Chap.3_Measuring market risks

Question 1

Cite three basic measures of risk, and explain which kind of risk they measure.

Answer 1

1. Standard deviation: measures volatility.
2. Beta: measures systematic risk of an asset.
3. Credit ratings: measure the credit (or counterparty) risk of an entity.

Question 2

What is the VIX index?

Answer 2

It is an index of implied (‘future’ or ‘expected’) volatility of 30-day options on the S&P500: it thus measures the market’s expectations for changes in near-term prices of the S&P500.

Question 3

What can you say about the VIX index in crisis times? In expansion (non-crisis) times?

Answer 3

1. In crisis times: it reflects fear; it is the fear gauge (Whaley, 2008).
2. In expansion (non-crisis) times: it reflects euphoria (ex.: speculative bubbles).

Question 4

What are credit ratings? What are they used for?

Answer 4

1. They are measures of credit (or counterparty) risk of an entity.
2. They are used to determine how likely an entity is to default on its debt.

Question 5

Cite the three main agencies that provide credit ratings.

Answer 5

1. S&P
2. Moody
3. Fitch

Question 6

What does this mean for a company to have its bond rated AAA/CC?

Answer 6

1. AAA bond rating: It’s a prime bond, with an almost null probability of default.
2. CC bond rating: It’s a junk bond, with imminent default.

Question 7

How is liquidity risk measured? Give some examples.

Answer 7

Question 8

What is the VaR? Define it (in full English).

Answer 8

The VaR (Value at Risk) measures the maximum possible loss on an investment, given a certain
probability, and on a certain time frame.

Question 9

“The stock price of company Y has a one-year 95% VaR equal to $200”: what does this mean?

Answer 9

This says that there is a 5% probability that this asset value decreases by more than $200 over one year.
Said differently, this asset has a 95% probability to experience losses smaller than $200 over one year.

Question 10

“The stock price of company Y has a one-month 95% VaR equal to $10 million”: represent graphically this VaR.

Answer 10

Question 11

What are the main ways to compute the VaR?

Answer 11

Question 12

What are the main uses of the VaR measure?

Answer 12

Question 13

What are the main advantages of the use of VaR as measure of risk? Its drawbacks?

Answer 13

Question 14

Which measure helps overcome the fact that the VaR is uninformative about extreme tails? How?

Answer 14

Expected shortfall (ES): Also called conditional value at risk, conditional tail expectation, expected
tail loss.

Question 15

What is expected shortfall. Explain it briefly.

Answer 15

ES is a measure of the average loss beyond the confidence interval. Example: an asset has a one-month 5% expected shortfall of 10 million euros. Over one month, it has a 5% probability to experience losses of 10 million euros on average (that is, 10 million or less).

Question 16

Explain the difference between the VaR and ES.

Answer 16

1. The VaR answers the question “How bad things can get?”.
2. ES answers the question “If things do get bad, what is the expected loss?”.

Question 17

What is the rationale of stress tests?

Answer 17

One flaw of the VaR is that it does not show how large a loss can be beyond the confidence level. Stress tests’s rationale is to find plausible scenarios of market stress, likely to result in large losses.

Question 18

What are the methods to construct stress tests?

Answer 18

1. Historical stress scenarios
2. Hypothetical stress scenarios
   2.1. Extreme value theory
   2.2. Monte Carlo methods