Ch 1: Market Risk Management

Question 1

Identifies potential losses under extreme market conditions, which are associated with much higher confidence levels.

Answer 1

stress-testing

Question 2

What are the types of financial risks?

Answer 2

market risk, credit risk, settlement risk, and operational risk

Question 3

The risk of losses due to movements in financial market prices or volatilities.

Answer 3

Market risk

Question 4

The risk of losses due to the fact that counterparties may be unwilling or unable to fulfill their contractual obligations.

Answer 4

Credit risk

Question 5

The risk of loss resulting from failed or inadequate internal processes, systems and people, or from external events.

Answer 5

Operational risk

Question 6

What are the usual risk management tools/measures?

Answer 6

Notional amounts, sensitivity measures, and scenario analysis.

Question 7

True or False. The usual measures of risk management provide some intuition of risk, they also measure what matters the downside risk for the total portfolio.

Answer 7

False (Although these measures provide some intuition of risk, they do not measure what matters – that is, the downside risk for the total portfolio.)

Question 8

Notional amounts, sensitivity measures, and scenario analysis fails to take into account what factors?

Answer 8

(1) differences in volatilities across markets,
(2) correlations across risk factors,
(3) and probability of adverse moves in the risk factors.

Question 9

In the case of an inverse floater investment, what will most likely happen?

a. When rates go up, the PV of the CF will drop, and discount rate will increase
b. When rates go down, the PV of the CF will drop, and discount rate will increase
c. When rates go up, the PV of the CF will increase, and discount rate will increase
d. When rates go down, the PV of the CF will drop, and discount rate will decrease

Answer 9

a. When rates go up, the PV of the CF will drop, and discount rate will increase

Question 10

only provides an indication of the potential loss

Answer 10

notional amount

Question 11

This measure reveals the extreme sensitivity of the bond to interest rates but does not answer the question of whether such a disastrous movement in interest rates is likely. It also ignores the nonlinearity between the note price and yields.

Answer 11

duration

Question 12

provides some improvement, as it allows the investor to investigate nonlinear, extreme effects in price. But again, the method does not associate the loss with a probability.

Answer 12

Scenario analysis

Question 13

The bond with a value of $100M has three times the duration of a similar 4.5 year note. If the worst increase in yield at the 95% level is 1.65%, what will be the VAR?

Answer 13

$22M [VAR = Market value (100M) × Modified duration (13.5) × Worst yield increase (0.0165)]

Question 14

the maximum loss over a target horizon such that there is a low, pre-specified probability that the actual loss will be larger.

Answer 14

Value at Risk (VAR)

Question 15

What is the stimulated daily return in dollars of the given problem: Consider for instance a position of USD 4 million short the yen, long the dollar. Given the two hypothetical days of S1 = 112.0 and S2 = 111.8.

Answer 15

-7.2M [Rt($) = Q0($)[St - St-1] / St-1] —> 4M x (111.8 - 112)/112 = -$7.2M

Question 16

represents extreme values on the higher end. It is the probability of observing a loss greater than or equal to a certain threshold.

Answer 16

right-tail probability (understanding how likely it is for our losses to be big in those extreme situations.)

Question 17

represents extreme values on the lower end. It is the probability of observing a value less than or equal to a certain threshold.

Answer 17

Left-tail probability

Question 18

When the outcomes are discrete, VAR is:

a. the smallest loss such that the left- tail probability is at least c
b. the largest loss such that the left-tail probability is at least c
c. the largest loss such that the right-tail probability is at least c
d. the smallest loss such that the right-tail probability is at least c

Answer 18

d. the smallest loss such that the right-tail probability is at least c

Question 19

16. What is the correct interpretation of a $3 million overnight VAR figure with 99% confidence level? The institution

(Example #1)
a. Can be expected to lose at most $3 million in 1 out of next 100 days
b. Can be expected to lose at least $3 million in 95 out of next 100 days
c. Can be expected to lose at least $3 million in 1 out of next 100 days
d. Can be expected to lose at most $6 million in 2 out of next 100 days

Answer 19

c. Can be expected to lose at least $3 million in 1 out of next 100 days

Question 20

17. Based on a 90% confidence level, how many exceptions in back testing a VAR would be expected over a 250-day trading year?

(Example #2:)
a. 10
b. 15
c. 25
d. 50

Answer 20

c. 25

Question 21

VAR is a useful summary measure of risk, subject to some caveats:

Answer 21

(1) VAR does not describe the worst loss,
(2) VAR does not describe the losses in the left tail, and
(3) VAR is measured with some error.

Question 22

implies that the risk of a portfolio must be less than the sum of risks for portfolio components.

