Lessons 1 & 2

Question 1

VAR (Value at Risk)

Answer 1

Measure used by some finance people to quantify risk of of an investment or of a portfolio and it’s quoted in units of dollars for a given probability and time horizon. For example, if it says lets’s say 1%, one-year value at risk of 10 million, it means that there is a 1% chance that the portfolio will lose 10 million in one year.

Question 2

Dodd - Frank Act

Answer 2

Requires the Federal Reserve to do annual stress tests for non-bank financial institutions it supervises.

Question 3

Stress Tests

Answer 3

• Method of assessing to firms or portfolios
• A simulation or analysis that assesses how a financial institution or instrument can handle a financial crisis

Question 4

S&P 500

Answer 4

The Standard and Poor’s 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States

Question 5

Annualizing

Answer 5

Multiplying by 12

Question 6

Beta of a stock

Answer 6

• Measure of how it relates to the stock market
• If beta is 1: asset goes up and down one for one in terms of returns with aggregate market

Question 7

Systematic risk / Market risk vs Idiosyncratic risk

Answer 7

• Market risk: Risk of the whole market
• Idiosyncratic risk: Risk particular to a specific investment

Question 8

Variance of a stock in terms of beta

Answer 8

variance of a stock = beta ^ 2 * variance of market return (systematic risk)

Question 9

Plotting systematic and unsystematic risk

Answer 9

y = return on stock
x = return on market
m = beta
constant B is alpha
slope beta tells how much a particular stock co-moves with the market and thus a measure of stock systematic risk

Question 10

Normal Distribution

Answer 10

Has a bell curved shape

Question 11

Cauchy Distribution

Answer 11

Has a normal distribution but also considers the fat tail (outliers)

Question 12

Central Limit Theorem

Answer 12

• Averages of a large number of independent indentically distributed shocks are aproximately normally distributed
• Can fail if underlying shocks are fat tailed
• Can fail if underlying shocks lose their independence

Question 13

Covariance

Answer 13

Covariance measures the direction of the relationship between two variables. A positive covariance means that both variables tend to be high or low at the same time. A negative covariance means that when one variable is high, the other tends to be low.

Question 14

How are risks determined for stocks

Answer 14

We should look at the covariance!

Question 15

beta formula (wrt covariance)

Answer 15

beta = covariance (ri, r market) / var (market)

Question 16

CAPM formula

Answer 16

E(ri ) = Rf + βi(E(rm) – Rf)
E(ri) = Return required on financial asset
Rf = Risk-free rate of return
βi = Beta value for financial asset
E(rm) = Average return on the capital market