Chapter 5: Market Risk

Question 1

What is Volatility risk

Answer 1

The risk of price movement that are more uncertain than usual affecting the pricing of products. Has the biggest affect on options market

Question 2

What is Market liquidity risk

Answer 2

The risk of loss through not being able o trade in a market or obtain a price on a desired product when required

Question 3

What is Currency risk

Answer 3

The risk that adverse movements in exchange rates drastically affect the value of a portfolio or instrument

Question 4

What is basis risk

Answer 4

This is the risk that, when hedging a position, the two instruments are not equal and opposite, but in fact behave in a similar manner

Question 5

What is interest rate risk

Answer 5

the risk that adverse movements in interest rates will directly affect fixed-income securities, futures, options and forwards

Question 6

What is commodity price risk

Answer 6

The risk of adverse price movements in the value of a commodity

Question 7

What is Equity price risk

Answer 7

The risk that the share price decreases or fails to rise in line with inflation. Also includes the risk that dividends may decrease or not be paid at all

Question 8

What are boundary issues

Answer 8

When multiple types of risk overlap/cause/affect one another

Question 9

What are market risk limits

Answer 9

A ‘stop-loss’ and may be expressed in terms of VaR or as an absolute number

Question 10

What do the market risk function do

Answer 10

Ownership of market risk management policy
Proactive management of market risk issues
Define escalation procedures
Validate Pricing and VaR models
Daily monitoring of risk utilization

Question 11

What is the central tendency

Answer 11

A typical value taken from market datasets that captures the ‘essence’ of the distribution

Question 12

What is the dispersion

Answer 12

How far values stray from the typical value

Question 13

What are the measures of central tendency

Answer 13

Mean
Median
Mode

Question 14

What are the measures of dispersion

Answer 14

Range
Quartile deviation
Variance
Standard Deviation

Question 15

What is quartile deviation

Answer 15

A measure of dispersion through the middle half f the distribution

Question 16

How to calculate quartile deviation

Answer 16

0.5(Q3-Q1)

Question 17

What is variance

Answer 17

A measure of dispersion and shows the spread of data around the mean

Question 18

How to calculate variance

Answer 18

the sum of the squares of the differences between the mean and each value divided by the number of values (Or number of values - 1 when using a sample)

Question 19

How to calculate standard deviation

Answer 19

Square root of the variance

Question 20

How often are returns within within one standard deviation of the mean

Answer 20

2/3

Question 21

What is distribution analysis

Answer 21

A statistical means of using historical data to predict future events and relies on an understanding of probability distributions

Question 22

What percentage of the data in a normal distribution will be within 2 standard deviations

Answer 22

95.5%

Question 23

What percentage of the data in a normal distribution will be within 3 standard deviations

Answer 23

99.75%

Question 24

What is regression analysis

Answer 24

A statistical tool for the investigation of relationships between variables. The effect of one variable on another.

Question 25

What is the correlation coefficient

Answer 25

It measures the strength of the relationship between two variables

Question 26

advantages of VaR

Answer 26

Provides statistical probability of potential loss Easily understood by non risk managers Translates all risks in a portfolio into a common standard

Question 27

Disadvantage of VaR

Answer 27

Does not specify maximum loss outside of the confidence level

Question 28

What is back testing

Answer 28

The practice of comparing the actual daily trading exposure to the previously predicted VaR figure

Question 29

What are the three ways VaR can be calculated

Answer 29

Historical simulation The Parametric Monte Carlo simulation

Question 30

What is the historical simulation

Answer 30

Involves looking back at what actually happened in the past and basing our view of the future o that analysis

Question 31

What is the parametric approach

Answer 31

This assumes that the distribution of possible returns can be plotted, based on a small number of factors, so that the required confidence level can be 'read off' the graph

Question 32

What is the Monte Carlo Simulation

Answer 32

Involves generating random set of results based on the actual underlying risk factors and again 'reading off' the graph

Question 33

What is the difference between stress testing and scenario analysis

Answer 33

The number of variables that are altered

Question 34

Advantages of historical simulation

Answer 34

Simple to communicate to non experts No need to make assumptions about the distribution of returns No need to estimate volatilities or correlations

Question 35

Disadvantages of historical simulation

Answer 35

Assumes that history will repeat itself which often is not the case

Question 36

Advantages of Parametric approach

Answer 36

The simplest way to calculate VaR Minimal computation time No simulations required

Question 37

Disadvantages of Parametric approach

Answer 37

The actual returns have to be normally distributed or the results will be incorrect Cannot be used with securities such as options as not normally distributed

Question 38

Advantages of Monte Carlo Method

Answer 38

Can be used on non-normally distributed instruments