FRM

PART I

EXPLANATIONS - QUANTITATIVE

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Explanations FRM Part I - Qunatitative

Answer 1: Correct answer is B

In the equation, b1 represents the slope coefficient, which indicates how the dependent variable moves in
response to changes to the independent variable.

Answer 2: Correct answer is C

Changes attributable to a particular condition or day should be tested using a dummy variable.

Answer 3: Correct answer is C

Both of the suggestions are methods for testing the specification of an econometric model. The point is to
find if other variables have significant explanatory power and if the relationships are correctly measured.

Answer 4: Correct answer is D

Using the addition rule, the probability of being accepted at Harvard or Yale, is equal to: P(Harvard) +
P(Yale) P(Harvard and Yale) = 0.25 + 0.42 0.028 = 0.642 or 64.2%.

Answer 5: Correct answer is B

This is true by definition. The correlation only applies to two variables at a time.
Answer 6: Correct answer is A

Using the total probability rule, we can compute the P(B):

C
C
P(B) = [P(B|A) P(A)] + [P(B|A ) P(A )]
P(B) = [0.5 0.4] + [0.2 0.6] = 0.32
Using Bayes formula, we can solve for P(A|B):
P(A|B) = [ P(B|A) / P(B) ] P(A) = [0.5 / 0.32] 0.4 = 0.625
Answer 7: Correct answer is A

If two events A and B are dependent, then the conditional probabilities of P(A|B) and P(B|A) will not equal
their respective unconditional probabilities (of P(A) and P(B), respectively). The other choices may or may
not occur, e.g., P(A | B) = P(B) is possible but not necessary.

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Answer 8:
Part 1) Correct answer is A

arithmetic mean = (11 + 12.5 + 8 + 9 + 13 + 7 + 15 + 2 16.5 + 11) / 10 = 7.20

1/10

geometric mean = (1.11 1.125 1.08 1.09 1.13 1.07 1.15 1.02 0.835 1.11)
0.10

= (1.932)

1 = 1.068 1 = 0.068 or 6.8%

Part 2) Correct answer is C

2

1/2

Standard deviation = [i (xi X) / (n 1)]

= (744.10 / 9) = (82.68) = 9.1%

Answer 9: Correct answer is D

CV stock A = 0.14 / 0.16 = 0.875

CV stock B = 0.03 / 0.20 = 1.5
Stock A has less dispersion relative to the mean than Stock B.

Answer 10: Correct answer is B

The actual value of the covariance for two variables is not very meaningful because its measurement is
extremely sensitive to the scale of the two variables, ranging from negative to positive infinity. Covariance
can, however be converted into the correlation coefficient, which is more straightforward to interpret.

Answer 11: Correct answer is B

Sixty-eight percent of all observations fall within +/- one standard deviation of the mean of a normal
distribution. Given a mean of 15 and a standard deviation of 10, the probability of having an actual
observation fall within one standard deviation, between 5 and 25, is 68%. The probability of an
observation greater than 25 is half of the remaining 32%, or 16%. This is the same probability as an
observation less than 5. Because 95% of all observations will fall within 20 of the mean, the probability of
an actual observation being greater than 35 is half of the remaining 5%, or 2.5%.
Answer 12: Correct answer is A

The t-distribution is the appropriate distribution to use when constructing confidence intervals based on
small samples from populations with unknown variance that are either normal or approximately normal.

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Answer 13: Correct answer is B

Calculate the standardized variable corresponding to the outcomes. Z1 = (91.13 50) / 25 = 1.645, and Z2
= (108.25 50) / 25 = 2.33. The cumulative normal distribution gives cumulative probabilities of F(1.645)
= 0.95 and F(2.33) = 0.99. The probability that the outcome will lie between Z1 and Z2 is the difference:
0.99 0.95 = 0.04. Note that even though you will not have a z-table on the exam, the probability values
for 1.645 and 2.33 are commonly used values that you should have memorized.

