Ch 2: Sources of Market Risk Flashcards
general principle that losses can occur because of a combination of two factors:
(1) The exposure to the factor, or dollar duration (a choice variable),
(2) The movement in the factor itself (which is external to the portfolio)
can be defined as risk that is due to issuer-specific price movements, after accounting for general market factors.
Specific risk
True or False. Continuous payoffs arise with some instruments, such as binary options, which pay a fixed amount if the option ends up in the money and none otherwise.
False. Discontinuous payoffs
arises from potential movements in the value of foreign currencies. This includes currency-specific volatility, correlations across currencies, and devaluation risk.
Currency risk
the external value of a currency is free to move, to depreciate or appreciate, as pushed by market forces. An example is the dollar/euro exchange rate.
pure currency float
In a ___________, a currency’s external value is fixed (or pegged) to another currency.
fixed currency system
In a __________, a currency that was previously fixed becomes flexible, or vice versa.
change in currency regime
which is the risk that the currency peg could fail.
devaluation risk
are expressed relative to a base currency, usually the dollar.
Exchange rates
the exchange rate between two currencies other than the reference currency.
cross rate
arises from potential movements in the level and volatility of bond yields.
Fixed-income risk
The primary determinant of movements in interest rates is
inflationary expectations
Di ko alam panue to tatanungin so, kabisaduhin niyo na langs
- Forecast Rate of Inflation:
- An increase in the expected rate of inflation is considered.
- Impact on Bonds with Fixed Nominal Coupons:
- Bonds with fixed nominal coupons become less attractive.
- Resulting Effect on Yield:
- The yield on these bonds increases.
defined as the nominal rate minus the rate of inflation over the same period.
real interest rate
defined as the difference between the long rate and the short rate.
term spread
True or false. Risk can be measured as either return volatility or yield volatility.
true
For purposes of computing the market risk of a U.S. Treasury bond portfolio, it is easiest to measure
(Example #2:)
a. Yield volatility because yields have positive skewness
b. Price volatility because bond prices are positively correlated
c. Yield volatility for bonds sold at a discount and price volatility for bonds sold at a premium to par
d. Yield volatility because it remains more constant over time than price volatility, which must approach zero as the bond approaches maturity
d. Yield volatility because it remains more constant over time than price volatility, which must approach zero as the bond approaches maturity
Consider the following single bond position of $10 million, a modified duration of 3.6 years, an annualized yield volatility of 2%. Using the duration method and assuming that the daily return on the bond position is independently identically normally distributed, calculate the 10-day holding period VAR of the position with a 99% confidence interval, assuming there are 252 business days in a year.
(Example #3)
a. $409,339
b. $396,742
c. $345,297
d. $334,186
d. $334,186
statistical technique that extracts linear combinations of the original variables that explain the highest proportion of diagonal components of the matrix.
Principal components
- Which one of the following statements about historic U.S. Treasury yield curve changes is true?
(Example #4:)
a. Changes in long-term yields tend to be larger than in short-term yields.
b. Changes in long-term yields tend to be of approximately the same size as changes in
short-term yields.
c. The same size yield change in both long-term and short-term rates tends to produce a
larger price change in short-term instruments when all securities are trading near par.
d. The largest part of total return variability of spot rates is due to parallel changes with a
smaller portion due to slope changes and the residual due to curvature changes.
d. The largest part of total return variability of spot rates is due to parallel changes with a
smaller portion due to slope changes and the residual due to curvature changes.
This real yield can be viewed as the internal rate of return that will make the discounted value of promised real bond payments equal to the current real price.
real interest rate risk
What is the relationship between yield on the current inflation-proof bond issued by the U.S. Treasury and a standard Treasury bond with similar terms?
(Example #5:)
a. The yields should be about the same.
b. The yield of the inflation bond should be approximately the yield on the Treasury
minus the real interest.
c. The yield of the inflation bond should be approximately the yield on the Treasury plus
the real interest.
d. None of the above is correct
d. None of the above is correct
the risk that yields on duration-matched credit-sensitive bond and Treasury bonds could move differently.
Credit spread risk
Eto din tandaan:
Tight Credit Spreads:
* Description: Narrow or tight credit spreads indicate a smaller difference in yields between credit-sensitive bonds (e.g., corporates, agencies, MBSs) and Treasuries.
* Benefit: Positions in tight credit spreads are advantageous, as they benefit from the stability or further tightening of spreads.
* Potential Gain: Profits can be realized as credit spreads remain stable or contract further.
Shrinking Credit Spreads:
* Description: Shrinking credit spreads imply a decreasing difference in yields between credit-sensitive bonds and Treasuries.
* Benefit: Similar to tight spreads, positions benefit from the continued reduction in credit spreads.
* Potential Gain: Investors can capitalize on the favorable conditions as the spreads contract.
