Deck 15: Market Risk

Question 1

Daily earnings at risk (DEAR) is defined as the dollar value of a position times price sensitivity of that position.

Answer 1

False

Question 2

The Volcker Rule allows U.S.depository institutions to invest in hedge funds and private equity funds in order to gain more diversification of the trading portfolio.

Answer 2

False

Question 3

The N-day Market value at risk (VAR) is defined as the daily earnings at risk (DEAR) times the number of days (N).

Answer 3

False

Question 4

The Volcker Rule is intended to reduce market risk at depository institutions.

Question 5

Market risk is the potential gain or loss caused by an adverse movement in market conditions.

Question 6

Losses among FIs that actively traded mortgage-backed securities reached over $3 trillion world-wide by mid-2009.

Question 7

Market risk is the uncertainty of an FI's earnings resulting from changes in market conditions such as interest rates and asset prices.

Question 8

The major traders of mortgage-backed securities prior to the recent financial crisis were investment banks and securities firms.

Question 9

As securitization of assets continues to expand, the management of market risk will become more important to FIs.

Question 10

Depository institutions are prohibited from proprietary trading by the Volcker Rule.

Question 11

If a trader in charge of an investment portfolio of an FI generates returns that are higher than other traders at the FI, she should be rewarded with higher compensation.

Question 12

Assets and liabilities that are expected to require extensive time to liquidate are normally placed in the investment portfolio.

Question 13

Although financial markets deteriorated during the summer of 2009, by September of that year the banking system had returned to normal operation.

Question 14

The Volcker Rule became effective in early 2013.

Question 15

Regulators include market risk of an institution when determining the required level of capital an FI must hold.

Question 16

Banks are limited by regulation to using the historic or back simulation method to quantify market risk exposure.

Question 17

The Volcker Rule reduces the specialness of banks in maturity intermediation by effectively forcing DIs to hold a matched maturity book.

Question 18

Considering the market risk of traders' portfolios for the purpose of establishing logical position limits per trader in each area of trading is a resource allocation benefit of market risk measurement.

Question 19

Market risk management is important as a source of information on risk exposure for senior management of an FI.

Question 20

Income from trading activities of FIs is less important today than the traditional activities of banks.

Question 21

The Value at Risk (VAR) provides information about the potential size of the expected loss given a level of probability.

Question 22

Monte-Carlo simulation is a tool for considering portfolio valuation under all possible combinations of factors that determine a security's value.

Question 23

The back simulation approach to estimating market risk exposure requires normally distributed asset returns, but does not require correlations of asset returns.

Question 24

Calculating the risk of a multi-asset trading portfolio requires the consideration of the correlations of returns between the different assets.

Question 25

For situations in which probability distributions exhibit fat tail losses, expected shortfall (ES) may look relatively small, but value at risk (VAR) may be very large.

Question 26

Daily price volatility of a bond can be estimated by multiplying the bond's modified duration by the adverse daily yield move.

Question 27

The DEAR of a portfolio of assets is simply the weighted average of each individual assets' DEAR.

Question 28

The back simulation approach to estimating market risk exposure requires the use of daily prices or returns for some period of immediately recent history.

Question 29

The JPM RiskMetrics model is based on the assumption of a binomial distribution of asset returns.

Question 30

One of the reasons FIs develop internal market risk measurement models is the proposal of the BIS to impose capital requirements on the trading portfolios of FIs.

Question 31

A major weakness of the RiskMetrics Model is the need to assume a symmetric or normal distribution of asset returns.

Question 32

Monte-Carlo simulation is a process of creating asset returns based on actual trading days so that the probabilities of occurrence are consistent with recent historical experience.

Question 33

The dollar value of a foreign exchange portfolio equals the FX position times the spot exchange rate.

Question 34

Price volatility is the price sensitivity of a trading position times the potential adverse move in yield.

Question 35

In estimating price sensitivity, the RiskMetrics model prefers to use modified duration over the present value of cash flow changes.

Question 36

A disadvantage of the back simulation approach to estimate market risk exposure is the limited confidence level based on the number of observations.

Question 37

The Expected Shortfall (ES) is a measure of market risk that estimates the expected losses beyond a given confidence level.

Question 38

The RiskMetrics model generally prefers using the present value of cash flow changes as the price-sensitivity weights.

Question 39

One advantage of RiskMetrics over back simulation approach to measure market risk is that RiskMetrics provides a worst case scenario number.

