Bionic Turtle FRM Practice Questions P1.T2. Quantitative Analysis Chapter 12: Measuring Return, Volatility, and Correlation

Licensed to Christian Rey Magtibay at christianrey_magtibay@yahoo.com. Downloaded August 22, 2021.
The information provided in this document is intended solely for you. Please do not freely distribute.
Bionic Turtle FRM Practice Questions
P1.T2. Quantitative Analysis
Chapter 12: Measuring Return, Volatility, and

Correlation
By David Harper, CFA FRM CIPM
www.bionicturtle.com
Chapter 12: Measuring Return, Volatility, and Correlation
P1.T2.21.3. RETURNS, VOLATILITY AND NON-NORMAL DISTRIBUTIONS ........................................ 3

P1.T2.21.4. NON-NORMAL DISTRIBUTIONS AND RANK CORRELATIONS ......................................... 7
P1.T2.702. SIMPLE (EQUALLY WEIGHTED) HISTORICAL VOLATILITY (HULL)..................................10
P1.T2.705. CORRELATION ......................................................................................................13
P1.T2.706. BIVARIATE NORMAL DISTRIBUTION ..........................................................................16
P1.T2.502. COVARIANCE UPDATES WITH EWMA AND GARCH(1,1) MODELS .............................19
P1.T2.503. ONE-FACTOR MODEL (HULL) ..................................................................................23
2
Chapter 12: Measuring Return, Volatility, and Correlation

P1.T2.21.3. Returns, volatility and non-normal distributions
P1.T2.21.4. Non-normal distributions and rank correlations
P1.T2.702. Simple (equally weighted) historical volatility
P1.T2.705. Correlation
P1.T2.706. Bivariate normal distribution
P1.T2.502. Covariance updates with EWMA and GARCH(1,1) models
P1.T2.503. One-factor model (Hull)
P1.T2.504. Copulas (Hull)
P1.T2.21.3. Returns, volatility and non-normal distributions

