Chapter 6 Flashcards
Market risk
What is market risk?
Market risk is the risk of losses arising from changes in market prices, such as interest rates, exchange rates, and commodity prices.
What is a transformation curve and how is it used in portfolio management?
A transformation curve shows the possible combinations of expected return and volatility for a portfolio of two assets, given their individual returns, volatilities, and correlation. It helps investors to choose the portfolio that best suits their risk-return preferences.
Explain the concept of diversification in portfolio management.
Diversification is the strategy of investing in a variety of assets to reduce portfolio risk. By combining assets with low or negative correlation, investors can reduce the overall volatility of their portfolio without sacrificing expected return.
What is the Capital Asset Pricing Model (CAPM)?
The CAPM is a model that describes the relationship between expected return and systematic risk (beta) for an asset. It states that the expected return of an asset is equal to the risk-free rate plus a risk premium that is proportional to the asset’s beta.
What is modified duration and how is it used to measure interest rate risk?
Modified duration measures the sensitivity of a bond’s price to changes in interest rates. It is calculated as the weighted average of the times until each cash flow is received, discounted by the bond’s yield to maturity. The higher the modified duration, the more sensitive the bond’s price is to interest rate changes.
Explain the purpose and mechanics of a futures contract.
A futures contract is a standardized agreement to buy or sell an asset at a specified price on a future date. It is used to hedge against price fluctuations or to speculate on future price movements. The buyer (seller) of a futures contract profits if the price of the underlying asset rises (falls).
Explain the purpose and mechanics of an interest rate swap.
An interest rate swap is an agreement between two parties to exchange interest rate payments. One party typically pays a fixed interest rate and receives a floating interest rate, while the other party does the opposite. Swaps are used to manage interest rate risk or to obtain a desired interest rate structure.
How can options be used to hedge foreign exchange risk?
Currency options provide the right, but not the obligation, to buy or sell a specific amount of foreign currency at a predetermined exchange rate on or before a future date. By purchasing a put option, a company can protect itself against a depreciation of the foreign currency, while a call option hedges against an appreciation.
What is a currency swap and how is it used to manage foreign exchange risk?
A currency swap is an agreement between two parties to exchange principal and interest payments in different currencies. It allows companies to effectively borrow in a foreign currency without directly accessing the foreign currency market. Currency swaps can be used to hedge long-term foreign exchange exposures or to obtain financing in a desired currency.
What is Value at Risk (VaR) for FX positions and how is it calculated?
VaR for FX positions measures the maximum potential loss on a foreign currency position over a specific holding period and at a given confidence level. It is calculated using the current exchange rate, the volatility of the exchange rate, the desired confidence level, and the holding period.
What is the difference between systematic and unsystematic market risk?
Systematic market risk affects the entire market and cannot be diversified away (e.g. interest rate changes, economic recessions). Unsystematic market risk is specific to a particular asset or sector and can be reduced through diversification.
Explain the concept of Value at Risk (VaR) and its limitations.
Value at Risk (VaR) is a statistical measure of the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval. For example, a 1-day 99% VaR of $1 million means there’s a 1% chance of losing more than $1 million in one day.
Limitations include:
1. It doesn’t provide information about the severity of losses beyond the VaR threshold
2. It assumes normal market conditions and may underestimate risk during market stress
3. It can be manipulated through the choice of parameters
How does duration measure interest rate risk for bonds?
Duration measures the sensitivity of a bond’s price to changes in interest rates. It represents the percentage change in bond price for a 1% change in yield. A higher duration indicates greater sensitivity to interest rate changes. Modified duration is often used, which adjusts for the bond’s yield to maturity.
What is the purpose of stress testing in market risk management?
Stress testing in market risk management aims to:
1. Assess the potential impact of extreme but plausible market scenarios
2. Identify vulnerabilities in the portfolio or risk management system
3. Evaluate the adequacy of capital and liquidity buffers
4. Inform risk limits and mitigation strategies
5. Complement VaR and other statistical risk measures
What is the difference between systematic and unsystematic risk?
Systematic risk affects the entire market or economy and cannot be diversified away (e.g. interest rate changes, recessions). Unsystematic risk is specific to a particular company or industry and can be reduced through diversification.