Answer 14: Correct answer is C

Calculating z-values, z1 = (110 120) / 20 = 0.5. z2 = (170 120) / 20 = 2.5. Using the z-table, P(0.5) =
(1 0.6915) = 0.3085. P(2.5) = 0.9938. P(0.5 < X < 2.5) = 0.9938 0.3085 = 0.6853. Note that on the
exam, you will not have access to z-tables, so you would have to reason this one out using the normal
distribution approximations. You know that the probability within +/ 1 standard deviation of the mean is
approximately 68%, meaning that the area within 1 standard deviation of the mean is 34%. Since 0.5 is
half of 1, the area under 0.5 to 0 standard deviations under the mean is approximately 34% / 2 = 17%.
The probability under +/ 2 standard deviations of the mean is approximately 99%. The value $170 is mid
way between +2 and +3 standard deviations, so the probability between these values must be (99% / 2) =
2%. The value from 0 to 2.5 standard deviations must therefore be (99% / 2) (2% / 2) = 48.5%. Adding
these values gives us an approximate probability of (48.5% + 17%) = 65.5%.

Answer 15: Correct answer is C

With a large sample size (135) the z-statistic is used. The z-statistic is calculated by subtracting the
hypothesized parameter from the parameter that has been estimated and dividing the difference by the
standard error of the sample statistic. Here, the test statistic = (sample mean hypothesized mean) /
1/2
1/2
1/2
(population standard deviation / (sample size) ) = (X ) / ( / n ) = (64,000 59,000) / (5,500 / 135 )
= (5,000) / (5,500 / 11.62) = 10.56.

Answer 16: Correct answer is D

z = (1.5% - 0.0%) / [(3.0% / 60)] = 3.87

Answer 17: Correct answer is D

By definition.

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Answer 18: Correct answer is D

The estimator is unbiased because the expected value of the sample mean is equal to the population
mean. The estimator is efficient because the variance of the sampling distribution is smaller than that for
other estimators of the parameter.
The estimator is not consistent. To be consistent, as the sample size increases, the standard error of the
sample mean should fall and the sampling distribution will be centered more closely on the mean. A
consistent estimator provides a more accurate estimate of the parameter as the sample size increases.

Answer 19: Correct answer is C

To solve this question, we first need to realize that the expected number of phone calls in an 8-hour day
is = 2 8 = 16. Using the Poisson distribution, we solve for the probability that X will be 20.
x -

P(X = x) = ( e ) / x!
20 -16
P(X = 20) = (16 e ) / 20! = 0.0559 = 5.59%

Answer 20: Correct answer is A

E(X)=np=5(0.60)=3.0. Var(X)=np(1-p)=5(0.60)(0.40)=1.2.

Answer 21: Correct answer is D

In the scatter plot, higher values of the return on stock A are associated with higher values of the return
on the market, i.e. a positive correlation between the two variables.

Answer 22: Correct answer is A

The slope coefficient in this regression is -5.9. This means a one unit increase of GSTERN suggests a
decrease of 5.9 units of RCRANTZ. The slope coefficient is the covariance divided by the variance of the
independent variable. Since variance (a squared term) must be positive, a negative slope term implies
that the covariance is negative.

Answer 23: Correct answer is A

The slope of the regression represents the linear relationship between the independent variable (the
percent change in sales people) and the dependent variable, while the intercept represents the predicted
value of the dependent variable if the independent variable is equal to zero. In this case, the percentage
change in sales is equal to: 0.72(0) + 0.01 = +0.01.

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Answer 24: Correct answer is B

2

Since the specification of Phillips would essentially be B0 + (B1 ) (Xi ), this precludes the application of
linear regression analysis because there is an exponent on B1, i.e., the specification is nonlinear with
respect to the parameters.

Answer 25:
Part 1) Correct answer is C

The confidence interval for the slope coefficient is b1 (tc sb1).

Part 2) Correct answer is B

The confidence interval for the slope coefficient is b1 (tc sb1).

Answer 26: Correct answer is A

2

The correlation coefficient is the square root of the R , r = 0.89.

