Market Risk
The second of the five risk-related disciplines on the FRM exam deals with Market Risk Measurement and Management. This material accounts for the largest percentage of questions on the FRM exam (30%). You will see approximately 42 questions on the exam that deal with the various types of market risk and the instruments used to measure market risk. Book 2 of our FRM Study Notes is devoted to this risk-related discipline and divides the market risk material into five sections:
- Derivatives
- Fixed Income Securities
- Value at Risk
- Foreign Exchange Risk
- Measuring and Managing Corporate Risk Exposures
Derivatives
This section is divided into three topic areas: forwards and futures, swaps, and options.
The forwards and futures material focuses mainly on how to price forwards and futures and how these derivatives can be used as hedging instruments. Pricing these contracts involves consideration of not only spot prices and risk-free rates, but also dividend yields and interim cash flows. Also mentioned, in two readings, are commodity forwards and futures. For commodities, you will learn how to apply convenience yields and storage costs to futures/forward prices.
There is one reading devoted to swaps in the FRM curriculum. Its main focus is on interest rate swaps and currency swaps. Specifically, you will learn the characteristics of each type of swap and how to value these swaps. There is increased emphasis this year on how to value swap instruments with forward rate agreements. Our Study Notes demonstrate how this can be done by using informative and simplistic examples.
There are several readings that address options. Everything from option trading strategies to the Black-Scholes-Merton model to types of exotic options is discussed. Other topics in this section deal with option pricing bounds, option pricing via binomial trees, and option Greeks (e.g., delta, theta, rho). Interpreting these “Greeks” has been a favorite testing topic for many years.
Fixed Income Securities
The main focus of the fixed income section is on bond valuation and interest rate sensitivity.
You will learn how to value bonds using discount rates, spot rates, and forward rates. In addition to finding the price of a bond, you will learn how yield to maturity can be calculated. This is where understanding the time value of money from the Quantitative Analysis material will come in handy. Another aspect of this section is how accrued interest is handled and how it impacts the price of a bond.
The concepts of duration and convexity play an important role in this section. You will learn how to calculate and interpret the different types of duration measures and how to apply the convexity adjustment to price estimates. It is worthwhile to understand how changes in a bond’s coupon rate, maturity, and yield affect duration.
Value at Risk
I briefly mentioned the concept of value at risk (VAR) in my last post on Quantitative Analysis. As the primary measurement tool for market risk, VAR appears throughout the curriculum. For example, not only will you encounter volatility estimation in VAR models in Book 1, but you will also learn how to apply VAR to a portfolio setting in Book 5.
The VAR section in Book 2 of our Study Notes introduces the concept of VAR and demonstrates its calculation using three VAR methods: delta-normal, historical simulation, and Monte Carlo simulation. Another important topic in this section is the idea of stress testing and how it can be used to complement VAR.
Foreign Exchange Risk
Up to this point, we have addressed three types of market risk: commodity risk, equity risk, and interest rate risk. Another major type of market risk is currency risk. The one reading from this section deals with how to determine foreign currency exposure. For the exam, it is important to understand the concept of interest rate parity.
Measuring and Managing Corporate Risk Exposures
There are three readings in this section that deal with corporate risk exposures. One of the main highlights is the introduction of cash flow at risk (CFAR) and how it differs from VAR. Another interesting concept is the impact of currency risk on firm cash flows.
This concludes the overview of Market Risk Measurement and Management. This material accounts for not only the greatest number of questions on the exam, but also the greatest number of readings in the curriculum. Like the Quantitative Analysis material, there is significant overlap between what is covered in this part of the FRM curriculum and what is covered in the CFA curriculum. In my next two posts, I’ll outline the risk-related disciplines of credit risk and operational risk. The material included in those two areas is what sets the FRM curriculum apart from other financial designations.