Question 40

The Bank for International Settlements (BIS) is an organization formed by the largest commercial banks operating in developed markets.

Question 41

Beta represents the systematic risk reflecting the co-movement of the returns on a specific stock with the returns of another stock.

Question 42

Economic-value stress testing is intended to capture the firm's exposure to unlikely but plausible events in abnormal markets.

Question 43

In the early 2000s the market risk capital requirement was a large proportion of the total risk capital requirements for the largest US banks.

Question 44

A charge reflecting the risk of the decline in the liquidity or credit risk quality of the trading portfolio is the general market risk capital requirement charge in the BIS framework.

Question 45

As compared to the BIS standardized framework model for measuring market risk, the internal models allowed by the large banks are subject to audit by the regulators.

Question 46

Banks in the countries that are members of the BIS must use the standardized framework to measure market risk exposures.

Question 47

The Sensitivities-Based Method (SBM) suggests that banks use analysis of "sensitivities" to estimate risk charges against beta risks.

Question 48

Equity trading risk weights of the BIS standardized approach vary between emerging markets and developed markets.

Question 49

Which of the following are included in the methodological approach to calculate the VAR?

A)measure exposures
B)measure sensitivity
C)measure risk
D)rank days by risk from worst to best
E)all of the above are included in the methodological approach

Question 50

Equity trading risk weights of the BIS standardized approach vary based on the industry of the stock being held and traded.

Question 51

Nonstatistical risk measures provide granular information on the firm's market risk exposure by looking at sensitivities to variables like credit spread, interest rate basis point values, and market values.

Question 52

The Monte Carlo simulation is a tool for considering portfolio valuation under all possible combinations of factors that determine a security's value.

Question 53

When using the BIS standardized model (partial risk factor approach) to determine capital requirements of the trading book, correlations for equity risk are set by the Federal Reserve.

Question 54

In the BIS framework, vertical offsets are charges that reflect the modified duration and interest rate shocks for the maturity of each trading position.

Question 55

The partial risk factor approach incorporates the return correlations between assets held in the trading portfolio.

Question 56

Basel III proposes the partial risk factor approach to measuring capital that must be kept against a trading book as a revised standardized approach that FIs may use rather than internal models to measure market risk.

Question 57

The root cause of much of the losses of FIs during the financial crisis of 2008-2009 was

A)interest rate risk.
B)market risk.
C)sovereign risk.
D)firm-specific risk.
E)systematic risk.

Question 58

The Default Risk Charge (DRC) is intended to capture jump-to-default risk and is calibrated to the credit risk treatment in the banking book to reduce potential discrepancy in capital requirements for similar risk exposures across the banking and trading books.

Question 59

Regulators usually view tradable assets as those held for horizons of

A)less than one year.
B)greater than one year.
C)less than a quarter.
D)less than a week.
E)less than three years.

Question 60

Conceptually, an FI's trading portfolio can be differentiated from its investment portfolio by

A)liquidity.
B)time horizon.
C)size of assets.
D)effects of interest rate changes.
E)liquidity and time horizon.

Question 61

How can market risk be defined in absolute terms?

A)A dollar exposure amount or as a relative amount against some benchmark.
B)The gap between promised cash flows from loans and securities and realized cash flows.
C)The change in value of an FI's assets and liabilities denominated in nondomestic currencies.
D)The cost incurred by an FI when its technological investments do not produce anticipated cost savings.
E)The capital required to offset a sudden decline in the value of its assets.

Question 62

The earnings at risk for an FI is a function of

A)the time necessary to liquidate assets.
B)the potential adverse move in yield.
C)the dollar market value of the position.
D)the price sensitivity of the position.
E)All of the options.

Question 63

Using market risk management (MRM) to identify the potential return per unit of risk in different areas by comparing returns to market risk so that more capital and resources can be directed to preferred trading areas is considered to be which of the following?

A)Regulation.
B)Resource allocation.
C)Management information.
D)Setting limits.
E)Performance evaluation.

Question 64

Which term defines the risk related to the uncertainty of an FI's earnings on its trading portfolio caused by changes, and particularly extreme changes in market conditions?

A)Interest rate risk.
B)Credit risk.
C)Sovereign risk.
D)Market risk.
E)Default risk.

Question 65

Daily earnings at risk (DEAR) is calculated as

A)the price sensitivity times an adverse daily yield move.
B)the dollar value of a position times the price volatility.
C)the dollar value of a position times the potential adverse yield move.
D)the price volatility times the √N.
E)More than one of the above is correct.