To calculate the covariance multiply the correlation coefficient by the product of the standard deviations of
the two variables:
COV = 0.89 4 9 = 5.34

Answer 27: Correct answer is B

t = 2.20/0.60 = 3.67. Since the t-statistic is larger than an assumed critical value of about 2.0, the slope
coefficient is statistically significant.
Answer 28: Correct answer is B

To solve this problem, one can assume any value for the total sum of squares. In this case, assume its 1.
2
The regression sum of squares is R multiplied by the total sum of squares, which is 0.46. The residual
sum of squares is the difference between the total sum of squares and the regression sum of squares,
which is 1 0.46 = 0.54. The numerator degrees of freedom is equal to the number of independent
variables, which is 4, and the mean regression sum of squares is the regression sum of squares divided
by the numerator degrees of freedom, which is 0.46 / 4 = 0.115. The denominator degrees of freedom is
the number of observations minus the number of independent variables, minus 1, which is 20 4 1 =
15. The mean squared error is the residual sum of squares divided by the denominator degrees of
freedom, which is 0.54 / 15 = 0.036. The F-statistic is the ratio of the mean regression sum of squares to
the mean squared error, which is 0.115 / 0.036 = 3.19, which is in between the F-values (with four
numerator degrees of freedom and 15 denominator degrees of freedom) of 3.06 for a p-value of 0.05
(calculated using the F-table at 5%) and 3.80 for a p-value of 0.025 (calculated using the F-table at 2.5%).

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Answer 29:
Part 1) Correct answer is A

34.98 + 1.2(16) + 0.5(10) = 59.18

Part 2) Correct answer is C

H0: bgender 0
Ha: bgender > 0
t-value of 1.58 < 1.65 (critical value)

Answer 30: Correct answer is A

Homoskedasticity refers to the basic assumption of a multiple regression model that the variance of the
error terms is constant.

Answer 31: Correct answer is B

2

The format of the GARCH equation is n = + n-1 + n-1, where ( + ) = persistence. For a model
to be stationary over time, the persistence must be less than one. A persistence of one means there is no
mean reversion and the higher the persistence (given that it is less than one), the longer it will take for
volatility to revert to a long run mean level following a large shock or movement. The persistence for
Equation 2 is (0.04 + 0.95) = 0.99, which is less than one meaning there is mean reversion. The
persistence for Equation 1 is higher than that of Equation 3, meaning mean reversion will take longer for
Equation 1. Because the persistence for Equation 1 is less than one, Equation 1 is a stationary model.
Equation 3 has a persistence greater than one, which mean the model shows no mean reversion. Only
Statement I is correct.

Answer 32: Correct answer is B

Answer 33: Correct answer is D

Monte Carlo simulation is subject to model risk.

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Answer 34: Correct answer is C

VAR is defined as the dollar or percentage loss in portfolio value that will be exceeded only X% of the
time. VAR(10%) = $0 indicates that there is a 10% probability that on any given day the dollar loss will be
greater than $0. Alternatively, we can say there is a 90% probability that on any given day the dollar gain
will be greater than $0. VAR was developed by commercial banks to provide a more accurate measure of
their economic capital requirements, taking into account the effects of diversification.

Answer 35: Correct answer is A

Fat tails, skewness, and other deviations from some assumed distribution are no longer a concern in the
estimation process for nonparametric methods. The other statements are false for the following reasons.
Nonparametric models do not require assumptions regarding the entire distribution of returns. Data is
used more efficiently with parametric methods than nonparametric methods. Multivariate density
estimation (MDE) allows for weights to vary based on how relevant the data is to the current market
environment, regardless of the timing of the most relevant data. MDE is also very flexible in introducing
dependence on state variables.

Answer 36: Correct answer is A

Weight of Stock = W S=0.40; Weight of Bonds = W B = 0.60

Expected Portfolio return = E(RP) = 0.40(9)+0.60(6) = 7.20%
Portfolio Standard deviation =
2

0.5

P = [(W S) (S) + (W B) (B) +2(W S)(W B)rSBSB]

2

0.5

= [(0.40) (0.18) +(0.60) (0.08) +2(0.40)(0.60)(0.25)(0.18)(0.08)]

0.5

= (0.009216)
= 9.6%

VAR = Portfolio Value [ E(R) -z]

= 2,000,000[0.072 (2.33)(0.096)] = $303,360.

