A. The bank became one of the largest players in the U.S. subprime market.
B. The bank increased its exposure to regional businesses in Germany.
C. The bank experienced only minor losses and continued operations as usual.
D. The bank sustained heavy losses and was sold to another German bank.
Sachsen Landesbank was heavily impacted by its subprime mortgage investments and faced massive losses during the financial crisis, leading to its sale.
105. What could have prevented Sachsen Landesbank's losses during the financial crisis?
A. Greater diversification of its investments and a focus on risk management.
B. A stronger commitment to regional lending in Germany.
C. A decision to avoid international expansion.
D. Increased reliance on securitization of other assets.
Diversification of its investments and improved risk management practices could have helped Sachsen Landesbank avoid significant losses during the crisis.
106. What is the primary factor that determines a company’s reputation?
A. The company’s annual financial report
B. The size of the company’s customer base
C. The public perception of its fairness, ethics, and treatment of stakeholders
D. The market share in its industry
A company’s reputation is based on how it is perceived by its stakeholders in terms of fairness, ethics, and responsibility.
107. Which of the following is a key area of growing influence on a company’s reputation?
A. Market share growth
B. Profit margins
C. Environmental, Social, and Governance (ESG) monitoring
D. Employee turnover rate
ESG monitoring is increasingly important in shaping a company’s reputation due to its impact on public perception and ethical standards.
108. Reputation risk arises from which of the following factors?
A. High employee turnover
B. Poor operational efficiency
C. A negative public perception of a company’s actions or behavior
D. Lack of capital investment
Reputation risk is caused by negative perceptions or rumors about a company’s behavior, especially if they involve ethical violations.
109. Which group of stakeholders are considered the biggest constituents to watch for managing reputation risk?
A. Employees, suppliers, and competitors
B. Regulators, shareholders, and media
C. Customers, regulators, and shareholders
D. Customers, suppliers, and shareholders
The primary stakeholders in reputation risk are customers, regulators, and shareholders, as their views significantly influence a company’s public image.
110. What is a potential consequence of poor reputation risk management, as demonstrated by the Volkswagen case?
A. A reduction in market share and brand loyalty
B. Increased operational efficiency
C. Decreased sales, share price drop, and regulatory fines
D. Increased production costs
Poor reputation management, as shown by Volkswagen, can lead to significant financial consequences including loss of sales, a drop in stock price, and hefty fines.
111. How did Volkswagen's reputation risk affect its share price after the scandal in 2015?
A. It doubled in value due to increased trust in the company
B. It remained unchanged as the scandal had no impact
C. It dropped by one-third as the scandal unfolded
D. It experienced a minor drop of 5%
Following the scandal, Volkswagen’s share price dropped significantly by one-third due to the reputational damage caused by unethical practices.
112. What happened to Volkswagen's reputation in the aftermath of the 2015 emissions scandal?
A. It recovered quickly due to their strong market position
B. It led to a higher customer trust and loyalty
C. It was severely damaged, leading to decreased sales and brand loyalty
D. It had no significant impact on Volkswagen’s brand
The scandal severely damaged Volkswagen’s reputation, leading to decreased consumer loyalty and a significant drop in sales.
113. What is a key characteristic of corporate governance?
A. Lack of transparency and accountability
B. Sole focus on short-term profitability
C. Adequate transparency and accountability
D. No board member independence
Corporate governance requires transparency, accountability, supervision of senior leaders, and adequate board member independence.
114. What was a primary failure in Enron’s corporate governance?
A. Strong board oversight
B. Lack of board oversight and excessive CEO control
C. Transparent accounting practices
D. Full disclosure of financial transactions
Enron's CEO controlled the board, and there was insufficient oversight, contributing to corporate governance failure.
115. How did Enron hide its financial losses?
A. By publicly announcing losses
B. By selling assets to other companies
C. By underreporting revenue
D. By using special purpose vehicles (SPVs) to hide losses
Enron used SPVs to move losses off its balance sheet and hide them from public scrutiny.
116. Which of the following was a major factor in Enron's downfall?
A. Lack of agency risk management
B. Mismanagement of liquidity risk
C. Efficient corporate governance structure
D. Transparent accounting practices
Enron’s senior management prioritized personal wealth over stakeholder interests, contributing to agency risk and its collapse.
117. What role did Arthur Andersen play in Enron's scandal?
A. They acted as an independent auditor without conflict of interest
B. They openly reported Enron’s financial misstatements
C. They were complicit in the fraud and failed to report it
D. They advised Enron on how to comply with SOX regulations
Arthur Andersen, Enron's auditor, was complicit in the fraudulent activities, which led to the firm's downfall and its own collapse.
118. What regulatory change resulted from Enron's failure?
A. The introduction of the Dodd-Frank Act
B. The creation of the Federal Reserve Bank
C. The establishment of the Securities and Exchange Commission (SEC)
D. The implementation of the Sarbanes-Oxley Act (SOX)
Enron's collapse led to the creation of the Sarbanes-Oxley Act (SOX) in 2002, aimed at enhancing corporate governance and accountability.
119. What does cyber risk primarily refer to?
A. The risk of market instability due to technology failures
B. The risk of financial or reputational loss resulting from a breach in internal technology infrastructures
C. The risk of losing customer trust through poor customer service
D. The risk of losing investments due to stock market fluctuations
Cyber risk involves financial or reputational losses due to breaches in technology systems, often through hacking or theft of sensitive data.