Learning objectives: Calculate, distinguish and convert between simple and
continuously compounded returns. Define and distinguish between volatility, variance
rate, and implied volatility. Describe how the first two moments may be insufficient to
describe non-normal distributions.
21.3.1. A concentrated fund has only four positions. At the beginning of the week, its initial value
was $1,000. The daily log returns for the portfolio over the five-day trading week are displayed
in the upper panel below; these log returns are suspiciously round for the sake of simple
calculations but please assume they are accurate daily log returns. In the lower panel, the
corresponding simple (aka, discrete holding period) returns are given; for example, on Monday
the first (Asset #1) asset's log return was 2.00% which corresponds to exp(2%)-1 = 2.020134%
but this is rounded in display to 2.020%.
With respect to this portfolio, four associates at the firm (Alice, Bob, Casandra, and Donald)
make the following four assertions:
 Alice says Asset #3 had a 5-day log return of exactly +9.0% because an asset's weekly
log return is the sum of its daily log returns; that is, she observes that 4.0% -2.0% +5.0%
-1.0% +3.0% = +9.0%.
3
 Bob says Asset #3 had a 5-day holding period (aka, simple) return of 9.42% because an
asset's weekly simple return is the sum of its daily simple returns; that is, he observes
that 4.018% - 1.980% + ... + 3.045% = + 9.278% where exp(4.0%)-1 = 4.018%.
 Casandra says that the portfolio's log return on Monday was exactly 3.60% because the
portfolio's daily log return is the weighted average of its components' log returns; that is,
she observes that (10%*2.0%) + (20%*1.0%) + (30%*4.0%) + (40%*5.0%) = 3.60%.
 Donald says that the portfolio's holding period (aka, simple) return on Monday was
3.6782% because the portfolio's daily simple return is the weighted average of its
components' simple returns; that is, he observes that (10%*2.020%) + (20%*1.005%) +
(30%*4.081%) + (40%*5.127%) = 3.67818% where exp(2.0%)-1 = 2.020%.
Who is correct?
a) Only Alice and Donald are correct
b) Only Bob and Casandra are correct
c) None of them are correct
d) All four of them are correct
21.3.2. Jack wants to estimate the volatility of a stock based on its daily closing prices last
week. He realizes this is a very small sample. The prices, along with the implied simple and log
returns, are displayed below.
In the final two columns, the daily returns have been squared (and the sum of those squared
returns are shown at the bottom). Because the sample is small, Jack computes his volatility
based on an unbiased sample variance. Further, although he realizes that variance is the
average squared difference from the mean, for purpose of this calculation he will assume the
mean daily return is zero (please note there is indeed good theoretical justification for
"excluding" the mean from the variance calculation for purposes of the volatility estimate); put
simply, he will not be using the average daily returns displayed on the bottom row as this
simplifies his calculation. Finally, although he realizes he can use either return, for this purpose
he prefers the log returns because they are time-additive.
4
Which is nearest to Jack's daily volatility calculation based on log returns, assuming zero mean
and an unbiased sample variance?
a) 5.33%
b) 6.50%
c) 9.67%
d) 13.00%
21.3.3. To estimate the risk of a stock, Peter calculates the daily sample standard deviation
based on historical daily log returns (n = 250) over the last year. Based on his calculations over
this historical sample, the daily volatility was 1.60%. Using this 1.60% as an input, Peter
performs two calculations to produce a value at risk (VaR) estimate.
 First, he scales the daily volatility to an annual volatility per 1.60% * sqrt(250) = 25.30%,
and thusly determines that the stock's volatility is 25.30% per annum.
 Second, he multiplies the annualized volatility by a quantile (aka, deviate) of 1.645 per
25.30% * 1.645 = 41.62%, and concludes that 41.62% is the relative value at risk (VaR)
in percentage terms.
Because the stock's current price is $60.00, he declares that the stock's 95% one-year relative
value at risk (VaR) is $60.00 * 41.62% = $24.97.
 Alice says that his method is correct under any and all assumptions
 Bob says that his first step imposes (aka, requires) normality and his second step
requires independence (the i.i.d. assumption)
 Cindy says that his first step requires independence (the i.i.d. assumption) and his
second step imposes (aka, requires) normality
 Earl says actual returns tend to skewed, heavy-tailed, and positively autocorrelated such
that Peter's estimate is higher than (aka, overstates) the true 95.0% one-year relative
VaR.
Who has the most accurate response to Peter's methodology?
a) Alice
b) Bob
c) Cindy
d) Earl
5
Answers:
21.3.1. A. True: Only Alice and Donald are correct
The advantage of log returns is that they are time-additive, but simple returns are not time
additive. The advantage of simple returns is that they are cross-sectionally additive (i.e., each
day's simple portfolio return is a weighted average of the components' simple return) but log
returns are not cross-sectionally additive.
21.3.2. B. True: 6.50%
The unbiased variance divides the sum of squares (SS) by (n-1) such that sqrt(0.01690/4) =
6.5002%.
21.3.3. C. True: Cindy
The square root rule (SRR) requires independence (i.i.d.) but not the normal distribution. The
use of the 1.645 deviate (aka, quantile) at 95.0% presupposes the normal distribution.
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-21-3-returns-

volatility-and-non-normal-distributions.23781/
6
P1.T2.21.4. Non-normal distributions and rank correlations

