The document outlines essential topics and tips for the Foundations of Risk Management in preparation for the FRM-I exam, including key concepts like the efficient frontier, market risk categorization, and the importance of enterprise risk management. It also covers quantitative methods, financial market products, value at risk, and study resources offered by EduPristine. The content aims to provide a comprehensive overview and practical strategies for effective exam preparation.

1. Important Topics to Remember Before
FRM‐I Exam
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2. Foundations of Risk Management
In this session, we will discuss the important points of Foundations of Risk Management:
1.
2.
Efficient Frontier: The optimal portfolios plotted along the curve have the highest expected return possible
for the given amount of risk
σp
Capital Market Line: E(R P )  R f  E(R p )  R f 
, all possible combinations of the market portfolio (P)
σM
and the risk free asset
covR i , R m 
Var R m 
3.
Always remember: β i 
4.
Market risk is greater than as predicted by CAPM if correlation between return and inflation is positive
5.
Risk can be classified into Operational Risk, Financial Risk and Market Based Risk
6.
Enterprise Risk Management (ERM) emphasizes a comprehensive, holistic approach to managing risk, shifting
away from a “silo‐ed” approach of separately handling each organizational risk
7.
Problems with Beta: a) It is Backward looking b) It is estimated with error c)Dependent on how the regression
is structured and whether the stock is publically traded in the first place
8.
4 Steps in AIRMIC Risk Management Process: (i) Identification of risk management and enterprise objectives
(ii) Risk Assessment (iii) Risk Treatment (iv) Risk Monitoring
9.
Poor Data can impact your financials: increase operating costs, increase penalties, delays in cash flows
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3. Foundations of Risk Management (Cont…)
10. GARP Code of Conduct: (a) Principals (i) Professional Integrity and Ethical conduct (ii) Conflicts of Interest (iii)
Confidentiality; (b) Professional Standards (i) Fundamental Responsibilities (ii) Adherence to generally
accepted practices of risk management
11. Semi‐standard deviation is used in the calculation of Sortino Ratio
12. Stack and Roll strategy was used in Metallgesellschaft
13. LTCM was a hedge fund using highly leveraged arbitrage trading activities in fixed income in addition to pairs
trading
14. Nick Leeson, a trader at Barings‐Singapore, led to failure of one of the oldest banks in UK: Barings Bank
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4. Quantitative Methods
In this session, we will share with you Tips of Quantitative Methods:
Probability:
Fav.Outcome
1.
If you understand the question and the basic formula of probability which is
, you can answer
TotalOutco me
each and every question of probability
2.
To solve Conditional Probability you must understand Bayes’ Theorem is quite important. There are two ways
you can solve Bayes’ based questions, one is to remember the formula which can be a nightmare (for me at
least!!). Second way is to use the Tree Diagrams, if you understand Tree diagrams properly; you will be able to
solve most of the questions like a cake walk
3.
Never forget two basic properties of probability which are: a) Sum of probabilities of all exhaustive events is
always 1, b) Probability of any event lies between 0 and 1
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5. Quantitative Methods (Cont…)
Basic Statistics:
1.
It is important to note that we need to use ‘n’ whenever we are calculating population standard deviation or
variance and use ‘n‐1’ while calculating sample standard deviation or variance
2.
Whenever in the question volatility is mentioned, it means standard deviation and not variance
3.
A quick way to solve some questions on progressions is to always remember: AM > GM > HM
4.
Understand the conceptual difference between GM and AM. Try to understand where you can use which one
and why?
5.
Many participants get confused between Covariance and Correlation. Always remember the relationship
between the two and how can you convert from first to the second. We get this problem especially in
portfolio variance Var ( aX  bY )  a 2Var ( X )  b 2Var (Y )  2 abCov ( X , Y ) . When covariance is not given
and correlation factor is given then we can convert the covariance to correlation in the above formula and
solve.
6.
Do not undermine the importance of skewness and kurtosis. Understand what kind of data can have negative
skew and positive excess kurtosis.
7.
There are comparatively new topics named ‘Coskewness’ and ‘Cokurtosis. Master these topics as there are
higher chances of getting questions on relatively new topics.
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6. Quantitative Methods (Cont…)
Distributions & Hypothesis Testing:
1.
Understand in detail about Random Variable
2.
Binomial Distribution is second most important distribution for FRM exam. Do not memorize the formula, but
try to understand concept behind the formula
3.
Whenever you get any question on Normal Distribution, draw a rough diagram and solve. It will be much
easier than mental calculations. As they say a picture is worth 1000 words.
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7. Quantitative Methods (Cont…)
Linear Regression:
1.
Properties of the ‘Random Error Component’ are the most important part of this topic
2.
You can expect some kind of question on the Relationship between ‘Total Variation’, ‘Explained Variation’,
‘Unexplained Variation’ and R2
3.
t is important to know the difference between ‘Conditional’ and ‘Unconditional’ Heteroskedasticity
4.
In multiple regression, multicollinearity is an important violation of the assumption of the model, which
refers to the condition when two or more independent variables in a multiple regression are highly correlated
with each other
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8. Quantitative Methods (Cont…)
Estimating Volatilities and Correlations:
1.
This topic is also covered in VaR section. Concept of ‘Mean Reversion’ and the Speed of ‘Mean Reversion’ is
important to learn in GARCH
2.
