Market Risk Flashcards by Viwe Thiyane

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

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

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Why is VAR a flexible measure?

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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How many types of VAR exist?

There are 3 types of VAR

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List the 3 types of VAR

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

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What does relative VAR measure?

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

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

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What does a VaR (%) show?

VaR (%) shows the total potential loss

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What does a relative VaR (%) show?

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

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

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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What does marginal VAR measure?

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

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What does marginal VAR show in terms of sensitivity?

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

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

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

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What does incremental VAR measure?

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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What does incremental VAR show in terms of sensitivity?

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

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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?

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

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What is incremental VAR useful for?

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

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What are risk models used for?

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

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What do VaR models based on principles of MPT focus on

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

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What does MPT assume?

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

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How many risk methodologies are there?

There are 3 risk methodologies

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

The 3 risk methodologies are:

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

What does the paremetric model do?

It specifies volatility, correlation, delta, and gamma

What does the Monte Carlo Simulation do?

It simulates random scenarios

What does the historical simulation do?

It relives history

What is the parametric method applied on?

It is applied on Traditional assets and linear derivatives

What is the monte carlo simulation method applied on?

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

What is the historical simulation method applied on?

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

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

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

What securities is the parametric method best for?

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

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

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

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

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

Which risk methodologies are mechanically the same and why?

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

What is the limitation of VAR

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

What is the limitation of the Parametric approach?

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

What is the limitation of the historical simulation approach ?

Historical simulation – assumes past distribution will forecast future distributions

What is the limitation of the Monte Carlo approach ?

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)

How many parameters need to be specified before calculating VaR?

3 parameters need to be specified before calculating VaR:

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

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

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

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

Does volatility increase linearly?

Volatility does not increase linearly – either increase or decrease

Why is Long-horizon forecasting complex ?

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

What does Time scale VaR do?

Time scale VaR estimates the square root of time scaling

What does Time scale VaR assume?

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

What is Time scale VaR useful for?

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

What are the main components of market risk?

1. Equity risk 2. Interest rate risk 3. Foreign exchange risk 4. Commodity risk

What are the Residual risks of market risk ?

1. Spread risk 2. Basis risk 3. Specific risk 4. Volatility risk

Why is stress testing important?

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

What 2 questions is stress testing fraed around?

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?

What are the 4 major approaches for generating stress scenarios?

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

What is MPT?

It is the Modern Portfolio Theory