FRM P2 Current Issues in Financial Markets: practice questions with answers

Question 1

A bank's machine-learning model for small-business credit approvals performed well at validation. Eighteen months later, after a sharp rise in interest rates changed borrower behaviour, default rates among approved applicants are well above model predictions, even though the code and input pipeline are unchanged. Which risk best describes this problem?

1. A Concept and data drift: the relationships the model learned no longer hold in the new environment
2. B Overfitting during development, which should have been caught by out-of-sample testing
3. C Hallucination, in which the model produces fabricated outputs
4. D Data poisoning by an attacker who altered the training data

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Answer: A. Machine-learning models learn patterns from historical data. When the economic regime changes, the distribution of inputs (data drift) and the link between inputs and outcomes (concept drift) can shift, so performance declines. Sound model risk management for AI includes continuous performance monitoring against outcomes, drift metrics, triggers for recalibration or retraining, and challenger models, in addition to initial validation and explainability.

Question 2

An asset manager plans to use a third-party generative AI model to draft client portfolio commentaries. Which control best addresses the most significant risks of this use case?

1. A Relying on the vendor's model card, because responsibility for outputs passes to the vendor
2. B Raising the model's temperature setting so outputs are more varied and less likely to repeat errors
3. C Limiting use to internal staff, which removes the need for any output validation
4. D Human review of every output before release, plus vendor due diligence covering data handling, model changes and service resilience

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Answer: D. Key generative AI risks for financial firms include fabricated or inaccurate outputs (hallucinations), leakage of confidential data into prompts or training, limited explainability, and concentration on a few third-party model providers. Supervisors expect firms to keep accountability, maintain human oversight proportionate to the impact of the use case, and apply third-party risk management to AI vendors.

Question 3

A bank's risk committee asks how geopolitical risk events are transmitted to financial institutions. Which statement is most consistent with the IMF's findings?

1. A Effects are confined to the countries directly involved, so a bank with no direct exposure to them faces no material risk from the conflict
2. B Geopolitical events mainly help banks, because deposit inflows from savers seeking safety allow them to expand lending to their customers
3. C Because markets price geopolitical risk fully in advance, events that actually materialise no longer cause meaningful market volatility
4. D Bank equity tends to fall and lending to decline when the home country or key foreign counterparts are in a military conflict, and exposed funds see outflows

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Answer: D. Geopolitical shocks spread across borders through trade and financial linkages and through commodity prices: firms' share prices fall significantly when a main trading partner is involved in a military conflict.

For financial institutions, bank equity tends to fall and lending declines when the home country or key foreign counterparts are in a conflict, and investment funds exposed to those countries suffer lower returns and higher outflows. The IMF recommends that institutions and supervisors devote adequate resources to identifying, quantifying and managing geopolitical risk, including through stress testing and scenario analysis.

Question 4

A securities market moves to a tokenized platform on which trades settle atomically: the asset and the payment are transferred at the same moment by a smart contract on a shared ledger. Which trade-off is most consistent with the IMF's analysis of tokenization?

1. A Atomic settlement removes the need for a settlement asset, so no form of money has to be represented on the ledger
2. B Settlement risk falls and collateral is tied up for less time, but assets and funds must be prepositioned before a trade, which can raise liquidity needs
3. C Atomic settlement raises counterparty risk, because each trade is treated as settled before either party has actually delivered
4. D Atomic settlement makes intermediaries such as brokers, custodians and clearing houses completely obsolete

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Answer: B. A shared, programmable ledger allows a smart contract to exchange funds and an asset in one step. This removes the delay of several business days in conventional clearing and settlement, reducing counterparty risk on the exchange and the time collateral is locked up.

The trade-off is that assets and funds have to be prepositioned for the trade to occur, so participants may need to hold more liquidity or collateral in advance. Tokenization is expected to cut the costs of intermediaries' processes rather than eliminate intermediaries.

Question 5

According to BIS cross-country evidence on what drives the growth of private credit, which combination of conditions is associated with a larger private credit footprint in a country?

1. A Higher policy rates, a more efficient banking system and looser bank regulation
2. B Lower policy rates, a less efficient banking system and stricter bank regulation
3. C Lower policy rates, a more efficient banking system and looser bank regulation
4. D Higher policy rates, a less efficient banking system and looser bank regulation

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Answer: B. BIS analysis of private credit across countries finds that its footprint is larger where:

- Policy rates are lower: low rates sent institutional investors such as pension funds and insurers searching for yield, and squeezed bank margins.
- The banking system is less efficient: this had the largest estimated effect, as private credit fills gaps left by banks.
- Bank regulation is stricter: a smaller but significant effect, consistent with some lending moving outside the banking system.

Borrowers are mostly small and mid-sized firms that banks underserve, often highly leveraged or with negative earnings. Private credit has not yet been through a full credit cycle, and fund portfolios tend to be concentrated by sector.

Question 6

Inflation in Country V is well above target. Its central bank holds back from raising interest rates because the government's large, short-maturity debt means higher rates could trigger a sovereign debt crisis. In the BIS analysis of monetary-fiscal interactions, how is this situation best described?

1. A Fiscal dominance driven by an economic constraint, outside the region of stability, which independence safeguards can do relatively little to prevent
2. B A policy mix inside the region of stability, because holding rates steady avoids a sovereign debt crisis and so preserves stability
3. C Fiscal dominance arising from political pressure, which can be removed entirely by strengthening the central bank's legal independence
4. D Financial repression, a strategy that the BIS recommends as the most reliable way of reducing high public debt

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Answer: A. The BIS describes a region of stability: the combinations of monetary and fiscal policy that foster macroeconomic and financial stability. Its edges are hard to locate and can shift abruptly as confidence changes.

Fiscal dominance is a situation in which monetary policy cannot tighten because of fiscal constraints. It can come from political pressure or from an economic constraint, when higher rates risk a sovereign debt crisis. Independence safeguards help against the first but do relatively little against the second. Keeping low and stable inflation ultimately requires fiscal backing, so the BIS stresses fiscal prudence and keeping a margin of safety from the region's boundaries.