Ch.1 Financial Markets, Prices and Risks Flashcards
Danielsson mentions in the first important slide that “Risk is Latent.” What does he mean by that? How do you adjust your risk management practice with respect to this saying.
Danielsson means that risk can come unexpectedly. So using only past prices/variables can be very missleading as risk develops in the shadows. It is thus important to test different scenarios that fall outside of history, or that happen very rarely.
What are the two types of market indexes?
Price-weighted index and value-weighted index. In former, the stocks’ weight is proportional to its price. In the latter, the wieghts are given by total market value.
When providing an analysis on stock prices and indexes, what characteristics of prices should one take into account?
Dividend payments, stock splits and perhaps inflation if the analysis is done on long time periods.
What is the relationship between log returns and simple returns? What are favorable characteristics of each?
Y = log(1 + R) where Y is log returns and R is simple returns.
COntinuous (log) returns are symmetric, so a drop of 50% in log returns succedded by an increase in 50% log returns comes back to the same point. That is not true for simple returns. However, simple returns are additive in a portfolio, not log returns.
What are three important stylised facts of most financial returns?
- Volatility Clusters
- Fat Tails
- Non-linear Dependence
Say we have a certain forecast for unconditional volatility for 1 day, and want to extend it over n days. How would you calculate it?
Multiply by square root of n.
What is the ACF. What does it tell us generally, and what can it tell us about returns and volatility.
The ACF is the Autocorrelation function. It tells is if there is some dependence between a variable at time t and its lagged values. It cannot tell us anything about returns, however, it tells us that volaility is somewhat predictable.
What is the definition of a fat tailed distribution?
A variable is said to have fat tails if extreme events of the pdf have a higher probability than those of a normaly distributed variable.
What does the letter mu represent in a student-t distribution? What values do stocks typically have?
It represents the degrees of freedom of the pdf. Values under 2 signify extreme fat tails, while a value of infinity means that the distribution is normal. Normal values range between 3 and 5.
What are signs that returns are not normally distributed?
If there were, one would never see returns lower than 20% as their probability is once in a universe.
Also, the probability of small positive returns is higher than normal. While small negative returns are lower than normal.
What are tests that can be used to identify tail fatness?
- QQ plots which compares empirical quantiles to normally distributed theoretical quantiles.
- Jacques Berqua Test and Kolmogorov Smirnoff.
What is one piece of evidence for non-linear dependence of stock returns?
Correlations between returns on different stocks much higher in period of stress than in normal times.
What is an exceedance correlation plot and how is it used in Risk Management.
Exceedence correlation plots display correlations between two variables conditional on those variables exceeding a certain threshold.
They can be used to assess non-linear dependence.
Copulas
THB, study at the end, don’t know if really in exam.
