INTRODUCTION TO ENTERPRISE RISK MANAGEMENT

FRM-PRACTICE EXAM – QUANTITATIVE ANALYSIS

REGRESSION ANALYSIS

QA 4.1 Consider two stocks, A and B. Assume their annual returns are jointly normally
distributed, the marginal distribution of each stock has mean 2% and standard
deviation 10%, and the correlation is 0.9. What is the expected annual return of stock
A if the annual return of stock B is 3% ?
El Sal = Elsa) = 2% E23)
a. 2%
Cm(b
-

Va 6B 10 %
E((z)
=
= +

b. 2.9% _
0 9
c. 4.7% Cors .

ElSAISB 3% ) =
SAP (Sa (S = 3% )
d. 1.1% =

)
3%
SAP(sa Si =
,
=
plsB = 3 %)
QA 4.2: A portfolio manager is interested in the systematic risk of a stock portfolio, so
he estimates the linear regression: 𝑅𝑃𝑡 − 𝑅𝐹 = 𝛼𝑃 + 𝛽𝑃 [𝑅𝑀𝑡 − 𝑅𝐹 ] + 𝜖𝑃𝑡 where 𝑅𝑃𝑡 is
the return of the portfolio at time 𝑡, 𝑅𝑀𝑡 is the return of the market portfolio at time 𝑡,
and 𝑅𝐹 is the risk-free rate, which is constant over time. Suppose that 𝛼 = 0.008, 𝛽 =
0.977, 𝜎(𝑅𝑃 ) = 0.167, and 𝜎(𝑅𝑀 ) = 0.156

What is the approximate coefficient of determination in this regression?

a. 0.913 R2 =
BY 62 (Rm)
b. 0.834 22/Rp)
c. 0.977
d. 0.955

QA 4.3: Which of the following statements about the linear regression of the return of
a portfolio over the return of its benchmark presented below are correct?
Portfolio Parameter Value
Cor(Rp) Rm)
Beta 1.25 =

62

Alpha 0.26

Coefficient of determination 0.66 R2 = 0 66

.
=
BRO2Si
Standard deviation of error 2.42 6(c) = 2 42.

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 INTRODUCTION TO ENTERPRISE RISK MANAGEMENT
I. The correlation is 0.71.
II. About 34% of the variation in the portfolio return is explained by variation in the
benchmark return.
III. The portfolio is the dependent variable.
IV. For an estimated portfolio return of 12%, the confidence interval at 95% is
(7.16% − 16.84%)
a. II and IV
b. III and IV
c. I, II, and III
d. II, III, and IV

QA 4.4: You built a linear regression model to analyze annual salaries for a developed
country. You incorporated two independent variables, age and experience, into your
model. Upon reading the regression results, you notice that the coefficient of
experience is negative, which appears to be counterintuitive. In addition, you discover
that the coefficients have low 𝑡-statistics but the regression model has a high 𝑅2 . What
is the most likely cause of these results?
a. Incorrect standard errors
b. Heteroskedasticity
c. Serial correlation
d. Multicollinearity

QA 4.6: Under what circumstances could the explanatory power of regression analysis
be overstated?
a. The explanatory variables are not correlated with one another.
b. The variance of the error term decreases as the value of the dependent variable
increases.
c. The error term is normally distributed.

QA 4.7. Fama and French (1996) added two risk factors beyond the market index to
explain past average rates of return. Which of the following ratios is a risk factor in the
Fama French empirical model?
A. EBITDA to total sales
B. Current assets to current liabilities
C. Net profit to total assets
D. Book-to-market values

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QA 4.8: Suppose the S&P 500 Index has an expected annual return of 7.2% and
volatility of 8.2%. Suppose the Andromeda Fund has an expected annual return of
6.8% and volatility of 7.0% and is benchmarked against the S&P 500 Index. According
to the CAPM, if the risk-free rate is 2.2% per year, what is the beta of the Andromeda
Fund?

A 0.92

B. 0.95

C. 1.13

D. 1.23

QA 4.9: Assume you are assigned the task of evaluating the stock of Sky-Air,Inc. To
valuate the stock, you calculate its required return using the CAPM. The following
information is available:

- Expected market risk premium 5%

- Risk – free rate 4%
- Sky – Air beta: 1.5

Using CAPM, calculate and interpret the expected return for Sky-Air

QA 4.10: Suppose that the two factor portfolios, portfolios 1 and 2, have expected
return 𝐸 (𝑟1 ) = 10% and 𝐸 (𝑟2 ) = 12% and that the risk-free rate is 4%. A portfolio 𝐴,
with beta on the first factor portfolio, 𝛽𝑃1 = 0,5; and beta on the second factor
portfolio, 𝛽𝑃2 =0,75.

1. What is the total risk premium on the portfolio?

2. The total expected return on the portfolio should be?

QA 4.11: We assume a lambda parameter of 0.85 under an exponential smoothing

(EWMA) approach to the estimation of today’s(t) daily volatility. Yesterday(t-1) is the
most recent daily return in our series. What are the weights assigned, respectively, to
yesterday’s (t-1) and the day before yesterday’s returns (t-2)?

a, 15.00% and 2.25%

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 INTRODUCTION TO ENTERPRISE RISK MANAGEMENT
b, 15.00% and 12.75%

c, 72.25% and 61.41%

d, 85.00% and 72.25%

QA 4.12. Suppose that the current volatility estimate is 3% per day and the long-run
average volatility estimate is 2% per day. What are the volatility estimates in ten days
and 100 days in a GARCH (1,1) model where 𝜔 = 0.000002, α = 0.04, and β = 0.94?

QA 4.13. An asset’s returns are normally distributed with an expected annual return
of 15% and volatility of 10.0% per annum. If there are 250 trading days per year,
which is nearest to the time horizon at which the 95% absolute VaR is approximately
zero?

a, 10 days
b, 150 days
c, 300 days
d. Given its nonzero volatility, the absolute VaR cannot be zero

QA 4.14. Suppose that the current volatility estimate is 3% per day and the long-run
average volatility estimate is 2% per day. What are the volatility estimates in ten days
and 100 days in a GARCH (1,1) model where 𝜔 = 0.000002, α = 0.04, and β = 0.94?

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