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Banking > Market Risk > Flashcards

Market Risk Flashcards

1
Q

At a 95% confidence and 1-day time horizon, what does a VaR of R11 million mean?

A

It means that on average, a FI would lose more that R11 million, only 1 day in 20 days

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2
Q

Why is VAR a flexible measure?

A

VaR is flexible measure:
1) Can be specific for various time horizons (1 day to 1 month) and different
confidence levels (90% to 99%)
2) Can be expressed as % of market value or currency terms (e.g. R, $)

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3
Q

How many types of VAR exist?

A

There are 3 types of VAR

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4
Q

List the 3 types of VAR

A

1) Relative VaR
2) Marginal VaR
3) Incremental VaR

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5
Q

What does relative VAR measure?

A

It looks at how much the portfolio underperform the benchmark in a worst-case month?

Therefore, it Quantifies the risk of tracking error, which is crucial for investment managers

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6
Q

What does it mean if a Mutual fund has a 1-month relative VaR of R8 million at a 99% confidence interval?

A

On average the mutual fund will underperform the benchmark by more than R8 million in 1 out of 100 months

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7
Q

What does a VaR (%) show?

A

VaR (%) shows the total potential loss

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8
Q

What does a relative VaR (%) show?

A

It shows how much more (or less) the portfolio might lose compared to its benchmark

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9
Q

If the benchmark is the S&P 500, what does a relative VaR of 3% mean?

A

A Relative VaR of 3% means there is a 1% chance that the portfolio could do 3% worse than the S&P 500 Index

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10
Q

What does marginal VAR measure?

A

Marginal VAR Measures how much additional risk a specific position adds to the total portfolio VaR

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11
Q

What does marginal VAR show in terms of sensitivity?

A

Marginal VAR shows How sensitive the overall portfolio risk is to changes in the size of that position

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12
Q

If Yahoo Equity: Standalone VaR is R0,9 million and Marginal VaR is R0,5 million, what does that mean? (specifically the marginal VAR)

A

It means that it adds R0,5 million to the overall portfolio risk

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13
Q

What does incremental VAR measure?

A

Incremental VAR Measures the change in total portfolio VaR when you slightly increase or decrease the weight of a specific position.

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14
Q

What does incremental VAR show in terms of sensitivity?

A

It shows how sensitive the portfolio’s risk is to changes in individual positions.

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15
Q

If you increase the Yahoo Equity position by R1 million, and the portfolio’s total VaR increases by R0.02 million, what is the Incremental VaR of the Yahoo stock?

A

The R0.02 million is the Incremental VaR of the Yahoo stock

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16
Q

What is incremental VAR useful for?

A

It is Useful for identifying which positions to adjust for gradual risk reduction

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17
Q

What are risk models used for?

A

Risk models are used to estimate max potential loss that portfolio could face due to market movements

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18
Q

What do VaR models based on principles of MPT focus on

A

VaR models based on principles of MPT focus on how diversification and correlation affect risk of portfolio

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19
Q

What does MPT assume?

A

MPT assumes risk can be predicted and managed by how asset prices move relative to each other

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20
Q

How many risk methodologies are there?

A

There are 3 risk methodologies

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21
Q

What are the 3 risk methodologies (that is the approaches of calculating Var?) ?

A

The 3 risk methodologies are:

1) Parametric
2) Historical simulation
3) Monte Carlo simulation

22
Q

What does the paremetric model do?

A

It specifies volatility, correlation, delta, and gamma

23
Q

What does the Monte Carlo Simulation do?

A

It simulates random scenarios

24
Q

What does the historical simulation do?

A

It relives history

25
Q

What is the parametric method applied on?

A

It is applied on Traditional assets and linear derivatives

26
Q

What is the monte carlo simulation method applied on?

A

It is applied on all types of instruments, linear and non linear

27
Q

What is the historical simulation method applied on?

A

It is applied on all types of instruments, linear and non linear

28
Q

What does the parametric method do an When is it useful?

A

It is useful for risk measurement during the trading day due to its simplicity and speed

29
Q

What securities is the parametric method best for?

A

It is best for stocks and bonds and options with simple payoff structures

30
Q

What does the Monte carlo method do and when is it useful?

A

It provides a fuller picture of risk by the end of the trading day (but more complex)

31
Q

What does the Historical siulation method do and When is it useful?

A

It re-prices the portfolio under multiple scenarios, providing a robust estimate of VaR and
help to assess risk at the end of the trading day

32
Q

Which risk methodologies are mechanically the same and why?

A

Monte Carlo and Historical simulation are mechanically the same because both revalue instruments but they just arrive there differently

33
Q

What is the limitation of VAR

A

It is limited by its fundamental assumptions that the future can be predicted by the past, which is not accurate

34
Q

What is the limitation of the Parametric approach?

A

Parametric approach assumes normally distributed returns - which are only meant to describe bad losses on normal bad day (missing extreme losses – fat tail events)

35
Q

What is the limitation of the historical simulation approach ?

A

Historical simulation – assumes past distribution will forecast future distributions

36
Q

What is the limitation of the Monte Carlo approach ?

A

Monte Carlo – addresses fat-tail problem but depend on assumptions about volatility and correlation based on historical data (is not always the case in reality)

37
Q

How many parameters need to be specified before calculating VaR?

A

3 parameters need to be specified before calculating VaR:

38
Q

What are the 3 parameters that need to be specified before calculating VaR?

A
  1. Confidence level
     Range between 90% and 99%
     RiskMetrics assumes 95%
  2. Forecast horizon
     FIs use 1-day forecast horizons
     Does not make sense to project market risk further
  3. Base currency
     Currency of equity capital and reporting currency of company
     Nedbank would use ZAR, BoA would use USD
39
Q

What is the relationship between a longer position and exposure to market volatility?

A

The longer the position the greater the potential loss more exposure to market volatility

40
Q

Does volatility increase linearly?

A

Volatility does not increase linearly – either increase or decrease

41
Q

Why is Long-horizon forecasting complex ?

A

Long-horizon forecasting is complex because:

 Autocorrelation – past returns may influence future returns

 Mean reversion of market returns – over time markets tend to revert to historical averages

 Interrelationship of economic factors – Economic variables affect long-term volatility

42
Q

What does Time scale VaR do?

A

Time scale VaR estimates the square root of time scaling

43
Q

What does Time scale VaR assume?

A

Assumes no mean reversion, trending, or autocorrelation – oversimplifies the market

44
Q

What is Time scale VaR useful for?

A

Useful to convert 1-day VaR figures to 10-day BIS regulatory VaR standards

45
Q

What are the main components of market risk?

A
  1. Equity risk
  2. Interest rate risk 3. Foreign exchange risk
  3. Commodity risk
46
Q

What are the Residual risks of market risk ?

A
  1. Spread risk
  2. Basis risk
  3. Specific risk
  4. Volatility risk
47
Q

Why is stress testing important?

A

Stress testing is important – models extreme scenarios that VaR might miss

48
Q

What 2 questions is stress testing fraed around?

A
  1. How much could I lose if stress scenario occurs? (Senior management would ask this)
  2. What event could cause me to lose more than a pre-defined threshold?
49
Q

What are the 4 major approaches for generating stress scenarios?

A
  1. Historical scenarios
  2. Shocks market rates to examine portfolio sensitivities
  3. Hypothetical future scenarios
  4. Analysing portfolio vulnerabilities
50
Q

What is MPT?

A

It is the Modern Portfolio Theory

51
Q
A

Banking (11 decks)

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