Chapter 5: Market Risk Flashcards
What is Volatility risk
The risk of price movement that are more uncertain than usual affecting the pricing of products. Has the biggest affect on options market
What is Market liquidity risk
The risk of loss through not being able o trade in a market or obtain a price on a desired product when required
What is Currency risk
The risk that adverse movements in exchange rates drastically affect the value of a portfolio or instrument
What is basis risk
This is the risk that, when hedging a position, the two instruments are not equal and opposite, but in fact behave in a similar manner
What is interest rate risk
the risk that adverse movements in interest rates will directly affect fixed-income securities, futures, options and forwards
What is commodity price risk
The risk of adverse price movements in the value of a commodity
What is Equity price risk
The risk that the share price decreases or fails to rise in line with inflation. Also includes the risk that dividends may decrease or not be paid at all
What are boundary issues
When multiple types of risk overlap/cause/affect one another
What are market risk limits
A ‘stop-loss’ and may be expressed in terms of VaR or as an absolute number
What do the market risk function do
Ownership of market risk management policy
Proactive management of market risk issues
Define escalation procedures
Validate Pricing and VaR models
Daily monitoring of risk utilization
What is the central tendency
A typical value taken from market datasets that captures the ‘essence’ of the distribution
What is the dispersion
How far values stray from the typical value
What are the measures of central tendency
Mean
Median
Mode
What are the measures of dispersion
Range
Quartile deviation
Variance
Standard Deviation
What is quartile deviation
A measure of dispersion through the middle half f the distribution
How to calculate quartile deviation
0.5(Q3-Q1)
What is variance
A measure of dispersion and shows the spread of data around the mean
How to calculate variance
the sum of the squares of the differences between the mean and each value divided by the number of values (Or number of values - 1 when using a sample)
How to calculate standard deviation
Square root of the variance
How often are returns within within one standard deviation of the mean
2/3
What is distribution analysis
A statistical means of using historical data to predict future events and relies on an understanding of probability distributions
What percentage of the data in a normal distribution will be within 2 standard deviations
95.5%
What percentage of the data in a normal distribution will be within 3 standard deviations
99.75%
What is regression analysis
A statistical tool for the investigation of relationships between variables. The effect of one variable on another.
What is the correlation coefficient
It measures the strength of the relationship between two variables
advantages of VaR
Provides statistical probability of potential loss
Easily understood by non risk managers
Translates all risks in a portfolio into a common standard
Disadvantage of VaR
Does not specify maximum loss outside of the confidence level
What is back testing
The practice of comparing the actual daily trading exposure to the previously predicted VaR figure
What are the three ways VaR can be calculated
Historical simulation
The Parametric
Monte Carlo simulation
What is the historical simulation
Involves looking back at what actually happened in the past and basing our view of the future o that analysis
What is the parametric approach
This assumes that the distribution of possible returns can be plotted, based on a small number of factors, so that the required confidence level can be ‘read off’ the graph
What is the Monte Carlo Simulation
Involves generating random set of results based on the actual underlying risk factors and again ‘reading off’ the graph
What is the difference between stress testing and scenario analysis
The number of variables that are altered
Advantages of historical simulation
Simple to communicate to non experts
No need to make assumptions about the distribution of returns
No need to estimate volatilities or correlations
Disadvantages of historical simulation
Assumes that history will repeat itself which often is not the case
Advantages of Parametric approach
The simplest way to calculate VaR
Minimal computation time
No simulations required
Disadvantages of Parametric approach
The actual returns have to be normally distributed or the results will be incorrect
Cannot be used with securities such as options as not normally distributed
Advantages of Monte Carlo Method
Can be used on non-normally distributed instruments
