Chapter 18 - Analysis of market risk

Question 1

Equity market features - Individual equities

Answer 1

Returns are rarely iid

Volatility varies over time

Extreme returns appear in clusters (volatility clustering)

Return series are leptokurtic (heavy-tailed and high peaked; kurtosis falls as period increases)

Question 2

Explain kurtosis

Answer 2

Kurtosis measures the ‘peakedness’ of a distribution. Leptokurtic means thinner, more acute peaks, and fatter tails

Higher kurtosis means more of the variance is due to infrequent extreme deviations, as opposed to more frequent modest deviations

Question 3

Equity market features - portfolio of equities

Answer 3

Correlations exist

Correlations vary over time

Multivariate returns show little evidence of cross-correlation (i.e. between time periods)

Multivariate series of absolute squared returns do show evidence of cross-correlation

Extreme returns in one series (equity) often coincide with extreme returns in another series (dependence appears higher during periods of volatility)

Question 4

Which factors are represented by the Credit Spread?

Answer 4

Expected probability of default, and the expected loss (loss may leave residual value)

Any risk premium attached to risk of default (the uncertainty of the first point above)

A liquidity premium

Question 5

Three common measures of credit spread

Answer 5

SON

Static spread: addition to risk-free rate at which discounted cash flows from risk bond equate to its price (allows for term structure underlying risk free rate and term premium)

Option-adjusted spread: adjusts the discount rate through stochastic modelling to allow for options embedded in bond (market consistent)

Nominal spread: difference between gross redemption yields

Question 6

Risks and returns can both be defined and measured with reference to chosen benchmarks, for example:

Answer 6

Strategic risk
Risk of poor performance of portfolio manager benchmark VS liability based benchmark

Active risk
Risk of poor performance of manager’s portfolio VS benchmark

Active return
Difference between actual return and benchmark

Question 7

Measures of a good benchmark

Answer 7

ATRIUMS

Appropriate
Trackable
Reflective of current investment opinion
Investable
Unambiguous
Measurable
Specified in advance