Learning objectives: Explain how the Jarque-Bera test is used to determine whether
returns are normally distributed. Describe the power law and its use for non-normal
distributions. Define correlation and covariance and differentiate between correlation and
dependence. Describe properties of correlations between normally distributed variables
when using a one-factor model.
21.4.1. For three assets (Gold, S&P5000, and the USDJPY exchange rate), Elizabeth collected
monthly returns over the last five years (T = 60 months) and computed the skewness (aka,
skew) and kurtosis for each return series, as displayed below. Given the skew and kurtosis, she
also computed the corresponding Jarque-Bera test statistics. The Jarque-Bera test will help her
decide if the returns are normal because it is a test of the null hypothesis that (jointly) skewness
and excess kurtosis are zero.
Elizabeth knows it will be easier to work with the dataset if the returns are normally distributed.
She would like to reach a decision with the typical confidence levels: either 95.0% or 99.0%. Are
these returns normal?
a) No, none of the return sets is plausibly normal: null hypothesis is rejected at all
reasonably high confidence levels
b) Only the USDJPY exchange rate return set might be normal: we fail to reject the null
with 99.0% confidence
c) Only the S&P500 index return series is normal: we fail to reject the null with 95.0%
confidence
d) Yes, all three return sets are normal: we fail to reject the null at all reasonably low
confidence levels
21.4.2. For his firm's equities portfolio, Luke estimates the one-month 95.0% confident relative
value at risk (VaR) is $12.0 million. He is assuming the loss and profit (L/P) has a normal
distribution. Based on this normality assumption, he re-scales this VaR in order to retrieve the
corresponding 99.0% VaR. However, he worries this will underestimate the VaR given the tails
are likely to be heavy. Consequently, using the same assumption of a one-month 95.0% VaR of
$12.0 million, he instead assumes a power law distribution with an alpha constant, α = 1.90.
Recall the power law distribution says that P(X > x) = k*x^(-α) where α and k are constants.
Which are nearest to the one-month 99.0% VaR under, respectively, the normal and power law
assumptions?
a) $17.0 and $28.0 million
b) $25.0 and $33.3 million
c) $49.0 and $39.6 million
d) $57.7 and $74.4 million
7
21.4.3. Emily listed the daily returns last week for two cryptocurrencies, bitcoin (BTC) and
Ethereum (ETH). These are very small samples of only five returns for each currency. The
returns are displayed below along with their ranks; e.g., Wednesday saw the worst performance
for both cryptocurrencies, while Tuesday saw the best performance. Albeit a very small sample,
the ranks do match on three of the days (Monday, Tuesday, and Wednesday) and differ on only
two days (Thursday and Friday).
What are, respectively, the Spearman's Rank and Kendall's tau?
a) -0.70 (rank) and -0.55 (Kendall's)

b) 0.33 (rank) and 0.67 (Kendall's)
c) 0.90 (rank) and 0.80 (Kendall's)
d) 1.40 (rank) and 1.60 (Kendall's)
8
Answers:
21.4.1. B. True: Only the USDJPY exchange rate return set might be normal: we fail to
reject the null with 99.0% confidence
The Jarque-Bera test has two degrees of freedom and critical values of 5.99 at 95.0% and 9.21
at 99.0%. Therefore, the null is easily rejected for Gold's and S&P500's returns: rejection of null
implies the returns are NOT normal. In regard to the USDJPY exchange rate, the p-value =
CHISQ.DIST.RT(7.621, 2) = 2.214%. This lies between 1% and 5% which is consistent with a
test statistic of 7.6 that lies between 5.99 and 9.21: we would reject the null with 95.0% but fail
to reject the null with 99.0% confidence.
21.4.2. A. True: $17.0 and $28.0 million
Under the normal assumption, the VaR is rescaled from 95.0% to 99.0% confidence as given by
$12.00 * 2.33/1..645 = $17.00 (or more precisely, $16.97).
Under the power law assumption, which is given by P(X > x) = k*x^(-α) but where we are told α
= 1.90 and the 95.0% VaR is $12.00, such that we can observe 5.0% = k*12.0^(-1.90). This
implies that k = 0.050*12.0^1.90 = 5.6158. Given P(X > x) = k*x^(-α), we can see that x = [k/P(X
> x)]^(1/α); in this case, the power law's 99.0% VaR is given by x = (5.6158/0.010)^(1/1.90) =
$27.99 million.
21.4.3. C. True: 0.90 (rank) and 0.80 (Kendall's)
The Spearman's rank correlation is given by 1 - 6*2/((5^2-1)*5) = 0.90.

Given there are nine (9) concordant pairs and only one (1) discordant pair, the Kendall's tau is
given by (9-1)(5*4/2) = 0.80
Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-21-4-non-normal-

distributions-and-rank-correlations.23802/
9
P1.T2.702. Simple (equally weighted) historical volatility (Hull)

Learning Objectives: Define and distinguish between volatility, variance rate, and implied
volatility. Describe the power law.
702.1. Consider the following series of closing stock prices over the ten most recent trading
days (this is similar to Hull's Table 10.3) along with daily log returns, squared returns and
summary statistics:
Although the actual average historical return is non-zero (ie, -0.001511), for purposes of
estimating volatility we will assume that the expected daily mean return is zero. For the purpose
of scaling the daily volatility to an annual volatility, we will further assume i.i.d. returns and 250
trading days per year.
Which is nearest to the simple (ie, historical unweighted), unbiased per annum volatility
estimate?
a) 5.0% per annum