Answer 37: Correct answer is A

If we transform two independent random variables, 1 and 2, by defining 1 = 1 and 2 = 1 + (12 1/2
) 2, 1 and 2 will have a correlation of .

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Answer 38: Correct answer is B

GBM is often used to simulate the price paths for equity and foreign exchange securities.

Answer 39: Correct answer is A

In order to account for simulations with multiple variables, it is possible to generate simulated variables
that are related by a correlation coefficient. This process can be extended to more than two variables
through a process known as the Cholesky factorization. However, the Cholesky factorization requires that
the covariance matrix be positive-definite for this process to be effective. It is also possible to use
principal components method to overcome difficulties in the Cholesky factorization method. Note that the
Cox, Ingersoll, Ross (CIR) model is a one-factor model of interest rate dynamics.

Answer 40: Correct answer is C

The weekly volatility is approximately equal to 2.77% a week (0.20 / 52). The 5% VAR for the stock price
is equivalent to a 1.65 standard deviation move for a normal curve. The 5% VAR of the underlying stock
is 0 2.77%(1.65) = 4.57%. A 1% change in the stock price results in a 9.91% change in the call
option value, therefore, the delta = 0.0991 / 0.01 = 9.91. For small moves, delta can be used to
estimate the change in the derivative given the VAR for the underlying asset as follows: VARCall =
VARStock = 9.91(4.57%) = 0.4529, or 45.29%. In words, the 5% VAR implies there is a 5% probability
that the call option value will decline by 45.29% or more over one week.
Answer 41:
Part 1) Correct answer is A

A slope coefficient in a multiple linear regression model measures how much the dependent variable
changes for a one-unit change in the independent variable, holding all other independent variables
constant. In this case, the independent variable size (= ln average assets under management) has a
slope coefficient of 0.6, indicating that the dependent variable ARAR will change by 0.6% return for a oneunit change in size, assuming nothing else changes. Pay attention to the units on the dependent variable.
Part 2) Correct answer is A

The t-statistic for testing the null hypothesis H0: i = 0 is t = (bi 0) / i, where i is the population
parameter for independent variable i, bi is the estimated coefficient, and i is the coefficient standard
error. Using the information provided, the estimated coefficient standard error can be computed as bIndex /
t = Index = 1.1 / 2.1 = 0.5238.
Part 3) Correct answer is B

The t-statistic for testing the null hypothesis H0: i = 0 is t = (bi 0) / i, where i is the population
parameter for independent variable i, bi is the estimated coefficient, and i is the coefficient standard
error. Using the information provided, the t-statistic for size can be computed as t = bSize / Size = 0.6 /
0.18 = 3.3333.

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Part 4) Correct answer is A

The t-statistic for testing the null hypothesis H0: i = 0 is t = (bi 0) / i, where i is the population
parameter for independent variable i, bi is the estimated parameter, and i is the parameters standard
error. Using the information provided, the estimated intercept can be computed as b0 = t 0 = 5.2
0.55 = 2.86.
Part 5) Correct answer is D

At 5% significance and 97 degrees of freedom (100 3), the critical t-value is slightly greater than, but
very close to, 1.984. The t-statistic for the intercept and index are provided as 5.2 and 2.1, respectively,
and the t-statistic for size is computed as 0.6 / 0.18 = 3.33. The absolute value of the all of the regression
intercepts is greater than tcritical = 1.984. Thus, it can be concluded that all of the parameter estimates are
significantly different than zero at the 5% level of significance.

Answer 42: Correct answer is A

The graph represents a negatively skewed distribution, and thus Point A represents the mean. By
definition, mean < median < mode describes a negatively skewed distribution.
The other statements are true. Chebyshevs Inequality states that for any set of observations (normally
distributed or skewed), the proportion of observations that lie within k standard deviations of the mean is
2
2
at least 1 1 / k . Here, 1 (1 / 1.3 ) = 1 0.59172 = 0.40828, or 40%.

Answer 43: Correct answer is A

CV = Standard Deviation / Mean = (8 / 20) = 0.4

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