Chapter 5: Market Risk

Question 1

what is volatility risk?

Answer 1

risk of adverse price movements, particularly effects options pricing

Question 2

what is market liquidity risk?

Answer 2

risk of loss through not being able to trade in the market or obtain a price on a desired product when required

Question 3

what is currency risk?

Answer 3

adverse movements in exchange rates, affects portfolios or instruments with cash flows denominated in a currency other than the investors home currency

Question 4

what is basis risk?

Answer 4

occurs when one risk exposure is hedged with an offsetting exposure in another instrument that behaves in a similar manner, risk in the combined position if the both move adversely

Question 5

what is interest rate risk?

Answer 5

adverse movements in interest rates, directly affects fixed income securities, futures options and forwards

Question 6

what is commodity price risk?

Answer 6

adverse price movements in the value of a commodity

Question 7

what price risks are related to equity price risk?

Answer 7

capital price risk, income price risk (related to dividends)

Question 8

what is the boundary issue that can arise between different types of market risk?

Answer 8

means that it is not straightforward to analyse which factors are causing which movements

Question 9

what is hedging?

Answer 9

means of reducing the risk of adverse price movements by taking an offsetting position in a related product, means of insuring against market risk

Question 10

what are market risk limits?

Answer 10

used as a tool for managing market risk in the same way that credit limits are applied to protect firms, specify the maximum loss

Question 11

what is the effectiveness of market risk limits dependent upon?

Answer 11

the accuracy of the risk measurement used to set the limits

Question 12

what effect does diversification have on on earnings?

Answer 12

although the earnings of individual businesses can be volatile, the combined earnings will be less so because of the inversely correlated securities ‘mellowing’ each other out

Question 13

what is HFT?

Answer 13

high frequency trading, uses mathematical models to predict the market, prices of securities over a few minutes or hours

Question 14

what features does an effective market risk function include?

Answer 14

• ownership of market risk management policy
• proactive management involvement
• defined escalation procedures
• independent validation
• ensuring VaR is not used alone
• independent daily monitoring of risk utilisation

Question 15

what is the central tendancy?

Answer 15

single number that captures the ‘essence’ of the distribution of data

Question 16

what is dispersion?

Answer 16

how far values stray on either side of the central tendency

Question 17

what are the three common measures of central tendancy?

Answer 17

mean, median and mode, mean is the most common

Question 18

what measures are there for dispersion?

Answer 18

• range and inter-quartile range
• quartile deviation
• variance
• standard deviation

Question 19

what is interquartile range?

Answer 19

ranks data against each other and presents the data in a series of quartiles, then measures the difference from the lowest rank quartile to the highest. difference in returns between the 25th percentile and the 75th percentile

Question 20

what is quartile deviation?

Answer 20

measure of the dispersion through the middle half of the distribution. it is the median plus or minus a quartile. calculated as half the difference between the upper and lower quartiles in a distribution

Question 21

what is the formula for quartile deviation?

Answer 21

Quartile deviation= 1/2(Q3-Q1)

Question 22

What is variance?

Answer 22

measure of dispersion and shows the spread of data around the mean, calculates the difference between each return from the mean and then squares it

Question 23

what is standard deviation?

Answer 23

it is the square root of the variance of a set of data and is the most commonly used measure of dispersion

Question 24

how can variance be used to calculate the beta of the stock?

Answer 24

variance of a set of stock returns provides a measure of the returns’ dispersion and is used to calculate the beta of the stock (measure of how closely its movement mirrors that of the general market)

Question 25

how can volatility be a measurement of risk?

Answer 25

can be seen as a variability of returns generated by an asset or portfolio, expressed mathematically by the standard deviation of their values, the more volatile the returns the greater the standard deviation, low standard deviation implies low risk

Question 26

what is distribution analysis?

Answer 26

statistical means of using historical data to predict future events and relies on an understanding of probability distributions

Question 27

what attributes does a normal distribution curve have?

Answer 27

• symmetrical
• defined by its mean and its standard deviation

Question 28

what is a confidence interval?