b) 15.0%
c) 25.0%
d) 35.0%
10
702.2. The number of visitors to a retail bank branch follows the power law (Hull 10.1) where
Prob(v > X) = k*X^(-α) with α = 2.0. Suppose that 5.0% of branches get 500 or more visitors per
day. What percentage of branches get 2,000 or more visitors per day?
a) 0.3125%
b) 1.000%
c) 1.250%
d) 2.625%
702.3. Your colleague Robert is estimating the daily volatility of your firm's traded stock price
based on this formula for the variance rate
1
= ( − )
−1
However, he wants to employ a few simplifications to his estimate of simple daily historical
volatility. Each of the following simplifying assumptions is acceptable EXCEPT which is likely a
mistake?
a) He is going to assume the expected (mean) return is zero

b) He is going to multiply the summation by 1/m instead of 1/(m-1)
c) Instead of summing the squared returns, he is going to sum returns (without squaring)
d) For the returns, u(i), he replaces log returns, ln[S(i)/S(i-1)], with simple returns, S(i)/S(i-
1)-1
11
Answers:
702.1. D. 35.00%. The unbiased variance = 0.004410/(n-1) = 0.004410/9 = 0.0004900, such

that daily volatility = sqrt(0.0004900) = 2.21359% and scaled volatility equals 2.21359% *
sqrt(250) = 35.00%
Please note that, alternatively, we can calculate the maximum likelihood estimated (MLE)
variance by using a denominator of (n) instead of (n-1); in this case, the variance estimate is
0.004410/10 = 0.000441, which is given in the exhibit. Then the daily volatility estimate equals
sqrt(0.000441) = 2.100% and the annualized volatility equals 2.100%*sqrt(250) = 33.20%, in
which case choice (D) is still the NEAREST choice. Why either? Because variance is a sample
estimator, and more than one estimator is possible. The issue is desirable properties of the
estimator.
702.2. A. 0.3125%
Per Hull 10.1 the power laws says Prob(v > X) = K*X^(-α). In this case, we are given 0.050 =
K*500^(-2.0) such that K = 0.050*500^2 = 12,500. Then the Prob(v > 2,000) = 12,500/2000^2 =
0.0031250 = 0.31250%.
702.3. C. Mistake: without squaring, positive and negative returns will offset and, for
example, high volatility might manifest as a low number; further, disperse values will not
"pull" the statistic with any greater weight.
In regard to (A), (B) and (D), each is TRUE as one of Hull's three simplifications. Specifically, for
the purpose of estimating daily volatility:
1. Hull replaces log returns, ln[S(i)/S(i-1)], with simple returns, S(i)/S(i-1)-1; however, either
is acceptable, as log returns are time-additive while arithmetic returns add cross-
sectionally across the portfolio, so it's a matter of minor technical trade-off.
2. He assumes the expected mean return is zero, which is a conventional assumption for a
daily horizon
3. He replaces unbiased (m-1) with MLE (m); either is acceptable.
Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t2-702-simple-equally-

weighted-historical-volatility-hull.10143/
12
P1.T2.705. Correlation
Learning objective: Define correlation and covariance and differentiate between
correlation and dependence.
705.1. In order to evaluate the potential of a linear relationship between portfolio returns and a
benchmark index, your colleague Richard conducted a univariate regression analysis. He
regressed the benchmark index returns, B(i), as the dependent (aka, response) variable against
portfolio returns, R(i), as the independent (aka, explanatory) variable. Here is his summary
output:
Which is nearest to the correlation coefficient between portfolio returns, R(i), and the
benchmark returns, R(b)?
a) a. 0.4937
b) 0.5150
c) 0.6237
d) We cannot know without the adjusted R^2
13
705.2. Consider the following probability matrix that displays four joint probabilities, Prob(X,Y):
Which is nearest to the correlation between (X) and (Y)?
a) 0.35
b) Zero
c) +0.29
d) +0.41
705.3. You have assumed a single-index model and regressed the returns for two stocks, stock
(A) and stock (B), against the index in separate univariate regressions. This produced the
following two linear functions, such that β(A) is 0.80 and β(B) is 1.40:
, = + , + ,
= 0.020 + 0.80 +
= 0.050 + 1.40 +
Additionally, the volatility of the index, σ(M), is 20.0%, the volatility of stock A, σ(A), is 32.0%
and the volatility of stock B, σ(B), is 40.0%. Which of the following is the implied correlation
between the two stocks?
a) 0.2240
b) 0.3500
c) 0.4900
d) 1.1200
14
Answers:
705.1. C. 0.6237. The coefficient of determination, R^2 = ESS/TSS = 1.728/4.442 = 0.3890; in

the case of a univariate regression, the correlation coefficient, r = SQRT(R^2) = sqrt(0.3890) =
62.37%
705.2. D. +0.41.
Covariance(X,Y) = E(X*Y) - E(X)*E(Y) = 5.20 - 1.50*3.40 = 0.10.

