GARP FRM Part II Practice Test

Financial Risk Manager (FRM) Part II is the applied GARP route for market risk, credit risk, operational risk, liquidity risk, treasury risk, investment risk, and current issues in financial markets.

This page includes 12 original sample questions for initial review. They are not official GARP questions and do not reproduce a live exam; they are designed to preview the applied risk-scenario reasoning that a full Finance Prep route would need to support.

What this route should test

• applying risk frameworks to trading, credit, liquidity, operational, and investment scenarios
• choosing the best risk response or measurement approach under realistic constraints
• interpreting model output, stress results, and risk-reporting implications
• connecting technical risk measures to governance and business decisions

Sample Exam Questions

These questions focus on risk-response judgment rather than isolated definitions. Use them to identify whether you need more work on market, credit, liquidity, operational, or governance application.

Question 1

Topic: credit migration

A corporate borrower has not defaulted, but its credit rating has been downgraded and market spreads have widened materially. What is the most likely risk-management implication?

• A. The credit exposure is unchanged because default has not occurred
• B. The position may require reassessment because credit quality, mark-to-market value, and capital use can change before default
• C. The downgrade affects equity investors only
• D. Spread widening removes the need for credit monitoring

Best answer: B

Explanation: FRM Part II questions often test credit deterioration before default. Downgrades and wider spreads can affect valuation, expected loss, limits, capital, and hedging decisions even when contractual payments are still current.

Question 2

Topic: operational risk

A bank suffers losses because an automated reconciliation control was disabled during a system migration and exception reports were not reviewed. Which risk type is most directly involved?

• A. Pure market risk
• B. Interest-rate risk
• C. Reinvestment risk
• D. Operational risk from process, system, and control failure

Best answer: D

Explanation: Operational risk includes failures of processes, systems, people, and controls. The fact pattern is not mainly about market movement; it is about a control breakdown during change management.

Question 3

Topic: liquidity stress

A firm funds long-dated illiquid assets with short-term wholesale borrowing. In a market stress, lenders refuse to roll funding. What is the key weakness?

• A. A maturity and liquidity mismatch that can create funding pressure even if assets are economically sound
• B. Excess diversification
• C. Too much permanent equity funding
• D. A pure accounting classification issue

Best answer: A

Explanation: Liquidity risk can become severe when asset maturities and funding maturities are mismatched. Long-term assets may retain value, but the firm can still face distress if short-term funding cannot be renewed.

Question 4

Topic: hedging basis risk

A commodity producer hedges its exposure with a futures contract on a related but not identical commodity. Prices usually move together, but the relationship weakens during stress. What risk remains?

• A. Settlement risk only
• B. No risk because any futures hedge is perfect
• C. Basis risk because the hedge and exposure may not move one-for-one
• D. Governance risk only

Best answer: C

Explanation: Basis risk arises when the hedge instrument does not perfectly track the exposure being hedged. A related futures contract can reduce risk while still leaving residual mismatch, especially during stress.

Question 5

Topic: risk-adjusted performance

A business unit has high accounting profit but also consumes a large amount of economic capital because of tail-risk exposure. What measure would best help compare it with lower-risk units?

• A. Revenue growth only
• B. Headcount growth
• C. Total assets without risk adjustment
• D. Risk-adjusted return on capital or a similar capital-adjusted performance measure

Best answer: D

Explanation: FRM Part II application questions often require connecting performance to capital and risk. A unit that earns more absolute profit may not create more risk-adjusted value if it consumes significantly more capital.

Question 6

Topic: counterparty credit valuation

A derivatives portfolio has positive exposure to a counterparty whose credit spread has widened. Which adjustment is most directly concerned with counterparty credit risk in valuation?

• A. Theta
• B. Credit valuation adjustment
• C. Duration gap
• D. Inventory turnover

Best answer: B

Explanation: Credit valuation adjustment reflects the effect of counterparty credit risk on derivative valuation. Spread widening can increase the adjustment because the counterparty’s credit quality has deteriorated.

Question 7

Topic: stress testing

Why should a firm run stress tests even if its VaR model is backtesting within expectations?

• A. Stress tests explore severe but plausible scenarios that may not appear in recent VaR backtests
• B. Stress tests prove that losses cannot occur
• C. VaR becomes illegal once stress testing exists
• D. Backtesting and stress testing answer the same question

Best answer: A

Explanation: Backtesting checks model performance against realized outcomes; stress testing explores severe scenarios and vulnerabilities. Both are useful because a model can pass ordinary backtests while still underrepresenting tail or concentration risk.

Question 8

Topic: risk aggregation

A group aggregates risks across business lines using correlations estimated during calm markets. What should the risk committee be most cautious about?

• A. Correlations are irrelevant for aggregation
• B. Calm-market correlations always overstate diversification benefits
• C. Correlations can change during stress, reducing expected diversification benefits
• D. Aggregation should ignore concentration risk

Best answer: C

Explanation: Correlation assumptions can break down under stress. Aggregation that relies too heavily on calm-period correlations may understate concentration and tail risk when diversification is needed most.

Question 9

Topic: model validation

A desk builds a complex market-risk model and wants approval from the same team that designed it because they understand the model best. What is the main governance problem?

• A. The model is automatically invalid because it is complex
• B. Validation should focus only on user-interface design
• C. Validation is unnecessary if the desk is profitable
• D. Independent review is needed to challenge assumptions, data, implementation, and use

Best answer: D

Explanation: Model validation should be sufficiently independent to challenge design choices and implementation. Expertise matters, but unchecked self-approval weakens model-risk governance.

Question 10

Topic: limit breach response

A trader breaches a risk limit after a volatile session. The position is profitable, and the trader argues no action is needed. What should the risk function do first?

• A. Ignore the breach because profit proves the risk was justified
• B. Follow the escalation and investigation process, including whether the limit remains appropriate and whether the position should be reduced or approved
• C. Permanently remove the limit
• D. Publicly discipline the trader before understanding the facts

Best answer: B

Explanation: A profitable breach is still a breach. The correct response is controlled escalation, documentation, and decision-making, not automatic punishment or automatic approval.

Question 11

Topic: investment risk

A portfolio manager is judged against a benchmark but repeatedly takes large off-benchmark sector positions without clear client authorization. Which risk measure or concern is most relevant?

• A. Tracking error and mandate compliance
• B. Accounts-payable turnover
• C. Warehouse shrinkage
• D. Payroll tax exposure

Best answer: A

Explanation: Investment-risk questions often connect portfolio risk to mandate and benchmark constraints. Large active positions can create tracking error and suitability or mandate issues even when the manager expects higher returns.

Question 12

Topic: emerging risk governance

A new market structure creates faster settlement, new operational dependencies, and less time for trade repair. What is the best risk-management response?

• A. Treat it as a technology issue outside risk governance
• B. Ignore it until a loss occurs
• C. Map the new process, identify operational and liquidity impacts, update controls, and monitor incidents
• D. Assume faster settlement always reduces every type of risk

Best answer: C

Explanation: Current-issues questions reward disciplined risk thinking. A new market process can reduce some exposures while increasing operational, funding, or control pressure. The best answer maps the changed workflow and updates controls.

FRM Part II quick checklist

• Can you separate market, credit, operational, liquidity, investment, and model-risk issues in one scenario?
• Can you choose the next governance action after a breach, stress result, validation issue, or liquidity warning?
• Can you explain why a risk measure is useful without treating it as a complete risk answer?

Related GARP pages

• FRM Part I
• Sustainability and Climate Risk
• GARP certification updates