Chapter 5 - Market Risk Flashcards
What are direct market factors and indirect market factors?
Direct = directly affect the performance of a company, such as health of balance sheet or management
Indirect = indirectly affected the performance of a company, interest rates, economic events.
what is market risk? what does the BIS state market risk as?
MR=risk of loss arising from changes in value of financial instruments
BIS= Risk of losses in on-and-off balance sheet risk positions arising from movement in market prices
Different types of market risk - volatility risk , what instrument it affects most?
VR = Risk of price movement that are more uncertain than usual affecting the pricing of products.
Affects - Options pricing
market liquidity risk , when does it occur?
Risk of loss through not being able to trade in a market or obtain a price on a desired product when required.
Occurs = lack of supply, shortage of market markers
currency risk , which instrument it affects most?
Caused by adverse movements in exchange rates.
Inherent when: Trading cryptocurrency as they display high volatility.
Basis risk
When one risk exposure is hedged with an offsetting exposure in another instrument that behaves similar, but not identical.
refers to the potential for a mismatch between the price movements of two related assets, such as a futures contract and the underlying asset, leading to unexpected financial outcomes.
interest rate risk
Caused by adverse movements in interest rates
Affects: fixed-income securities, futures, options, and forwards
Commodity risk, why is it volatile? other factor? result of it being volatile?
Risk of an adverse price movement in value of a commodity. Commodities are traded in markets where the concentration of supply in hands of a few supplies, so there is big price volatility.
Other factors affected price: cost of storage.
Result: higher volatilities and larger price discontinuities (movements when price leaps)
Equity price risk, where do the returns come from and what are the risks to?
Returns come from - capital growth and income
Risks = Capital risk, income risk
what are the boundary issues that can arise between different types of market risk?
Liquidity risk - increases price level risk
Volatility risk - exacerbate price level risk
Interest rate risk - indirectly affect economy and markets
what are the key drivers of market risk?
Currency, interest rate and liquidity risk
What are the techniques of market risk: Hedging, definition, instruments, problems
Definition - reducing the risk of adverse price movements by taking offset position in related product
Main instrument: Derivatives (futures and options) = investor buying put options giving investor ability to sell at strike price.
Problems: Trade-off between risk of adverse market movements and the cost of hedge.
What are the techniques of market risk: Market risk limits - definition, expressed as, problems, benefits
Definition - tool for managing market risk by setting maximum loss it is prepared to make on portfolio or transaction. ALSO called stop-loss limit. Dependent upon the accuracy of the risk measurement.
Expressed as - VaR, or absolute number of the instrument being traded.
Problems: Risk limits have to be inflated to accommodate the errors, professional may exploit the inaccuracy of risk measurement
Benefits - set the risk appetite for firm, useful for electronic trading.
What are the techniques of market risk: Diversification - definition, and how are the weightings done
Definition - combining the weightings of an asset in a portfolio to spread risk. Weightings (given in proportion of the portfolio held in each security)
What are the techniques of market risk: Electronic Trading - the speed which means, combination of what reduces market risk? Problems?
Models can run fast = which means that - firms offer tight spreads, and enables high-frequency trading (HFT) to turn over high volumes of trades, enables small position limits to be employed.
Combination of small position limits and fast liquidation time reduces level of market risk, so firms can act as market makers.
Problems: speed isn’t always good because competitors can replicate. Flash crashes.
what are the three things to know about sampling?
(central tendency, dispersion, standard devation)
1) What is the typical value? = a single number that captures the ‘essence’ of the distribution = CENTRAL TENDENCY
2) Are there values which stray far from the typical value = DISPERSION
3) How closely do the characteristics mirror population? = STANDARD DEVATION
Measures of central tendency: three common measures
- Mean - average value
- median - middle items, half data above and below
- Mode - most frequent
Which is the most common use of central tendency, but issues?
What is often used when there are extreme outliers or skewed data?
What is used for qualitative data?
- The mean, but it doesn’t recognise any outliers
- The median because its not influenced same way, more robust.
- The mode is used where there is a common value and qualitative data.
Measures of dispersion: The range and inter-quartile range
What does it establish?
What is the range? and drawbacks?
what is the inter-quartile range? how to work out?
Range and Inter-quartile range (establishes the distribution of values around median)
Range = difference between highest and lowest.
Drawback = data distorted by extreme values and ignores in between numbers
Inter-quartile range = ranks data against each other and presents the data s a series of quartiles. It measures the difference from the lowest rank quartile to the highest.
How to work out
1) Find medium
2) Split into quarters
3) find medium of lower quarter and higher quarter
4) subtract them.
Measures of dispersion: Quartile Deviation
What it measures? the formula? how to work out?
Measure through the middle half of distribution. It is the median plus or minus a quartile. Calculated as the difference between upper and lower quartiles. Useful because it is not influenced by extremely high or low scores.
Formula = 1/2 (Q3-Q1)
How to work out
1) Find median = Q2
2) use Q2 to divide the data into two parts (lowest 50% consists of values less than Q2 etc)
3) Calculate Q1 as median of lower data set and Q2 as higher set
4) Q3-Q1/2 = Quartile Deviation
Measures of dispersion: Variance
What is it?
The steps?
How to work out Standard Deviation?
How to work out a sample instead?
Variance = shows spread of data around the mean. Calculates the difference between each return from mean and squares it, then these are totalled and their average represents the variance.