Answer 22

Subadditivity

Question 23

What are the alternative measures of risk:

Answer 23

• The Entire Distribution
• The Conditional VAR
• The Standard Deviation
• The Semi-standard Deviation
• The Drawdown

Question 24

true or false. the VAR of a portfolio can be greater than the sum of sub-portfolios VARs.

Answer 24

true

Question 25

22. has access to the whole distribution and could report a range of VAR numbers for increasing confidence levels.

Answer 25

Entire Distribution

Question 26

23. This measures the average of the loss conditional on the fact that it is greater than VAR.

Answer 26

conditional VAR

Question 27

simple summary measure of the distribution

Answer 27

standard deviation

Question 28

26. What is the advantage and disadvantage of the standard deviation?

a. Advantage: it takes into account few observations, not all of it around the quantile; Disadvantage: it is symmetrical and cannot distinguish between large losses or gains.
b. Advantage: it takes into account all observations, not just the few around the quantile; Disadvantage: it is symmetrical and cannot distinguish between large losses or gains.
c. Advantage: it takes into account all observations, not just the few around the quantile; Disadvantage: it is assymmetrical and has the same differences
between large losses or gains.
d. Advantage: it takes into account few observations, not all of it around the quantile; Disadvantage: it is assymmetrical and has the same differences between large losses or gains.

Answer 28

b. Advantage: it takes into account all observations, not just the few around the quantile; Disadvantage: it is symmetrical and cannot distinguish between large losses or gains.

Question 29

27. simple extension of the usual standard deviation that considers only data points that represent a loss.

Answer 29

semi-standard deviation

Question 30

True or false. The semistandard deviation is sometimes used to report downside risk, but is much less intuitive and less popular than VAR.

Answer 30

true

Question 31

semi-standard deviation Accounts for _____ in the distribution which makes this measure advantageous.

Answer 31

assymmetries

Question 32

30. is the decline from peak over a fixed time interval.

Answer 32

Drawdown

Question 33

is the largest such value over the period, or decline from peak to trough (local maximum to local minimum).

Answer 33

maximum drawdown

Question 34

32. This measure is useful if returns are not independent from period to period. Alternatively, drawdowns are useful measures of risk if the portfolio is actively managed.

a. Both statements are true
b. first is true, second is false
c. first is false, second is true
d. Both statements are false

Answer 34

a. Both statements are true

Question 35

True or false. maximum drawdown measures are directly comparable across portfolios, similar to VAR or the standard deviation, which are defined over a fixed horizon or in annual terms.

Answer 35

false. maximum drawdown measures are not directly comparable across portfolios, in contrast with VAR or the standard deviation, which are defined over a fixed horizon or in annual terms.

Question 36

measures the worst shortfall in cash flows due to unfavorable movements in market risk factors.

Answer 36

cash flow at risk (CFAR)

Question 37

Quantities can also be affected by the exchange rate through foreign competition effects. Because quantities are random, this creates_______.

Answer 37

quantity uncertainty

Question 38

36. Given the following 30 ordered percentage returns of an asset, calculate the VAR and expected shortfall at a 90% confidence level: −16,−14,−10, −7,−7,−5,−4,−4,−4,−3,−1,−1, 0, 0, 0, 1, 2, 2, 4, 6, 7, 8, 9, 11, 12, 12, 14, 18, 21, 23.

(Example #3:)
a. VAR (90%) = 10, expected shortfall = 14
b. VAR (90%) = 10, expected shortfall = 15
c. VAR (90%) = 14, expected shortfall = 15
d. VAR (90%) = 18, expected shortfall = 22

Answer 38

b. VAR (90%) = 10, expected shortfall = 15

Question 39

The _____ the confidence level, the greater the VAR measure; the ____ the horizon, the greater the VAR measure

Answer 39

higher, longer

Question 40

As confidence level increases, the number of occurrences below VAR ____, leading to poor measures of high quantiles.

Answer 40

shrinks

Question 41

systematically checks whether the frequency of losses exceeding VAR is in line with p = 1 − c

Answer 41

backtesting

Question 42

the usual recommendation is to pick a confidence level that is not too high, such as __ to __.

Answer 42

95 to 99%

Question 43

The extrapolation from a one-day horizon to a longer horizon can be done containing the ff except:

a. the distribution to be invariant to the horizon
b. the distribution to be the same for various horizons
c. innovations to be independent across days
d. the confidence level to be used should be lower

Answer 43

d. the confidence level to be used should be lower

Question 44

When the purpose is to avoid bankruptcy or provide a conservative measure of downside risk, institutions may choose a _________. This involves being more certain that potential losses won’t exceed the calculated VAR.

a. Higher confidence level
b. Lower confidence level
c. Short horizon
d. Long horizon

Answer 44

a. Higher confidence level

Question 45

44. Institutions may opt for a __________ when a less conservative risk measure is acceptable, and they are willing to tolerate a higher likelihood of exceeding the VAR.