120. In the SWIFT case, what was the amount of money stolen from the Bangladesh Bank?
A. $50 million
B. $100 million
C. $81 million
D. $1 billion
Hackers stole $81 million from Bangladesh Bank using the SWIFT system in a sophisticated cyberattack.
121. How did the hackers access the SWIFT system in the 2016 Bangladesh Bank cyberattack?
A. Through the use of employee credentials
B. By exploiting vulnerabilities in SWIFT’s software
C. By bypassing encryption protocols
D. Through a phishing attack on SWIFT employees
The hackers used stolen employee credentials to gain access to the SWIFT system and initiate fraudulent fund transfers.
122. What stopped the hackers' attempt to steal $1 billion from the Bangladesh Bank in the SWIFT case?
A. A technical failure in the SWIFT system
B. Intervention by Bangladesh Bank's senior management
C. A typo ("fandations" instead of "foundations") in one of the transfer requests
D. The transfer of funds was blocked by an external bank
The hackers' attempt to steal $1 billion was stopped when a typo was noticed in one of the transfer requests, leading to the blocking of further transfers.
123. How did the hackers attempt to hide the transfer of funds in the SWIFT case?
A. By using encryption to conceal the transfer details
B. By sending funds to anonymous accounts
C. By blocking transaction notifications temporarily
D. By using malware to delete records and disable confirmation notifications
The hackers used malware to delete the transfer records and disable the transaction confirmation notifications, attempting to cover up the theft.
124. What happened after Bangladesh Bank realized it was not receiving transfer notifications in the SWIFT case?
A. The bank attempted to retrieve the transferred funds from casinos
B. The bank rebooted its system and received a flood of transfer notifications
C. The bank immediately contacted the police to investigate
D. The bank froze all transactions and reported the case to SWIFT
When the Bangladesh Bank realized it wasn’t receiving transfer notifications, it rebooted its system, which caused the transfer records to flood in, exposing the cyber theft.
125. What was one key lesson from the S&L crisis regarding interest rate risk?
A. Extending loans to shorter terms reduces interest rate risk.
B. Duration matching between assets and liabilities doesn't help mitigate interest rate risk.
C. Duration matching between assets and liabilities and derivatives can mitigate interest rate risk.
D. Increasing loan duration decreases the interest rate risk of a bank.
Duration matching and using derivatives like caps, floors, and swaps can help mitigate interest rate risk, as opposed to extending loan terms.
126. How can liquidity risk be mitigated in a bank?
A. By using short-term funding sources.
B. By using only long-term assets.
C. By using costly long-term funding sources.
D. By increasing the liquidity of short-term liabilities.
Liquidity risk is most dangerous when short-term liabilities fund long-term assets. Long-term funding sources can mitigate this risk.
127. What is a key characteristic of dynamic hedging strategies?
A. They use long-term contracts and require minimal supervision.
B. They are used primarily in static market environments.
C. They require active supervision and incur higher transaction costs.
D. They involve matching the hedging instrument exactly to the position being hedged.
Dynamic hedging strategies require active management and higher transaction costs due to their reliance on short-term contracts.
128. What mistake did LTCM make in their value-at-risk (VaR) modeling?
A. They used a 10-day time horizon, which was too short for market shocks.
B. They did not account for short-term market shocks in their model.
C. They used a 10-day time horizon, which was too short for surviving market shocks.
D. They overestimated the impact of long-term market movements.
LTCM's use of a 10-day horizon for VaR was too short and failed to account for market shocks that could occur outside this window.
129. What is a key lesson from the Barings Bank case study?
A. Trading profits should never be questioned if they are consistent.
B. Back-office supervision can be minimized to reduce operational costs.
C. There should be a clear separation of supervision between back-office and front-office operations.
D. Rogue traders should not be a concern if profits appear consistent.
The Barings Bank case highlights the importance of separating the supervision of back-office and front-office operations to prevent rogue trading.
130. What is reputation risk related to in terms of environmental impact?
A. The replacement of packaging with sustainable sources leads to reputation loss.
B. Only accounting fraud can lead to reputation risk.
C. Reputation risk arises when actions cause reputational damage to a firm.
D. Environmental changes always result in reputation loss for firms.
Reputation risk arises when actions negatively affect a firm's image, like fraud or poor handling of environmental issues.
131. What is a key lesson from the Enron scandal regarding corporate governance?
A. The CEO and CFO should have the full power over the board’s decisions.
B. Independent auditors should approve management’s policies.
C. The roles of the chairman of the board and CEO should be separated.
D. The CEO should oversee all decisions without board oversight.
The Enron scandal emphasized the importance of separating the roles of chairman of the board and CEO to ensure proper corporate governance.
132. What is the primary risk associated with cyber risk in firms?
A. Risk of losing market share due to digital inefficiency.
B. Risk of financial loss due to poor employee performance.
C. Risk of financial or reputational loss due to breaches of internal technology infrastructure.
D. Risk of losing customers due to ineffective marketing strategies.
Cyber risk primarily involves financial or reputational loss due to breaches of technology infrastructure, which is increasingly important in the digital age.
