Market Risk

Question 1

what is market risk

Answer 1

the risk of losses due to movements in market prices including default risk, interest rate risk, credit spread risk, equity risk, foreign exchange risk and commodities risk.

Question 2

what are 2 properties of risk limits

Answer 2

• Hierarchical
• Sub-additive.

Question 3

what are 3 tail risk measures

Answer 3

VaR
stressed VaR
expected shortfall

Question 4

what are the 5 sensitivities and define each

Answer 4

• Delta: change in price with respect to the underlying price.
• Rho: change in price with respect to the interest rate.
• Theta: change in price with respect to time.
• Gamma: change in delta with respect to the underlying price.
• Vega: change in price with respect to volatility.

Question 5

what is P&L attribution

Answer 5

the amount of the P&L that comes from a certain variable

Question 6

what is the formula for calculating P&L attribution

Answer 6

δ_1=V(α_2,β_1,ϕ_1,ψ_1 )-V(α_1,β_1,ϕ_1,ψ_1 )

Question 7

what is a stress test

Answer 7

a test to see the impact of a hypothetical event on the value of a portfolio.

Question 8

what two characteristics should a stress test have

Answer 8

they should be severe and probable

Question 9

what are the 3 types of stress tests

Answer 9

o Single factor shock.
o Historical scenarios.
o Hypothetical scenarios.

Question 10

what is reverse stress testing

Answer 10

seeing what the most probable scenarios are that lead to a certain amount of loss.

Question 11

what are the 4 axioms of a coherent risk measure

Answer 11

1. Normalization: a portfolio with no positions has no risk
2. Translation invariance: adding cash to a portfolio reduces its risk.
3. Positive homogeneity: doubling a portfolio doubles its risk.
4. Subadditivity: diversification decreases the risk in a portfolio.

Question 12

what is value at risk (VaR)

Answer 12

the potential loss a portfolio can suffer for a given time horizon and confidence level.

Question 13

what are 3 advantages of VaR

Answer 13

o Easy to understand
o Fairly robust to outliers
o Well established back testing procedures.

Question 14

what are three disadvantages of using VaR

Answer 14

o A single number summary of the entire loss distribution.
o Model risk: you can badly mis-specify the loss distribution.
o Not sub-additive.

Question 15

when is VaR subadditive

Answer 15

when the distribution of the entire portfolio is elliptical (multivariate normal, t, logistical)

Question 16

what are 3 ways VaR can be computed

Answer 16

1. historical simulation
2. analytically
3. using a Monte Carlo simulation

Question 17

what are the steps in the construction a historical simulation to compute VaR

Answer 17

 Construct a set of losses using the valuation function for the portfolio.
 Assign each a value an equal probability.
 Order the losses from smallest to largest.
 VaR is the [(n+1)(1-α)]th largest loss

Question 18

what are 3 ways to deal with volatility when doing a historical simulation

Answer 18

1. Assume a constant volatility for each σ(K,T).
2. Let σ(K,T) be its own risk factor.
3. Choose a parameterization of σ(K,T) and use those as risk factors.

Question 19

how is VaR computed using the analytical approach

Answer 19

by assuming some loss distribution

Question 20

what is an advantage and disadvantage of the analytical method

Answer 20

advantage: good estimates
disadvantages: not very realistic.

Question 21

what are 2 advantages and 1 disadvantage of using the Monte Carlo method to compute VaR

Answer 21

advantages: introduces new scenarios and not just historical ones, variance reduction techniques improve estimates
disadvantage: only as good as the model used to generate the samples

Question 22

what does expected shortfall do

Answer 22

considers the entire tail of losses beyond a specified quantile

Question 23

what is an advantage and disadvantage of ES

Answer 23

advantage: sub-additive
disadvantages: sensitive to all scenarios in the tail

Question 24

what are two methods that companies compute capital

Answer 24

1. standardized method
2. internal model-based approach

Question 25

what are the 3 components in the standardized method

Answer 25

1. Sensitivity based capital charge
2. Default risk capital charge
3. Residual risk add-on