a. Higher confidence level
b. Lower confidence level
c. Short horizon
d. Long horizon

Answer 45

b. Lower confidence level

Question 46

Use a _________ when accuracy in measuring downside risk is crucial, especially in rapidly changing portfolios or when quick corrective actions are necessary.

a. Higher confidence level
b. Lower confidence level
c. Short horizon
d. Long horizon

Answer 46

c. Short horizon

Question 47

Choose a ________ when the purpose is capital adequacy or when institutions need to set aside enough capital for corrective actions as problems develop. This is often the case for institutions such as pension funds.

a. Higher confidence level
b. Lower confidence level
c. Short horizon
d. Long horizon

Answer 47

d. Long horizon

Question 48

The VAR on a portfolio using a one-day horizon is USD 100 million. The VAR using a 10-day horizon is

(Example #4:)
a. USD 316 million if returns are not independently and identically distributed
b. USD 316 million if returns are independently and identically distributed
c. USD 100 million since VAR does not depend on any day horizon
d. USD 31.6 million irrespective of any other factors

Answer 48

b. USD 316 million if returns are independently and identically distributed

Question 49

The Basel market risk charge requires VAR to be computed with the following parameters:

a. A horizon of 10 trading days, or two calendar weeks
b. A 99% confidence interval
c. An observation period based on at least a year of historical data and updated at least once a quarter
d. All of the above

Answer 49

d. All of the above

Question 50

is designed to provide a buffer against losses due to idiosyncractic factors related to the individual issuer of the security. It includes the risk that an individual debt or equity moves by more or less than the general market, as well as event risk.

Answer 50

specific risk charge

Question 51

Which of the following quantitative standards is not required by the amendment to the Capital Accord to incorporate market risk?

(Example #5:)
a. Minimum holding period of 10 days
b. 99th percentile, one-tailed confidence interval
c. Minimum historical observation period of two years
d. Update of data sets at least quarterly

Answer 51

c. Minimum historical observation period of two years

Question 52

Specific risk capital charge is designed

(Example #6:)
a. To protect against credit risk related to the individual issuer of a security
b. To protect against a five-standard-deviation adverse movement in the price of an
individual security
c. To protect against an upward scenario shift in the price of an individual security
owing to factors related to the individual issues
d. To protect against credit and liquidity risk related to the individual issuer of a security

Answer 52

a. To protect against credit risk related to the individual issuer of a security

Question 53

The standard VAR calculation for extension to multiple periods also assumes that positions are fixed. If risk management enforces loss limits, the true VAR will be

(Example # 7)
a. The same
b. Greater than calculated
c. Less than calculated
d. Unable to be determined

Answer 53

c. Less than calculated

Question 54

A trading desk has limits only in outright foreign exchange and outright interest rate risk. Which of the following products cannot be traded within the current limit structure?

(Example # 8)
a. Vanilla interest rate swaps, bonds, and interest rate futures
b. Interest rate futures, vanilla interest rate swaps, and callable interest rate swaps
c. Repos and bonds
d. Foreign exchange swaps, and back-to-back exotic foreign exchange options

Answer 54

b. Interest rate futures, vanilla interest rate swaps, and callable interest rate swaps

Question 55

Stress-testing is a key risk management process, which includes:

Answer 55

(1) scenario analysis, (2) stressing models, volatilities, and correlations, and (3) developing policy responses.

Question 56

Scenario analysis submits the portfolio to large movements in financial market variables. These scenarios can be created using a variety of methods except:

a. Moving key variables one at a time
b. Using historical scenarios
c. Retaining portfolio positions
d. Creating prospective scenarios

Answer 56

c. Retaining portfolio positions

Question 57

the risk of loss due to an observable political or economic event.

Answer 57

event risk

Question 58

An event leading to changes in economic policies

a. Changes in governments
b. Changes in economic policies
c. Coups, civil wars, invasion
d. Currency devaluation

Answer 58

a. Changes in governments

Question 59

An event of default, capital controls, inconvertibility, changes in tax laws, expropriations, and so on

a. Changes in governments
b. Changes in economic policies
c. Coups, civil wars, invasion
d. Currency devaluation

Answer 59

b. Changes in economic policies

Question 60

An event wherein there are other signs of political instability

a. Changes in governments
b. Changes in economic policies
c. Coups, civil wars, invasion
d. Currency devaluation

Answer 60

c. Coups, civil wars, invasion

Question 61

An event that are usually accompanied by other drastic changes in market variables

a. Changes in governments
b. Changes in economic policies
c. Coups, civil wars, invasion
d. Currency devaluation

Answer 61

d. Currency devaluation

Question 62

True or false. the objective of stress-testing and management response should be to ensure that the institution can withstand likely scenarios without going bankrupt

Answer 62

true

Question 63

Value-at-risk analysis should be complemented by stress-testing because stress-testing

(Example # 9)
a. Provides a maximum loss, expressed in dollars
b. Summarizes the expected loss over a target horizon within a minimum confidence
interval
c. Assesses the behavior of portfolio at a 99% confidence level
d. Identifies losses that go beyond the normal losses measured by VAR

Answer 63

d. Identifies losses that go beyond the normal losses measured by VAR

Question 64

is usually viewed as a component of market risk. Lack of this risk can cause the failure of an institution, even when it is technically solvent.

