Ch 2: Sources of Market Risk

Question 1

general principle that losses can occur because of a combination of two factors:

Answer 1

(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)

Question 2

can be defined as risk that is due to issuer-specific price movements, after accounting for general market factors.

Answer 2

Specific risk

Question 3

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.

Answer 3

False. Discontinuous payoffs

Question 4

arises from potential movements in the value of foreign currencies. This includes currency-specific volatility, correlations across currencies, and devaluation risk.

Answer 4

Currency risk

Question 5

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.

Answer 5

pure currency float

Question 6

In a ___________, a currency’s external value is fixed (or pegged) to another currency.

Answer 6

fixed currency system

Question 7

In a __________, a currency that was previously fixed becomes flexible, or vice versa.

Answer 7

change in currency regime

Question 8

which is the risk that the currency peg could fail.

Answer 8

devaluation risk

Question 9

are expressed relative to a base currency, usually the dollar.

Answer 9

Exchange rates

Question 10

the exchange rate between two currencies other than the reference currency.

Answer 10

cross rate

Question 11

arises from potential movements in the level and volatility of bond yields.

Answer 11

Fixed-income risk

Question 12

The primary determinant of movements in interest rates is

Answer 12

inflationary expectations

Question 13

Di ko alam panue to tatanungin so, kabisaduhin niyo na langs

Answer 13

• 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.

Question 14

defined as the nominal rate minus the rate of inflation over the same period.

Answer 14

real interest rate

Question 15

defined as the difference between the long rate and the short rate.

Answer 15

term spread

Question 16

True or false. Risk can be measured as either return volatility or yield volatility.

Answer 16

true

Question 17

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

Answer 17

d. Yield volatility because it remains more constant over time than price volatility, which must approach zero as the bond approaches maturity

Question 18

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

Answer 18

d. $334,186

Question 19

statistical technique that extracts linear combinations of the original variables that explain the highest proportion of diagonal components of the matrix.

Answer 19

Principal components

Question 20

20. 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.

Answer 20

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.

Question 21

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.

Answer 21

real interest rate risk

Question 22

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

Answer 22

d. None of the above is correct

Question 23

the risk that yields on duration-matched credit-sensitive bond and Treasury bonds could move differently.

Answer 23

Credit spread risk

Question 24

Eto din tandaan:

Answer 24

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.

Question 25

arises in the context of home mortgages when there is uncertainty about whether the homeowner will refinance the loan early.

Answer 25

Prepayment risk

Question 26

This represents the spread over the equivalent Treasury minus the cost of the option component.

Answer 26

option-adjusted spread (OAS)

Question 27

During 2002, an Argentinean pension fund with 80% of its assets in dollar-denominated debt lost more than 40% of its value. Which of the following reasons could explain all of the 40% loss:

(Example #6:)
a. The assets were invested in a diversified portfolio of AAA firms in the U.S.
b. The assets invested in local currency in Argentina lost all their value and the value of
the dollar-denominated assets stayed constant.
c. The dollar-denominated assets were invested in U.S. Treasury debt, but the fund had
bought credit protection on sovereign debt from Argentina.
d. The fund had invested 80% of its funds in dollar-denominated sovereign debt from
Argentina.

Answer 27

d. The fund had invested 80% of its funds in dollar-denominated sovereign debt from
Argentina.

Question 28

arises from potential movements in the value of stock prices.

Answer 28

equity risk

Question 29

the market value of freely traded shares

Answer 29

market float

Question 30

refers to the proportion of the index due to the biggest stocks.

Answer 30

Concentration

Question 31

arises from potential movements in the value of commodity contracts, which include agricultural products, metals, and energy products.

Answer 31

Commodity risk

Question 32

32. Identify the major risks of being short $50 million of gold two weeks forward and being long $50 million of gold one year forward.

(Example #7)
I. Gold liquidity squeeze
II. Spot risk
III. Gold lease rate risk
IV. USD interest rate risk

a. II only
b. I, II, and III only
c. I, III, and IV only
d. I, II, III, and IV

Answer 32

c. I, III, and IV only

Question 33

Which of the following products should have the highest expected volatility?

(Example # 8)
a. Crude oil
b. Gold
c. Japanese Treasury bills
d. EUR/CHF

Answer 33

a. Crude oil

Question 34

The historical simulation (HS) approach is based on the empirical distributions and a large number of risk factors. The Risk Metrics approach assumes normal distributions and uses mapping on equity indices. The HS approach is more likely to provide an accurate estimate of VAR than the Risk Metrics approach for a portfolio that consists of

(Example #9)
a. A small number of emerging market securities
b. A small number of broad market indexes
c. A large number of emerging market securities
d. A large number of broad market indexes

Answer 34

a. A small number of emerging market securities