Aineas part

Question 1

What is alpha?

Answer 1

The extra return made on a portfolio in excess of that predicted by CAPM (the weighted average of all investors = 0)

Question 2

Is risk management necessary for a well-diversified shareholder?

Answer 2

Maybe not, but it decreases the risk of bankruptcy costs

Question 3

What are the two markets for trading financial instruments?

Answer 3

Exchange traded market – futures

Over the counter market – forwards

Question 4

Derivatives can be used for

Answer 4

Hedging – reducing risk
Speculation – taking arbitrary risks
Arbitrage – riskless profiting from market price discrepancies

Question 5

A utility function is concave if:

Answer 5

The first derivative (marginal utility) is positive
AND
The second derivative (diminishing marginal utility) is negative

Question 6

When is an individual risk averse?

Answer 6

When u[E(x)] > E[u(x)]

Question 7

What are the most common risks insurance companies face?

Answer 7

• Moral hazard – change of behaviour of the insured agent

- Adverse selection – attracting bad risk when unable to distinguish between good and bad

Question 8

The Greeks

Answer 8

Measure different aspects of market risk in a transaction

Question 9

Delta

Answer 9

Indicates how sensitive the portfolio value is to a variable. Delta neutrality provides protection against relatively small asset price moves between rebalancing

Question 10

What’s important to remember when delta hedging in terms of linear and non-linear products?

Answer 10

• Linear products are relatively easy to hedge against both small and large changes without changing the hedge
• Non-linear products are only hedged for small price movements and needs to be changed frequently

Question 11

Gamma

Answer 11

The rate of change in a portfolio’s delta with respect to the price of the underlying asset. Gamma neutrality provides protection against larger movements in the asset price between rebalancing

Question 12

Vega

Answer 12

Change of value of the portfolio with respect to the volatility of the underlying asset price. Vega neutrality protects against variations in volatility between hedge rebalancing. (when sigma increases by 1% the portfolio value increases/decreases with Vega)

Question 13

Explain the advantages and disadvantages with Value at Risk

Answer 13

Advantages – relatively easy to calculate and understand

Disadvantages – unreliable for longer time periods and under abnormal market conditions

Question 14

Expected shortfall (conditional Value at Risk)

Answer 14

The expected loss during a period conditional on the loss being greater than VaR

Question 15

Extreme Value Theory

Answer 15

Estimates the tails of a distribution

Question 16

Correlation

Answer 16

Measure that describes the linear relationship between two variables p = cov(x,y) / sqrt(var(x)*var(y)

Question 17

Covariance

Answer 17

Covariance between the daily returns of the two variables cov = E[(x-u)*(x-u)]

Question 18

Copulas

Answer 18

The marginal distribution of a variable is the unconditional distribution of the variable