Market Risk Flashcards
what is market risk
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.
what are 2 properties of risk limits
- Hierarchical
- Sub-additive.
what are 3 tail risk measures
VaR
stressed VaR
expected shortfall
what are the 5 sensitivities and define each
- 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.
what is P&L attribution
the amount of the P&L that comes from a certain variable
what is the formula for calculating P&L attribution
δ_1=V(α_2,β_1,ϕ_1,ψ_1 )-V(α_1,β_1,ϕ_1,ψ_1 )
what is a stress test
a test to see the impact of a hypothetical event on the value of a portfolio.
what two characteristics should a stress test have
they should be severe and probable
what are the 3 types of stress tests
o Single factor shock.
o Historical scenarios.
o Hypothetical scenarios.
what is reverse stress testing
seeing what the most probable scenarios are that lead to a certain amount of loss.
what are the 4 axioms of a coherent risk measure
- Normalization: a portfolio with no positions has no risk
- Translation invariance: adding cash to a portfolio reduces its risk.
- Positive homogeneity: doubling a portfolio doubles its risk.
- Subadditivity: diversification decreases the risk in a portfolio.
what is value at risk (VaR)
the potential loss a portfolio can suffer for a given time horizon and confidence level.
what are 3 advantages of VaR
o Easy to understand
o Fairly robust to outliers
o Well established back testing procedures.
what are three disadvantages of using VaR
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.
when is VaR subadditive
when the distribution of the entire portfolio is elliptical (multivariate normal, t, logistical)
what are 3 ways VaR can be computed
- historical simulation
- analytically
- using a Monte Carlo simulation
what are the steps in the construction a historical simulation to compute VaR
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
what are 3 ways to deal with volatility when doing a historical simulation
- Assume a constant volatility for each σ(K,T).
- Let σ(K,T) be its own risk factor.
- Choose a parameterization of σ(K,T) and use those as risk factors.
how is VaR computed using the analytical approach
by assuming some loss distribution
what is an advantage and disadvantage of the analytical method
advantage: good estimates
disadvantages: not very realistic.
what are 2 advantages and 1 disadvantage of using the Monte Carlo method to compute VaR
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
what does expected shortfall do
considers the entire tail of losses beyond a specified quantile
what is an advantage and disadvantage of ES
advantage: sub-additive
disadvantages: sensitive to all scenarios in the tail
what are two methods that companies compute capital
- standardized method
- internal model-based approach
what are the 3 components in the standardized method
- Sensitivity based capital charge
- Default risk capital charge
- Residual risk add-on