The Standard deviation(X) = 0.50 and Standard deviation(Y) = sqrt(0.240) = 0.48989, such that
Correlation(X,Y) = Covariance(X,Y)/[Standard deviation(X)*Standard deviation(Y)] =
0.10/[0.50*sqrt(0.240)] = 0.408248.
705.3. B. 0.3500. Covariance(A,B) = β(A)*β(B)*σ(M)^2 = 0.80*1.40*0.20^2 = 0.04480 and

correlation = 0.04480/(0.32*0.40) = 0.350.
Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t2-705-correlation-

hull.10172/
15
P1.T2.706. Bivariate normal distribution

Learning objectives: Describe properties of correlations between normally distributed
variables when using a one-factor model.
706.1. The data and plot below show a bivariate normal sample distribution. The first two
columns, z(1) and z(2), display random standard normal variables, N(0,1). Because X(1) is a
(non-standard) random normal variable with mean, µ, of 2.0 and standard deviation, σ, of 4.0, it
is given by X(1) = 2.0 + 4.0 * z(1). On the other hand, X(2) is correlated with X(1) according to
the selected correlation parameter, ρ(X1, X2), of 0.80.
What is the missing third realization ("???") of X(2)?
a) -1.27
b) +3.03
c) +8.50
d) +13.12
16
706.2. The general single-factor model below, given by U(i), characterizes both U(1) and U(2)
which are both dependent on a common factor, (F):
= + 1−
= 0.12 + 1 − 0.12
= 0.70 + 1 − 0.70
What is the coefficient of correlation between U(1) and U(2)?
a) -0.4900
b) +0.0840
c) +0.5044
d) +0.8200
706.3. Yesterday's volatility, σ(n-1), and the return data for two assets is shown below:
Yesterday's correlation,ρ(A,B), between the asset was 0.50. If we assume a lambda, λ,

parameter of 0.850, which is nearest to the updated correlation between the two assets if we
use an exponentially weighted moving average (EWMA) model to update the correlation?
a) 0.500
b) 0.533
c) 0.600
d) 0.731
17
Answers:
706.1. D. +13.12
e(2) = ρ*z(1) + z(2)*sqrt(1-ρ^2) = 0.80*0.340+1.050*sqrt(1-0.80^2) = 0.9020, is the random

correlated standard normal variable.
The realized X(2) = µ+σ*e(2) = 5.0+9.0*0.9020 = $13.1180.
In order to generate random but correlated standard normal variables, we can use:
= + 1−
706.2. B. In +0.0840 = 0.70*0.12
706.3. C. 0.600
Covariance(n-1) = 0.50*2.0%*3.0% = 0.00030;
Covariance(n) = 0.85 * 0.00030 + (1-0.85)*(-2.0%)*(-5.0%) = 0.0004050;
Updated variance(A) = σ^2(A) = 0.85*2.0%^2 + (1-0.85)*(-2.0%^2) = 0.000400;
Updated variance(B) = σ^2(B) = 0.85*3.0%^2 + (1-0.85)*(-5.0%^2) = 0.001140;
Updated correlation, ρ(A,B), = 0.0004050/[sqrt(0.000400)*sqrt(0.001140)] = 0.59975.
Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t2-706-bivariate-normal-

distribution-hull.10189/
18
P1.T2.502. Covariance updates with EWMA and GARCH(1,1) models