Answer 64

liquidity risk

Question 65

arises when transactions cannot be conducted at quoted market prices due to the size of the required trade relative to normal trading lots.

Answer 65

Asset liquidity risk, also called market/product liquidity risk

Question 66

arises when the institution cannot meet payment obligations.

Answer 66

Funding liquidity risk, also called cash-flow risk

Question 67

Funding liquidity needs can be met from the ff except:

a. sales of cash
b. sales of other assets
c. borrowings
d. Settlement of liabilities

Answer 67

d. Settlement of liabilities

Question 68

Highly liquid assets, such as major currencies or Treasury bonds, are characterized by the following:

a. Tightness, depth, resiliency
b. Tightness, liquidity, thinness
c. Tightness, volume, resiliency
d. Tightness, closeness, thinness

Answer 68

a. Tightness, depth, resiliency

Question 69

a measure of the divergence between actual transaction prices and quoted mid-market prices.

Answer 69

Tightness

Question 70

a measure of the volume of trades possible without affecting prices too much (e.g., at the bid/offer prices), and is in contrast to thinness.

Answer 70

Depth

Question 71

a measure of the speed at which price fluctuations from trades are dissipated.

Answer 71

Resiliency

Question 72

occurs when there is a shift in demand away from low-grade securities toward high-grade securities.

Answer 72

flight to quality

Question 73

Which of the following statements regarding liquidity risk is correct?

(Example # 10:)
a. Asset liquidity risk arises when a financial institution cannot meet payment
obligations.
b. Flight to quality is usually reflected in a decrease in the yield spread between
corporate and government issues.
c. Yield spread between on-the-run and off-the-run securities mainly captures the liquidity premium, and not the market and credit risk premium.
d. Funding liquidity risk can be managed by setting limits on certain markets or products
and by means of diversification.

Answer 73

c. Yield spread between on-the-run and off-the-run securities mainly captures the liquidity premium, and not the market and credit risk premium.

Question 74

The following statements compare a highly liquid asset against an (otherwise similar) illiquid asset. Which statement is most likely to be false?

(Example #11:)
a. It is possible to trade a larger quantity of the liquid asset without affecting the price.
b. The liquid asset has a smaller bid-ask spread.
c. The liquid asset has higher price volatility because it trades more often.
d. The liquid asset has higher trading volume.

Answer 74

c. The liquid asset has higher price volatility because it trades more often.

Question 75

“Illiquid” describes an instrument that

(Example #12)
a. Does not trade in an active market
b. Does not trade on any exchange
c. Cannot be easily hedged
d. Is an over-the-counter (OTC) product

Answer 75

a. Does not trade in an active market

Question 76

(This requires some knowledge of markets.) Which of the following products has the least liquidity?

(Example #13)
a. U.S. on-the-run Treasuries
b. U.S. off-the-run Treasuries
c. Floating-rate notes
d. High-grade corporate bonds

Answer 76

c. Floating-rate notes

Question 77

In a market crash, which of the following are usually true?

(Example #14)
I. Fixed-income portfolios hedged with short U.S. government bonds and futures
lose less than those hedged with interest rate swaps given equivalent durations.
II. Bid–offer spreads widen because of lower liquidity.
III. The spreads between off-the-run bonds and benchmark issues widen.

a. I, II, and III
b. II and III
c. I and III
d. None of the above

Answer 77

b. II and III

Question 78

Which one of the following statements about liquidity risk in derivatives instruments is not true?

(Example # 15)
a. Liquidity risk is the risk that an institution may not be able to, or cannot easily, unwind or offset a particular position at or near the previous market price because of
inadequate market depth or disruptions in the marketplace.
b. Liquidity risk is the risk that the institution will be unable to meet its payment obligations on settlement dates or in the event of margin calls.
c. Early termination agreements can adversely impact liquidity because an institution may be required to deliver collateral or settle a contract early, possibly at a time when the institution may face other funding and liquidity pressures.
d. An institution that participates in the exchange-traded derivatives markets haspotential liquidity risks associated with the early termination of derivatives contracts.

Answer 78

d. An institution that participates in the exchange-traded derivatives markets has potential liquidity risks associated with the early termination of derivatives contracts.