Answer 28

a model that predicts the future performance of the instrument to a given level of probability, linked to the number of standard deviations away from the mean

Question 29

what is the formula for probability?

Answer 29

number of ways an event can occur/total number of possible outcomes

Question 30

what is the technical definition for volatility?

Answer 30

measure of the standard deviation of the returns of a financial instrument, used to quantify the risk of the instrument over that time, expressed in annualised terms

Question 31

what is regression analysis?

Answer 31

statistical tool for the investigation of relationships between variables, used to ascertain the effect of one variable to another

Question 32

what does the correlation coefficient measure?

Answer 32

strength of hte relationship between two variables, has a value ranging from - (negatively correlated) to 0 (not correlated) to 1 (positively correlated)

Question 33

how can a risk free return be provided through diversification?

Answer 33

only when securities are perfectly negatively correlated can they combined to provide risk-free return

Question 34

what is the beta of a stock used for?

Answer 34

used to describe the relationship of its returns with that of the financial market as whole

Question 35

what do the different beta quantities convey?

Answer 35

beta of 0= price is not correlated with the market
positive beta= asset generally follows the market
negative beta= asset behaves inversely to the market

Question 36

what is alpha used to measure?

Answer 36

the difference between a funds expected returns, based on its beta and its actual returns

Question 37

what is optimisation?

Answer 37

techniques that obtain the best expected returns from the right mix of correlations and variances, mean variance optimization

Question 38

what is VaR?

Answer 38

expresses the maximum loss that can occur in a specific time period within a specified confidence level

Question 39

what is VaR used for?

Answer 39

to estimate portfolio market risk

Question 40

who sets VaR limits?

Answer 40

market risk functions, monitor them to ensure that traders or fund managers do not exceed them

Question 41

what are the advantages of using VaR?

Answer 41

• statistical probability of potential loss provided
• understood by non-risk managers
• translates all risks in a portfolio into a common standard

Question 42

what is the main disadvantage of VaR?

Answer 42

does not clearly outline how bad the situation could get

Question 43

what is back testing?

Answer 43

practice of comparing the actual daily trading exposure to the previously predicted VaR figure

Question 44

what are the three main ways VaR can be calculated?

Answer 44

1. Historical simulation
2. parametric (analytical) approach
3. Monte Carlo simulation

Question 45

what is the historical simulation approach and what does it involve?

Answer 45

looks back at what actually happened in the past and basing view of the future on that analysis, uses the portfolios risk factor to estimate its risk exposure in the future

Question 46

what are the advantages/disadvantages as of the historical simulation approach?

Answer 46

• conceptually simple enough to communicate, no need to make assumptions about returns, no need to estimate volatilities and correlations between various assets
• assumes history will repeat itself

Question 47

what is the parametric (analytical) approach and what does it involve?

Answer 47

assumes portfolio returns are normally distributed, uses standard deviation of returns to ‘plot the graph’ and drive the VaR figure at the required confidence level

Question 48

what are the advantages/disadvantages of the parametric approach?

Answer 48

• simplest method used to compute VaR
• simplicity is also its main drawback
• cannot be used with securities such as options because the returns on them do not follow normal distribution

Question 49

what is the monte Carlo simulation method for computing VaR and what does it involve?

Answer 49

involves developing a model for future stock price returns and then running multiple hypothetical values through the model to obtain distribution of return values, follows a similar algorithm to the one used for historical simulations, repeating process produces dataset of hypothetical portfolio returns then ranked from worst to best in order to arrive at desired percentile confidence level

Question 50

what are the advantages and disadvantages of the monte carlo simulation approach?

Answer 50

• can be used to produce VaR for non-normally distributed instruments such as options
• requires a high level of computing power to perform all simulations, takes time

Question 51

what is the difference between scenario and stress testing?

Answer 51

number of variables that are altered. stress test alters one variable at a time and sees its effects on the rest of the portfolio. scenario analysis looks at how the portfolio as a whole behaves under a condition of multiple changes

Question 52

what is the aim of scenario and stress testing?

Answer 52

to enable the board and senior management to better asses the potential impact of various market-related changes on the institutions earnings and capital position