Exam: CH 20 Value at risk

Question 1

What is VaR (Value at Risk)

Answer 1

• VaR is the loss level V that will not be exceeded with a specified probability
• A loss that will not be exceeded at some specified confidence level

Question 2

Why do regulators use VaR?

Answer 2

• Regulators use VaR in determining the capital a
  bank is required to to keep to reflect the market
  risks it is bearing

Question 3

What is market risk capital?

Answer 3

• is k times the 10-day

99% VaR where k is at least 3.0

Question 4

T/F:

Regulators don’t base the capital they require banks to keep on VaR.

Answer 4

• True

Question 5

What do regulators use for market risk?

Answer 5

• For market risk they use a 10-day time horizon and a 99% confidence level

Question 6

What do regulators use for credit risk?

Answer 6

• For credit risk they use a 99.9% confidence level and a 1 year time horizon

Question 7

What is expected shortfall?

Answer 7

• Expected shortfall is the expected loss given that the loss is greater than the VaR level

Question 8

Which is more appealing, expected shortfall or VaR?

Answer 8

• Although expected shortfall is theoretically more appealing than VaR, it is not as widely used

Question 9

What are the advantages of VaR?

Answer 9

• It captures an important aspect of risk in a single number
• It is easy to understand
• It asks the simple question: “How bad can things get?

Question 10

What is historical simulation?

Answer 10

• A simulation based on historical data

Question 11

How is a historical simulation completed?

Answer 11

• Create a database of the daily movements in all
  market variables.
• The first simulation trial assumes that the
  percentage changes in all market variables are
  as on the first day
• The second simulation trial assumes that the
  percentage changes in all market variables are
  as on the second day
• and so on

Question 12

historical simulation:

How are losses and gains calculated?

Answer 12

• The loss between today and tomorrow is then calculated for each trial (gains are negative losses)
• The losses are ranked and the one-day 99% VaR is set equal to the 5th worst loss

Question 13

What is the N-day VaR for market risk usually assumed to be?

Answer 13

• the square root of N x (TImes) the one-day VaR

- This assumption is in theory only perfectly correct if daily changes are normally distributed and independent

Question 14

What is the model-building approach or the variance-covariance approach?

Answer 14

• It is the main alternative to historical simulation, to make assumptions about the probability distributions of the return on the market variables and calculate the
  probability distribution of the change in the value of the portfolio analytically

Question 15

What is assumed with the linear model?

Answer 15

We assume

• The daily change in the value of a portfolio is linearly related to the daily returns from market variables
• The returns from the market variables are normally distributed

Question 16

When can the linear model be used?

Answer 16

• Portfolio of stocks
• Portfolio of bonds
• Forward contract on foreign currency
• Interest-rate swap

Question 17

When should the quadratic model be used?

Answer 17

• Historical simulation can be used in conjunction with the quadratic model (This avoids the need to revalue the portfolio for each simulation trial)
• The quadratic model is also sometimes used in conjunction with a Monte Carlo simulation