Learning Objectives: Define correlation and covariance, differentiate between correlation
and dependence.
502.1. About the consistency condition, each of the following is true EXCEPT:
a) All variance-covariance matrices are internally consistent

b) An arbitrary small change to a positive-semidefinite matrix with 1,000 rows and columns
(i.e., 1,000 * 1,000) can render it no longer being positive-semidefinite
c) A positive-semidefinite matrix is a matrix that satisfies w(T)Ωw for all vectors w, where
w(T) is the transpose of w
d) If a correlation matrix is not positive-semidefinite, the correlations are internally
inconsistent.
502.2. Suppose that the current daily volatilities of asset A and asset B are, σ(A, n-1) = 3.0%
and σ(B, n-1) = 5.0%, respectively. The prices of the assets at close of trading yesterday were
$10.00 and $20.00 and the estimate of the coefficient of correlation between the returns on the
two assets made at that time was 0.30. The lambda (λ) parameter used in the EWMA model is
0.80. The prices of the assets at close of trading today are $11.00 and $21.00. Which is nearest
to the updated correlation estimate? (Note: this is a variation on Hull's question 11.5)
a) 0.18
b) 0.32
c) 0.44
d) 0.52
502.3. Suppose that the current daily volatilities of asset X and asset Y are 3.0% and 6.0%,
respectively. The prices of the assets at close of trading yesterday were $50.00 and $70.00 and
the estimate of the coefficient of correlation between the returns on the two assets made at this
time was 0.50. Correlations and volatilities are updated using a GARCH(1,1) model. The
estimates of the model’s parameters are: alpha (α) = 0.040 and beta (β) = 0.940. For the
correlation, omega (ω) = 0.000001 and for the volatilities omega (ω) = 0.000003. If the prices of
the two assets at close of trading today are $55.00 and $84.00, which is nearest to the updated
correlation estimate? (note: this is a variation on Hull's question 11.6)
a) 0.33
b) 0.48
c) 0.66
d) 0.73
19
Answers:
502.1. A. Not all variance-covariance matrices are internally consistent. A positive-

semidefinite matrix is a matrix that satisfies Hulls equation 11.4: w(T)Ωw ≥ 0 for all vectors w. If
a correlation matrix is not positive-semidefinite, the correlations are internally inconsistent.
Hull: "Once variance and covariance rates have been calculated for a set of market variables, a
variance-covariance matrix can be constructed. When i ≠ j, the (i,j) element of this matrix shows
the covariance rate between variable (i) and variable (j). When i = j it shows the variance rate of
variable (i). (See Section 15.3. Not all variance-covariance matrices are internally consistent.
The condition for an N*N variance-covariance matrix, Ω, to be internally consistent is:
w(T)Ωw ≥ 0 (Hull's formula 11.4)
for all N*1 vectors (w) where w(T) is the transpose of (w). A matrix that satisfies this property is
known as positive-semidefinite.
... If we make a small change to a positive-semidefinite matrix that is calculated from

observations on three variables (e.g., for the purposes of doing a sensitivity analysis), it is likely
that the matrix will remain positive-semidefinite. However, if we do the same thing for
observations on 1,000 variables, we have to be much more careful. An arbitrary small change to
a positive-semidefinite matrix is quite likely to lead to it no longer being positive-semidefinite."
20
502.2. D. 0.52
See calculations in spreadsheet HERE
21
502.3. C. 0.66 See calculations in spreadsheet HERE
Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t2-502-covariance-

updates-with-ewma-and-garch-1-1-models.8339/
22
P1.T2.503. One-factor model (Hull)

Learning Objectives: Describe properties of correlations between normally distributed
variables when using a one-factor model.
503.1. Let (U) be a random normal with mean of 5.0 and standard deviation of 3.0, and let (V)
be a random normal with mean of 10.0 and standard deviation of 6.0; i.e., U ~ N(5.0, 3.0^2) and
V ~ N(10.0, 6.0^2). We want to generate samples from a bivariate normal distribution where the
correlation parameter (rho) is 0.70. If the univariate standard normal random draws are z(1) = -
0.880 and z(2) = +0.630, such that z(1) informs (U), which are nearest to the corresponding
bivariate samples?
a) $2.36 and $9.00

