Class 4: Market Risk

Question 1

what is the Value at Risk (VaR) model?

Answer 1

Estimate of potential loss in loan portfolio over a given holding period at a given level of confidence

Probability distribution of a loan portfolio value reducing by an estimated amount over a given time horizon.

Time horizon estimate is over a daily, weekly or monthly basis.

Question 2

explain/define VaR in market risk?

Answer 2

Question 3

explain quantiles and profit & loss?

Answer 3

Question 4

what are the three steps in VaR calculations?

Answer 4

Question 5

which probability should we use?

Answer 5

Question 6

what is a holding period?

Answer 6

Question 7

Sign of VaR meaning?

Answer 7

Question 8

what are the main issues of implementation of var?

Answer 8

Question 9

what does Coherence mean in regards to market risk?

Answer 9

Question 10

what does monotonicity mean in regards to market risk?

Answer 10

Question 11

what is translation invariance?

Answer 11

Question 12

what is positive homogeneity?

Answer 12

Question 13

In positive homogeneity, what happens when it is violated?

Answer 13

Question 14

what does subadditivity mean?

Answer 14

Question 15

does VaR really violate subadditivity?

Answer 15

Question 16

how may manipulate Var?

Answer 16

Question 17

what is the definition of expected shortfall?

Answer 17

Question 18

what does back testing mean?

Answer 18

Question 19

what is the length of holding periods?

Answer 19

Question 20

what are longer holding periods?

Answer 20

Question 21

what are scaling laws?

Answer 21

Question 22

what is liquidity risk?

Answer 22

Question 23

what is interest rate risk?

Answer 23

Question 24

Foreign exchange risk?

Answer 24

Forex Risk or FX Risk or exchange rate risk or currency risk

Occurs when we are valuing one currency (base currency) in terms of another currency.

Currency Pair
Base currency - appreciation
Quote currency - depreciation

Question 25

Defining Exposure and Risk?

Answer 25

Increase in the foreign currency value increases the domestic currency value of a firm’s foreign currency assets and liabilities: foreign currency receivables and payables, bank deposits etc.,

Increase in the interest rates reduces the market value of a portfolio of fixed rate bonds and may increase the interest payouts

Increase in the rate of inflation may increase the value of unsold stocks, revenue from the future sales and future cost of production.

Thus, the firm is ‘exposed’ to unforeseen changes in the number of variables in the environment – also called as “Risk Factors”

Question 26

what equity price risks?

Answer 26

Risk arising out of fluctuations in equity prices

High volatile stocks bear higher risk

Less volatile ones bear less risk

Impacts portfolio

Question 27

what is the capital market line?

Answer 27

Question 28

what is commodity price risk?

Answer 28

Uncertainty in price that adversely impacts the profit margins of producers. Also impacts users of those commodities.

Examples:
Steel prices - increases the cost of
automobile production and impacts profit
margins

    Cotton, corn, wheat, oil, sugar, copper, 
     aluminium etc.,

Question 29

what are capital adequacy norms for banking industries?

Answer 29

Capital Adequacy Ratio is the ratio of a bank’s capital in relation to its risk weighted assets and current liabilities.

Decided by Central Banks and Bank Regulators to prevent commercial banks from taking excess leverage and becoming insolvent in the process.

CAR = Tier I + Tier II + Tier III Capital funds / Risk Weighted Assets

Aggregate of risk weighted assets and other exposures

Assets of banks were classified and grouped in five categories to Credit Risk Weights of zero ‘0’, 10, 20, 50 and up to 100%.

Assets like cash and coins usually have ‘zero’ risk weight, while “unsecured loans” might have a risk weight of 100%

Question 30

what are the constituents of capital?

Answer 30

Question 31

what are the strategies of managing interest rate risk?

Answer 31

Shorten duration of bank assets or lengthen duration of bank liabilities

To completely immunize net worth from interest-rate risk, set DURgap = 0

Question 32

what are the types of stress testing depending on the objective?

Answer 32

Question 33

what are the four different types of sensitivity analysis?

Answer 33

one factor at a time

Multi factor at a time

regression analysis

Difference in log odds ratio

Question 34

what is duration gap analysis?

Answer 34

Duration Gap Analysis: measures the sensitivity of a bank’s current year net income to changes in interest rate.

Requires determining the duration for assets and liabilities, items whose market value will change as interest rates change. Let’s see how this looks for First National Bank.