Steps
1) Find mean
2) work out difference from mean
3) square each deviation
4) divide the sum of squared deviations by number of total number
Standard Deviation
- the square root of the variance
5) take square root of variance to obtain standard deviation
Sample
- N -1
Understand the relevance and application of measure of dispersion and variance: Why is Variance used and Standard Deviation?
Variance = provides measure of how closely its movement mirrors that of the general market.
Standard Deviation = volatility of an investment’s return, measures how widely the values are dispersed or fluctuate around mean position. More volatile = greater standard deviation
Two-thirds of the time, we can expect the return to be within one standard deviation above or below average.
Understand the term distribution analysis, definition, what the curve should be?
using historical data to predict future events and relies on an understanding of probability distributions - of which one is the “normal distribution”
Normal distribution curve:
- symmetrical
- defined by its mean and standard deviation
Understand the term confidence interval
Confidence intervals show the range of possible losses or gains, giving a certain level of confidence about the outcome.
Know the following concepts of risk measurement: Probability
How likely an event is
Number of ways event can occur/ Total number of possible outcomes
Know the following concepts of risk measurement: Volatility, definition, measure, why its used and what it can either be
Description of how variable they are.
Measure of a standard deviation of the returns of a financial instrument within a specific time horizon.
It is used to quantify the risk of the instrument and can be an absolute number or a faction of the mean return.
Know the following concepts of risk measurement: Regression
Regression analysis: investigation of relationships between variables, for example effects of changes on money supply in relation to inflation.
Measure their differing values over time, plot on a scatter-gram.
Know the following concepts of risk measurement: Correlation Coefficients
what does it measure?
beta of a stock meaning?
0, positive, negative beta?
Measures the strength of the relationship between two variables.
Beta of a stock = describes the relationship of its returns of the financial market as a whole.
Asset with a beta of 0 = price is not correlated with market.
Asset with positive beta = asset follows the market
Asset with negative beta = asset inversely follows the market, asset decrease if market goes up.
Know the following concepts of risk measurement: Optimisation
what does it refer to?
what is it also called and what does this mean?
when can it be used?
refers to portfolio construction techniques that obtain the best expected returns from the right mix of correlation and variances.
Called = mean-variance (MV) optimisation. This refers to mean or expected return of the investment and the variance is the measure of risk associated with portfolio.
Can be used:
- minimising the risk for a given return
- maximising the expected return for given risk
Understand the value-at-risk approach to managing market risk: VaR what it expresses and includes?
Expresses the maximum loss that can occur with a specified confidence over a specified period. It includes the level of confidence!
Understand the value-at-risk approach to managing market risk: VaR Limits, what it ensures, advantages and disadvantages
VaR limits = ensures traders or fund managers do not exceed.
Advantages:
- provides statistical probability
- readily understood by non-risk managers
- translates all risks in a portfolio in a common standard.
Disadvantage
- does not specify how bad situation could get
Understand the value-at-risk approach to managing market risk: Validation and Back Testing
Model risk and the link the VaR models
What is back testing? what does it ensure?
when is it performed and who by?
VaR models can break down if the assumptions that they are based upon are violated or simply found to be untrue. This is called Model risk.
Back testing
- practise of comparing the actual daily trading exposure to the previously predicted VaR figure.
- Test of reliability of the VaR method and ensures quality.
Performed on a daily basis by financial reporting function.
Know the three different approaches to VaR: Historic simulation
what does it involve and look at?
the steps?
advantages and disadvantages?
HS = involves looking back at what happened in the past and basis this on future analysis. Looks at portfolio risk factor to eliminate risk exposure in future.
Steps
1) identify risk factors that affect returns
2) select sample of actual historic risk factors
3) apply each of those daily changes to current value of each risk factor
4) list out all resulting portfolio values and order by value.
Advantages
- simple
- no need to make assumptions
- no estimates
Disadvantages
- assumes history will repeat itself
Know the three different approaches to VaR: The parametric (analytical) approach
Approach assumes that portfolio returns are normally distributed and uses the standard deviation of the returns to plot the graph, this requires confidence level.
IT ASSUMES RETURNS ARE NORMALLY DISTRIBUTED.
Advs
- simplest method
Disadvantages
- If actual returns are not normally distributed, results not accurate.
- can not be used for all securities, such as options.
Know the three different approaches to VaR: Monte Carlo Simulation Method
Developing a model for future stock price returns, and uses made up numbers to work out return.
Advantages
- Can be used for options due to random numbers
Disadvantages
- Takes time to run simulations
Understand the underlying purposes, principles and application of main type of scenario and stress testing.
what does ST and ST do which VaR doesnt?
What’s the difference between the two
what must be portfolio be subjected to?
Scenario testing and stress testing shows how bad a situation can get, unlike VaR.
Difference between the two
- Number of variables that are altered, stress test alters one variable at a time to analyse its effects on rest of portfolio.
- scenario analysis looks at how the portfolio behaves under conditions of multiple changes.
Portfolio must be subjected to ‘extreme’ market event scenarios
Stress tests risk factors
- general interest rates
- individual stock prices
- individual stock volatility
- correlation coefficients that describe relationship between instruments in portfolio.
Advantages of ST and ST
- enables board and seniors to better assess the potential impact of various market-related changes on the institutions earning’s and capital position.
CISI Question: what are scenario analysis subjected to?
extreme market event scenarios
which tool is used to ascertain the relationship between variables?
Regression analysis
what do many probability distributions have?
fat tail
what is true about relationship of median and mean?
median is more robust feature of central tendancy
what is a calculation of VaR?
Historical simulation
