Topics under Current Issues in Financial Markets in FRM Part 2 Exam

Current Issues in Financial Markets is one of the six broad topics that GARP tests in its FRM Part 2 exam. This broad topic has a 10% weight in the exam. This means out of 80 questions asked, you may expect 8 questions from this section. This area focuses on current issues that have a strong impact on financial markets.

The broad knowledge points covered in “Current Issues in Financial Markets” include the following:

• Reference rates
• Artificial intelligence (AI), machine learning, and “big data”
• Risk management implications of COVID-19
• Phasing out of Libor
• Climate risk
• Cyber resiliency in the wider financial system

There are ten readings in this section. If you go through the GARP specified learning objectives (LOs) for this section, you will find that all the LOs are non-computational. As GARP generally asks tricky questions from the non-computational LOs, you need to pay special attention to this section to score well in the exam.

Let’s go through the essence of each of the ten readings and identify the concepts that GARP might test on the exam day.

Chapter 1: Beyond LIBOR: a primer on the new benchmark rates

The transition from a reference rate regime based on interbank offered rates (IBORs) to one based on a new set of overnight risk-free rates (RFRs) is a vital paradigm shift for markets. This reading provides an overview of RFR benchmarks and compares some of their key characteristics with those of existing benchmarks.

While the new RFRs can serve as good and reliable overnight reference rates rooted in transactions in liquid markets, they do so at the cost of not capturing banks’ marginal term funding costs. Hence, it is likely that multiple rates may coexist under the new normal, fulfilling different purposes and market requirements. For the exam, focus on the following:

• Features comprising an ideal benchmark
• Issues that led to the replacement of LIBOR as the reference rate
• Risks inherent in basing risk-free rates (RFR’s) on transactions in the repo market

Chapter 2: Machine Learning: A Revolution in Risk Management and Compliance?

Financial institutions (FIs) are increasingly using machine learning approaches to manage and extract regulatory reporting data and unstructured information. This reading aims to introduce the machine learning field and covers several “regtech” application cases. The ability of machine learning methods to analyze very large amounts of data can substantially improve analytical capabilities across risk management and compliance areas.

Data quality and availability can be an issue. The predictive performance and granularity of analysis of several approaches may come at the expense of increased model complexity and a dearth of explanatory insight. This can be an issue particularly where analytics are used in a regulatory context, and a supervisor or compliance team will want to examine and understand the applied model. For the exam, focus on the following:

• Process of machine learning and different machine learning approaches
• Application of machine learning approaches within the financial services sector and the types of problems to which they can be applied
• Application of machine learning in three use cases:
  • Credit risk and revenue modeling
  • Fraud.
  • Surveillance of conduct and market abuse in trading

Chapter 3: Artificial Intelligence and Machine Learning in Financial Services

This reading talks about the financial stability implications of the growing use of artificial intelligence (AI) and machine learning in financial services. For the exam, focus on the following:

• Drivers that have contributed to the growing use of FinTech and the supply and demand factors that have spurred the adoption of AI and machine learning in financial services
• Use of AI and machine learning in the following cases:
• Customer-focused uses
• Operations-focused uses
• Trading and portfolio management in financial markets
• Uses for regulatory compliance
• Possible effects and potential benefits and risks of AI and machine learning on financial markets and how they may affect financial stability

Chapter 4: Climate Change: Physical Risk and Equity, Global Financial Stability Overview: Markets in the Time of COVID-19

This reading talks about how climate change can affect global financial stability. For the exam, focus on the following:

• Channels through which climate change can affect financial stability
• How climate change and climate risk have affected equity prices and equity valuations
• How country characteristics such as insurance penetration and economic development impact the extent to which climatic disasters affect equity prices

Chapter 5: The Green Swan – Central Banking and Financial Stability in the Age of Climate Change

This reading talks about how a “green swan” event (climate change) can be a threat to price stability and financial stability. For the exam, focus on the following:

• Concept of “green swan”, how it differs from “black swan” and why climate change is considered a ‘green swan” event
• Why climate change is a threat to price stability?
• Why climate change is a threat to financial stability?
• Measures that members of the financial safety net should consider under the risk, time horizon, and system resilience approaches as well as the limitations of these measures

Chapter 6: When Selling Becomes Viral: Disruptions in Debt Markets in the COVID-19 Crisis and the Fed’s Response

This reading talks about how the COVID-19 crisis has kind of disrupted the debt markets and how the Fed has responded to the crisis. For the exam, focus on the following:

• Evolution of bond and CDS prices during March-April 2020
• Comparison of the developments in debt markets during the Great Financial Crisis of 2008-2009 and during the COVID-19 crisis
• Effects of frictions and arbitrage limitations on price movements in debt markets during March-April 2020
• The Fed’s interventions in debt markets during March-April 2020 as well as the rationale for and effects of these interventions

Chapter 7: Global Financial Stability Report: Markets in the Time of COVID-19

This reading discusses how the COVID-19 crisis has hit the financial markets and the crisis’s monetary and financial policy responses. For the exam, focus on the following:

• Developments in financial and commodity markets during March-April 2020
• Global financial vulnerabilities intensified by the slowdown in economic activity and tightened financial conditions following the COVID-19 outbreak
• Various monetary and financial policy responses to COVID-19 as well as the future steps that should be taken

Chapter 8. Financial Crime in Times of COVID-19 – AML and Cyber Resilience Measures

This reading discusses the cyber-crimes perpetrated during the COVID-19 crisis and the anti-money laundering and cyber resilience measures. For the exam, focus on the following:

• Cyber threats faced by financial institutions because of the Covid-19 crisis
• Cyber resilience measures taken by international and national financial authorities in response to the increased cyber threats since the outbreak of Covid-19
• Anti-money laundering (AML) and anti-terrorism financing (ATF) measures taken by international and national financial authorities in response to the increased ML and TF risks since the outbreak of Covid-19

Chapter 9: Replacing LIBOR

Most financial experts are aware that LIBOR will likely cease at the end of 2021. Yet, it continues to be the most important global benchmark interest rate, forming the basis for an estimated $400 trillion of contracts. This reading examines the US dollar LIBOR transition process, emphasizing the substantial progress and the major hindrances await ahead. Regulators in the US and elsewhere are well aware of the risks of delay and are now pushing hard for LIBOR users to get ready for a world without LIBOR. For the exam, focus on the following:

• Key issues that could cause systemic disruption when LIBOR ends.
• Current state of the transition and the challenges that lie ahead.
• Government institutions’ role in the transition

Chapter 10: Cyber Risk and the U.S. Financial System: A Pre-Mortem Analysis

This reading talks about how a cyber-attack may get amplified through the U.S. financial system, focusing on the wholesale payments network. The impairment of any of the five most active U.S. banks will cause substantial spillovers to other banks, with 38 per cent of the network getting impacted on average.

When banks react to uncertainty by liquidity hoarding, the potential impact in forgone payment activity is huge, reaching more than 2.5 times daily GDP. In a reverse stress test, it is found that interruptions stemming from banks with less than $10 billion in assets are adequate to impair a substantial amount of the system. For the exam, focus on the following:

• Direct costs of and the spillovers caused by a cyber-attack
• How cyber shocks can get amplified through financial networks
• Policy responses that can be implemented against cyber events