Market Risk

Question 1

what is market risk

Answer 1

uncertainty resulting from changes in market prices

ie the estimated potential loss under adverse circumstances

Question 2

market risk mainly effects two other risks, what are they?

Answer 2

interest risk and FX risk

Question 3

why is market risk measurement important? (5)

Answer 3

mgmt info
setting risk limits
resource allocation
preformance evaluation
regulation

Question 4

what are the two ways to measure market risk?

Answer 4

Riskmetrics ie DEAR

Historic/back simulation

Question 5

for the pricemetrics ie DEAR= $MV of position x price volatility or
DEAR = $MV of position x price sensit x potential adverse move in yield

how do we measure the price volatility?

Answer 5

volatility is based on duration, the greater the duration the greater the volatility.

deltaPrice/Price = - duration (change in rate /1+R)

Question 6

what does the modified duration tell us? how is it calculated

Answer 6

price sensitivity therefore
-MD x potential adverse move in yield = daily price volatility

MD= D/1+R

Question 7

how is the potential loss for more than one day calculated?

Answer 7

DEAR x squrt(number of days)

Question 8

how is FX volitility calculated?

Answer 8

tcrit x var(exchange rate)

ie (1.65 x 0.0065)

Question 9

when measuring the DEAR of en entire portfolio, how do you measure correctly?

Answer 9

(square each original DEAR, then times 2xcorrelation between each DEAR by each the two DEARS reflected in correlation) all of this to the power of 1/2

see formula sheet

Question 10

what is the main assumption made with DEAR (weakness)?

Answer 10

that returns are normally distributed

Question 11

what are advantages of historic/ back simulation approach?

Answer 11

simple
no normal distribution assumption
no need for SD or correlation figures for asset returns

Question 12

how does historic/ back simulation approach work?

Answer 12

revaluation of current asset portfolio based on actual historic prices, then calc 5% worst case outcomes

Question 13

what are the disadvangtages of the historic/ back simulation approach?

Answer 13

• 500 prior observations may not be enough, however increasing the number by going futher back in time is not desirable
• complete dependance on particular historical data (period may be unusual, only reflects risk of that data)