In EWMA, we give higher weights to recent observations, because what happened yesterday is more
important than what happened 5 years ago. Memorize the formula as many times there are simple questions
based on the formula
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9. Financial Market Products
In this session, we will share with you Tips on ‘Financial Market Products’
Futures and Forwards:
1.
‘Over the Counter’ has no intermediary and no standardized contracts, parties can be created their
own T&C with each other
2.
Clearing House is an important institution that acts as intermediary for financial transactions
3.
Variation Margin is the additional margin required to deposit on ‘Margin Call’ to make the amount
equal to ‘Initial Margin’. Don’t confuse ‘Initial Margin’ with ‘Maintenance Margin’
4.
You can expect at least one question on ‘Basis Risk’ concept
5.

Optimal Hedge Ratio h  
S
 F
6.
The main difference between Future and Forward is that Future is traded on Exchange and Forward is
traded on OTC. If you understand the difference between Exchange and OTC, you know the difference
between Future and Forward
7.
In determining Forward price, if you understand the concept of ‘Income’, and Cost; you will be able to
do every type of forward price questions: F0 = S0e(r‐q+c)t. Anything which is a cost shall be added and
income shall be deducted
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10. Financial Market Products (Cont…)
Bonds:
1.
It is always good to draw the timeline to visualize the cash‐flow. Especially in case of forward rates
2.
While asked to find the YTM of a bond, don't forget to adjust the outcome of I/Y on calculator with frequency
of coupon payments. If you are calculating YTM using semi‐annual coupon payments, multiply the outcome
of I/Y * 2.
3.
Always put PMT = 0, in case of Zero Coupon bonds otherwise calculator will take the PMT value of the
previous calculation
4.
Macaulay and Modified duration ignore the embedded options in the bond whereas Effective Duration
calculations takes into account a bond’s embedded options
5.
Duration is good for small changes in yield and parallel shift in the Yield curve
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11. Financial Market Products (Cont…)
Options:
1.
There is a difference between Long Call and Short Put. Long Call is the Right to buy and Short Put is the
Obligation to buy
2.
Put Call parity is only applicable to European options: p + S = c + Xe‐rt
3.
Remember the Max profit and Max loss of all option strategies. If you are not able to memorize, just try to
draw the diagram and it will be clear to you. Even if it is not clear, then just take any stock price (towards
extremes) as example to calculate the loss and profit. It will be crystal clear
4.
Delta is the most important option greek. It is also considered as the probability of the option expiring in the
money
5.
An option with large gamma has large negative theta
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12. Financial Market Products (Cont…)
Swaps:
1.
Interest rate swaps can be used to change/transform a liability to asset and vice versa
2.
In the valuation of Interest rate swap, one can consider it like long in fixed rate bond and short in floating rate
bond
3.
Currency Swaps has more credit risk than IRS has, because in currency swap there is exchange of actual
principal
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13. Value at Risk
In this session, we will share with you Tips on ‘Value at Risk’
1.
VaR represents maximum potential loss in value of a portfolio of financial instruments with a given probability over
a certain time horizon. VAR  Z X % *  * Asset Value
2.
VaR for a portfolio has similar concept as standard deviation for a portfolio has:
VaR portfolio (in %)  wa2 (%VAR a ) 2  w 2 (%VAR b ) 2  2w a w b * (%VAR a ) * (%VAR b ) *  ab
b
3.
VaR can be measured with two methods: (i) Linear Valuation Method: a) Delta Normal Method (ii) Full Revaluation
Method (a) Historical Simulation (b) Monte Carlo Simulation
4.
Linear Valuation doesn’t work for portfolios of non‐linear securities
5.
There are two explanations for the Fat Tails: (i) Conditional Mean: Mean changing over the period of time (ii)
Conditional Volatility: Volatility changing over the period of time
6.
Full Revaluation Method accounts for non‐linearity of derivatives whereas delta normal assumes a linear
approximation. It is also important to understand that it accounts for extreme fluctuations
7.
You can expect at least 1 question on Historical Simulation. It has a benefit that there are no assumptions required
about the distribution of returns. It is not exposed to any model risk. The biggest drawback with the Historical
Simulation method is that the changes in volatility and correlation from structural changes are not recognized
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14. Value at Risk (Cont…)
9.
The Monte Carlo approach assumes that there is a known probability distribution for the risk factors
10. One shall understand that: Some companies define operational risk as all the risk that is not market or credit
risk. But this is a very broad definition of operational risk. The Basel definition of operational risk is “the risk
of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from
external events
11. One should remember that there are two kinds of rating: (i) Internal Rating (ii) External Rating
12. Transfer risk is the risk that the government will impose restrictions on the transfer of funds by debtors in the
country in question to foreign creditors, either for financial or other reasons. This risk is almost exclusively
related to foreign currency exposure
13. It is important to understand Expected Loss: EL = Exposure * LGD*PD. EL is the amount the bank can lose on
an average over a period of time
14. Banks need to create a loan loss reserve based on historical data for the losses which they expect. Expected
Loss (EL) is based on certain values of UGD, LGD, PD which are calculated. The Banks need to be prepared
with some capital if the EL varies from the average historical behavior. This deviation from the average EL is
known as Unexpected Loss (UL)
15. The required capital reserve – which acts as a buffer against insolvency for the bank in the event of the
default by an obligor – is known as economic capital
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