Chapter 5: Market Risk

Question 1

What is market risk?

Answer 1

The risk of loss arising from changes in the value of financial instruments

Question 2

What is a direct market risk factor?

Answer 2

Direct company performance. E.G. Balance Sheet, Earnings, Management.

Question 3

What is an indirect market risk factor?

Answer 3

Variables outside the company’s control. Interest rates, economic environment, sector sentiment.

Question 4

What is volatility risk?

Answer 4

The risk that price movements are more uncertain than usual.

Question 5

What is market liquidity risk?

Answer 5

Not being able to trade at a desired price due to a lack of market participants.

Question 6

What is currency risk?

Answer 6

Caused by adverse movements in exchange rates. Occurs when an investor holds an instrument in a currency different from their base currency.

Question 7

What is basis risk?

Answer 7

When one risk exposure is hedged in another instrument that behaves in a manner that may not be completely opposite. Basis risk exists to the extent that the two positions do not exactly mirror each other.

Question 8

What is interest rate risk?

Answer 8

Caused by adverse movements in central interest rates.

Question 9

What is Equity risk?

Answer 9

Capital growth or income is lower than expected.

Question 10

Why are interest rates and bond prices inversely related?

Answer 10

Higher interest rates make the return provided by bonds less appealing. In order for it to become attractive to investors the price has to fall.

Question 11

What is hedging?

Answer 11

Reducing the risk of adverse price movements by taking an offsetting position in a related product. Insurance against market risk.

Question 12

What products are commonly used to hedge?

Answer 12

Derivatives, primarily futures, and options.

Question 13

What are market risk limits?

Answer 13

Tools for managing market risk. E.g. Maximum loss

Question 14

What are the problems with market risk limits?

Answer 14

They often have to be inflated to accommodate uncertainty in risk measurement.

Question 15

How does diversifying lower risk?

Answer 15

A portfolio will have a lower standard deviation of return than an individual security

Question 16

What is the aim of market risk analysis?

Answer 16

Not to eliminate risk, but to be able to predict which market risks yield the greatest returns.

Question 17

What is the issue with large data sets for market risk analysis?

Answer 17

Hard to distinguish between expected behaviours and outliers

Question 18

What is the central tendency in a sample?

Answer 18

A single number that captures the ‘essence’ of the distribution

Question 19

What is dispersion in a sample?

Answer 19

How far the other values stray from the central tendency

Question 20

How can central tendency be measured? 3 ways.

Answer 20

Mean, mode, median

Question 21

What is the difference between quantitative and qualitative data?

Answer 21

Quantitative is countable/measurable. Qualitative is descriptive.

Question 22

How is dispersion measured? 4 ways

Answer 22

Range
Quartile deviation
Variance
Standard Deviation

Question 23

What is Quartile Deviation?

Answer 23

It is the measure of the dispersion through the middle half of a distribution.

Question 24

How do you calculate Quartile Deviation?

Answer 24

Step one
* Find the median of the data set and call this median Q2 (Q2 is also called the second quartile value).
Step two
* Use Q2 to divide the original data set into two parts.
* The lower 50% consists of those values less than Q2.
* The upper 50% consists of values greater than Q2.
If the number of items in the dataset is odd, then include Q2 in both the lower and upper data sets.
Step three
* Calculate Q1 as the median of the lower data set (Q1 is called the first quartile position).
* Calculate Q3 as the median of the upper data set (Q3 is called the third quartile position).
Step four
* (Q3 – Q1)/2 is the quartile deviation.

Question 25

How is variance calculated?

Answer 25

In a data set, the difference between each value from the mean, squared. The mean of these values is the variance.

Question 26

How do you get standard deviation from variance?

Answer 26

Square root it. v = sd^2

Question 27

What is distribution analysis?

Answer 27

Using historical data to predict future events with probability distributions.

Question 28

How can normal distribution of investment returns be used to predict future returns?

Answer 28

Assuming that the returns remain normal, you can predict that there is an x probability of certain returns. Called the confidence interval.

Question 29

What is fat-tailed distribution?

Answer 29

In real life most models do not fit normal distribution perfectly. There is always a probability of at 3+ sigma event. Periodically there will be extreme deviations from the mean, thus fat-tailed.

Question 30

What is regression analysis?

Answer 30

The study of the effect of one variable on another. For example the effect of price increase on demand.

Question 31

How is regression data analysed?

Answer 31

Often using a scatter-gram, line of best fit, R-value.

Question 32

What is the beta of a stock?

Answer 32

It’s correlation co-efficient with the whole market.

Question 33

What is the alpha of a fund?

Answer 33

Refers to its performance vs its benchmark.

Question 34

How is portfolio optimisation formulated mathematically?

Answer 34

Minimising the risk for a given return
Maximising the expected return for a given risk

Question 35

What is Value at Risk (VaR)

Answer 35

Measure that expresses the maximum loss that can occur with a specified confidence over a specified period.

Question 36

What are the advantages of using VaR

Answer 36

Provides probability of potential loss
Easy to understand
Translates risk into a standard that can be used across the firm

Question 37

What is the main limitation of VaR

Answer 37

No indication of how bad it can get. E.g. 95 days out of 100 you will lose no more than $1m, what about the other 5 days?

Question 38

How can you validate VaR?

Answer 38

By back testing, compare the historical PnL to the VaR model.

Question 39

What are the 3 different approaches to VaR?

Answer 39

Historical simulation
Parametric/Analytical approach
Monte Carlo simulation

Question 40

What is historical simulation?

Answer 40

A VaR approach.
Uses historic analysis of a portfolio’s risk to estimate future risk exposure

Question 41

What is the parametric/analytical approach?

Answer 41

Assumes portfolio returns are normally distributed, uses confidence intervals to determine VaR.

Question 42

How does historical simulation differ to just plotting historical returns?

Answer 42

Models the returns of a portfolio with multiple different risk variables, imagine it as a parallel universes of how the market could’ve performed in different past circumstances which is then averaged and plotted.

Question 43

What is the Monte Carlo simulation method?

Answer 43

Develops a model (set of equations) for future stock price returns. Runs multiple hypothetical values through this model to obtain a distribution of return values.
Essentially Historical Simulation but for the future.
Then analyse these returns to provide VaR.

Question 44

What is a stress test?

Answer 44

Altering one variable significantly to analyse it’s effect on the portfolio.
E.g. a large hike in interest rates

Question 45

What does a stress test capture?

Answer 45

Portfolio performance under extreme market events.