Chapter 15: Market Risk

Question 1

What is meant by market risk?

Answer 1

Market risk is the risk related to the uncertainty of an FI’s earnings on its trading portfolio caused by changes in market conditions such as interest rate risk and foreign exchange risk. Market risk emphasizes the risks to FIs that actively trade assets and liabilities rather than hold them for longer term investment, funding, or hedging purposes.

Question 2

Why is the measurement of market risk important to the manager of an FI?

Answer 2

a. Provide information on the risk positions taken by individual traders.
b. Establish limit positions on each trader based on the market risk of their portfolios.
c. Help allocate resources to departments with lower market risks and appropriate returns.
d. Evaluate performance based on risks undertaken by traders in determining optimal bonuses.
e. Help develop more efficient internal models so as to avoid using standardized regulatory models.

Question 3

What is meant by VaR? What are the three measurable components? What is the price volatility component?

Answer 3

VaR (VAR or Value at Risk) is defined as the estimated potential loss of a portfolio’s value over a one-day unwind period as a result of adverse moves in market conditions, such as changes in interest rates, foreign exchange rates, and market volatility.
Daily VaR is comprised of (a) the dollar value of the position, (b) the price sensitivity of the assets to changes in the risk factor, and (c) the adverse move in the yield.
The product of the price sensitivity of the asset and the adverse move in the yield provides the price volatility component.

Question 4

In what sense is duration a measure of market risk?

Answer 4

Duration or modified duration provides an easily measured and usable link between changes in the market interest rates and changes in the market value of fixed-income assets.

Question 5

How is Monte Carlo simulation useful in addressing the disadvantages of back simulation? What is the primary statistical assumption underlying its use?

Answer 5

Monte Carlo simulation can be used to generate additional observations that more closely capture the statistical characteristics of recent experience. The generating process is based on the historical variance-covariance matrix of FX changes. The values in this matrix are multiplied by random numbers that produce results that pattern closely the actual observations of recent historic experience.

Question 6

What is the difference between VaR and expected shortfall (ES) as measure of market risk?

Answer 6

VaR corresponds to a specific point of loss on the probability distribution. It does not provide information about the potential size of the loss that exceeds it.
Expected shortfall (ES), (conditional VaR and expected tail loss) is a measure of market risk that estimates the expected value of losses beyond a given confidence level. 
ES provides more information about possible market risk losses than VaR.