Question 66

The capital requirements of internally generated market risk exposure estimates can be met

A)only with two types of capital.
B)only with Tier 1, Tier 2, or Tier 3 capital.
C)with retained earnings and common stock only.
D)only with retained earnings, common stock, and long-term subordinated debt.
E)only with short- or long-term subordinated debt.

Question 67

The portfolio of a bank that contains assets and liabilities that are relatively illiquid and held for longer holding periods

A)is the trading portfolio.
B)is the investment portfolio.
C)contains only long term derivatives.
D)is subject to regulatory risk.
E)cannot be differentiated on the basis of time horizon and liquidity.

Question 68

Considering the Capital Asset Pricing Model, which of the following observations is incorrect?

A)In a well-diversified portfolio, unsystematic risk can be largely diversified away.
B)Systematic risk is considered to be a diversifiable risk.
C)Total risk is the sum of systematic risk and unsystematic risk.
D)Systematic risk reflects the co-movement of a stock with the market portfolio.
E)Unsystematic risk is specific to the firm.

Question 69

If a stock portfolio replicates the returns on a stock market index, the beta of the portfolio will be

A)less than 1.
B)greater than 1.
C)equal to 0.
D)equal to 1.
E)negative.

Question 70

If an FIs trading portfolio of stock is not well-diversified, the additional risk that must be taken into account is

A)unsystematic risk.
B)default risk.
C)timing risk.
D)interest rate risk.
E)systematic risk.

Question 71

In calculating the value at risk (VAR) of fixed-income securities in the RiskMetrics model,

A)the VAR is related in a linear manner to the DEAR.
B)the price volatility is the product of the modified duration and the adverse yield change.
C)the yield changes are assumed to be normally distributed.
D)All of the options.
E)the price volatility is the product of the modified duration and the adverse yield change and the yield changes are assumed to be normally distributed.

Question 72

An advantage of the historic or back simulation model for quantifying market risk includes

A)calculation of a standard deviation of returns is not required.
B)all return distributions must be symmetric and normal.
C)the systematic risk of the trading positions is known.
D)there is a high degree of confidence when using small sample sizes.
E)None of the options.

Question 73

In the RiskMetrics model, value at risk (VAR) is calculated as

A)the price sensitivity times an adverse daily yield move.
B)the dollar value of a position times the price volatility.
C)the dollar value of a position times the potential adverse yield move.
D)the price volatility times the √N.
E)DEAR times the √N.

Question 74

Market risk measurement considers the return-risk ratio of traders, which may allow a more rational compensation system to be put in place.Thus market risk measurement (MRM) aids in

A)regulation.
B)resource allocation.
C)management information.
D)setting limits.
E)performance evaluation.

Question 75

Which of the following is a problem encountered while using more observations in the back simulation approach?

A)Past observations become decreasingly relevant in predicting VAR in the future.
B)Calculations become highly complex.
C)Need to assume a symmetric (normal) distribution for all asset returns.
D)Requirement for calculating the correlations of asset returns.
E)Calculations become highly complex; need to assume a symmetric (normal) distribution for all asset returns.

Question 76

Which of the following items is not considered to be an advantage of using back simulation over the RiskMetrics approach in developing market risk models?

A)Back simulation is less complex.
B)Back simulation creates a higher degree of confidence in the estimates.
C)Asset returns do not need to be normally distributed.
D)The correlation matrix does not need to be calculated.
E)A worst-case scenario value is determined by back simulation.

Question 77

When using the RiskMetrics model, price volatility is calculated as

A)the price sensitivity times an adverse daily yield move.
B)the dollar value of a position times the price volatility.
C)the dollar value of a position times the potential adverse yield move.
D)the price volatility times the √N.
E)None of the options.

Question 78

A reason for the use of market risk management (MRM) for the purpose of identifying potential misallocations of resources caused by prudential regulation is which of the following?

A)Regulation.
B)Resource allocation.
C)Management information.
D)Setting limits.
E)Performance evaluation.

Question 79

Which benefit of market risk measurement (MRM) provides senior management with information on the risk exposure taken by FI traders?

A)Regulation.
B)Resource allocation.
C)Management information.
D)Setting limits.
E)Performance evaluation.

Question 80

Which of the following securities is most unlikely to have a symmetrical return distribution, making the use of RiskMetrics model inappropriate?

A)Common stock.
B)Preferred stock.
C)Option contracts.
D)Consol bonds.
E)30-year U.S.Treasury bonds.