b) $3.11 and $3.97
c) $4.37 and $15.02
d) $8.87 and $19.32
503.2. Sometimes the correlations between normally distributed variables are defined using a
factor model. Suppose that U(1), U(2), ... U(N) have standard normal distributions. In a one-
factor model, each U(i) has a component dependent on a common factor, (F), and a component
that is uncorrelated with the other variables. Each of the following statements is true about the
one-factor model EXCEPT which is false?
a) A one-factor model imposes some structure on the correlations and has the advantage
that the resulting covariance matrix is always positive-semidefinite
b) If we do not assume factor model, the number of correlations to estimate for (N)
variables is N*(N-1)/2; for example, if N = 30, 435 = 30*29/2 correlation pair estimates
are required
c) If we do assume a one-factor model, the minimum number of parameter estimates is
only (2*N), an systematic value plus a non-systematic value for each variable; for
example, if N = 20, then 40 = 2*20 estimates are required at a minimum
d) An example of a one-factor model from the world of investments is the capital asset
pricing model where the return on a stock has a component dependent on the return
from the market and an idiosyncratic (non-systematic) component that is independent of
the return on other stocks
23
503.3. In a one-factor model, each U(i) has a component dependent on a common factor, F,
and a component that is uncorrelated with the other variables. Formally, U(i) = a(i)*F + sqrt[1 -
a(i)^2]*Z(i), where (F) and Z(i) have standard normal distributions and a(i) is a constant between
-1.0 and +1.0. The Z(i) are uncorrelated with each other and uncorrelated with (F). Consider two
variables, U(1) and U(2) as follows:
 U(1) = a(1)*F + sqrt[1 - a(1)^2]*Z(1) = 0.650*F + sqrt[1 - 0.650^2]*Z(1)
 U(2) = a(2)*F + sqrt[1 - a(2)^2]*Z(2) = 0.480*F + sqrt[1 - 0.480^2]*Z(2)
Which is nearest to the coefficient of correlation between U(1) and U(2)?
a) 0.0973
b) 0.1498
c) 0.2028
d) 0.3120
24
Answers:
503.1. A. $2.36 and $9.00

Given U ~ N(5.0, 3.0^2), V ~ N(10.0, 6.0^2), z(1) = -0.880 and z(2) = +0.630:
U = 5.0 + 3.0*z(1) = 5.0 + 3.0*-0.880 = $2.360;
V = 10.0 + 6.0*[rho*z(1) + sqrt(1 - rho^2)*z(2)] = 10.0 + 6.0*[0.70*(-0.880) + sqrt(1 -
0.70^2)*0.630] = $9.003
503.2. C. If we assume a one-factor model, the minimum number of parameter estimates

is (N)
Hull: "Factor Models: Sometimes the correlations between normally distributed variables are
defined using a factor model. Suppose that U(1), U(2), ..., U(N) have standard normal
distributions (i.e., normal distributions with mean zero and standard deviation 1). In a one-factor
model, each U(i) has a component dependent on a common factor, F, and a component that is
uncorrelated with the other variables. Formally
U(i) = a(1)*F + sqrt[1 - a(1)^2]*Z(1) (formula 11.6)
where F and the Z(i) have standard normal distributions and a(i) is a constant between -1.0 and
+1.0. The Z(i) are uncorrelated with each other and uncorrelated with F. In this model, all the
correlation between U(i) and U(j) arises from their dependence on the common factor, F. The
coefficient of correlation between U(i) and U(j) is a(i)*a(j).
A one-factor model imposes some structure on the correlations and has the advantage that the
resulting covariance matrix is always positive-semidefinite. Without assuming a factor model,
the number of correlations that have to be estimated for the N variables is N*(N-1)/2. With the
one-factor model, we need only estimate N parameters: a(1), a(2), ... , a(N). An example of a
one-factor model from the world of investments is the capital asset pricing model where the
return on a stock has a component dependent on the return from the market and an
idiosyncratic (nonsystematic) component that is independent of the return on other stocks (see
Section 1.3). The one-factor model can be extended to a two-factor, three-factor, or multi-factor
model."1
In regard to (A), (B) and (D), each is TRUE
503.3. D. 0.3120. The correlation coefficient = a(1)*a(2) = 0.650*0.480 = 0.3120.
Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t2-503-one-factor-

model-hull.8345/
1
John Hull, Risk Management and Financial Institutions, 5th Edition (Boston: Pearson Prentice Hall, 2018)
25

Bionic Turtle FRM Practice Questions P1.T2. Quantitative Analysis Chapter 12: Measuring Return, Volatility, and Correlation

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Bionic Turtle FRM Practice Questions P1.T2. Quantitative Analysis Chapter 12: Measuring Return, Volatility, and Correlation

Uploaded by

Copyright:

Available Formats

Licensed to Christian Rey Magtibay at christianrey_magtibay@yahoo.com. Downloaded August 22, 2021.

Bionic Turtle FRM Practice Questions

P1.T2. Quantitative Analysis

Chapter 12: Measuring Return, Volatility, and

Chapter 12: Measuring Return, Volatility, and Correlation

P1.T2.21.3. RETURNS, VOLATILITY AND NON-NORMAL DISTRIBUTIONS ........................................ 3

Chapter 12: Measuring Return, Volatility, and Correlation

P1.T2.21.3. Returns, volatility and non-normal distributions

21.3.1. A. True: Only Alice and Donald are correct

21.3.2. B. True: 6.50%

21.3.3. C. True: Cindy

Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-21-3-returns-

P1.T2.21.4. Non-normal distributions and rank correlations

What are, respectively, the Spearman's Rank and Kendall's tau?

a) -0.70 (rank) and -0.55 (Kendall's)

21.4.2. A. True: $17.0 and $28.0 million

21.4.3. C. True: 0.90 (rank) and 0.80 (Kendall's)

The Spearman's rank correlation is given by 1 - 6*2/((5^2-1)*5) = 0.90.

Discuss here in the forum: https://www.bionicturtle.com/forum/threads/p1-t2-21-4-non-normal-

P1.T2.702. Simple (equally weighted) historical volatility (Hull)

a) 5.0% per annum

a) He is going to assume the expected (mean) return is zero

702.1. D. 35.00%. The unbiased variance = 0.004410/(n-1) = 0.004410/9 = 0.0004900, such

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t2-702-simple-equally-

Which is nearest to the correlation between (X) and (Y)?

705.1. C. 0.6237. The coefficient of determination, R^2 = ESS/TSS = 1.728/4.442 = 0.3890; in

Covariance(X,Y) = E(X*Y) - E(X)*E(Y) = 5.20 - 1.50*3.40 = 0.10.

705.3. B. 0.3500. Covariance(A,B) = β(A)*β(B)*σ(M)^2 = 0.80*1.40*0.20^2 = 0.04480 and

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t2-705-correlation-

P1.T2.706. Bivariate normal distribution

What is the missing third realization ("???") of X(2)?

Yesterday's correlation,ρ(A,B), between the asset was 0.50. If we assume a lambda, λ,

e(2) = ρ*z(1) + z(2)*sqrt(1-ρ^2) = 0.80*0.340+1.050*sqrt(1-0.80^2) = 0.9020, is the random

The realized X(2) = µ+σ*e(2) = 5.0+9.0*0.9020 = $13.1180.

706.2. B. In +0.0840 = 0.70*0.12

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t2-706-bivariate-normal-

P1.T2.502. Covariance updates with EWMA and GARCH(1,1) models

a) All variance-covariance matrices are internally consistent

502.1. A. Not all variance-covariance matrices are internally consistent. A positive-

w(T)Ωw ≥ 0 (Hull's formula 11.4)

... If we make a small change to a positive-semidefinite matrix that is calculated from

502.3. C. 0.66 See calculations in spreadsheet HERE

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t2-502-covariance-

P1.T2.503. One-factor model (Hull)

a) $2.36 and $9.00

Which is nearest to the coefficient of correlation between U(1) and U(2)?

503.1. A. $2.36 and $9.00

503.2. C. If we assume a one-factor model, the minimum number of parameter estimates

U(i) = a(1)*F + sqrt[1 - a(1)^2]*Z(1) (formula 11.6)

In regard to (A), (B) and (D), each is TRUE

503.3. D. 0.3120. The correlation coefficient = a(1)*a(2) = 0.650*0.480 = 0.3120.

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p1-t2-503-one-factor-

You might also like

The Spearman's rank correlation is given by 1 - 62/((5^2-1)5) = 0.90.

Covariance(X,Y) = E(XY) - E(X)E(Y) = 5.20 - 1.50*3.40 = 0.10.

705.3. B. 0.3500. Covariance(A,B) = β(A)β(B)σ(M)^2 = 0.801.400.20^2 = 0.04480 and

e(2) = ρz(1) + z(2)sqrt(1-ρ^2) = 0.800.340+1.050sqrt(1-0.80^2) = 0.9020, is the random

The realized X(2) = µ+σe(2) = 5.0+9.00.9020 = $13.1180.

U(i) = a(1)F + sqrt[1 - a(1)^2]Z(1) (formula 11.6)

503.3. D. 0.3120. The correlation coefficient = a(1)a(2) = 0.6500.480 = 0.3120.