Deck 9: Market Risk

Question 1

Which of the following statements is true?

A) DEAR acknowledges that an FI can sell all its bonds tomorrow, as markets are entirely liquid.
B) DEAR assumes that an FI cannot sell all its bonds tomorrow, although in reality this might be possible.
C) DEAR assumes that an FI can sell all its bonds tomorrow, although in reality it might take many days for the FI to unload its position.
D) DEAR acknowledges that an FI cannot sell all its bonds tomorrow, but that instead it might take many days for the FI to unload its position.

Answer 1

C

Question 2

Which of the following statements is true?

A) Daily price volatility is calculated as the price sensitivity to a small change in yield multiplied by the adverse daily yield move.
B) Daily price volatility is calculated as the negative modified duration of a security multiplied by the adverse daily yield move.
C) The daily price volatility of a security influences how much an FI might lose in case of adverse market movements.
D) All of the listed options are correct.

Answer 2

D

Question 3

Which of the following statements is true?

A) Since regulators are concerned with the social cost of a failure, regulatory models will normally tend to be more conservative than private sector models that are concerned only with the private costs of failure.
B) Since regulators are concerned with the social cost of a failure, regulatory models will normally tend to be less conservative than private sector models that are concerned only with the private costs of failure.
C) Regulators and private firms are both concerned with the social cost of a failure and thus their models do not differ.
D) None of the listed options are correct.

Answer 3

A

Question 4

The N-day market value at risk (VAR) equals daily earning at risk multiplied by the square root of N if we assume that yield shocks are:

A) dependent, that daily volatility is approximately constant and that the FI is 'locked in' to holding the asset in question for N number of days.
B) independent, that daily volatility is approximately constant and that the FI is 'locked in' to holding the asset in question for N number of days.
C) dependent, that daily volatility is approximately constant and that the FI is 'locked in' to holding the asset in question for N minus one number of days.
D) independent, that daily volatility is approximately constant and that the FI is 'locked in' to holding the asset in question for N minus one number of days.

Question 5

Assume the market value of a position is $100 000 and that its modified duration is 3.30 years. Further assume that the potential adverse move in yield is 16.5 basis points. What are the daily earnings at risk for this position (round to two decimals)?

A) $54.45
B) $544.50
C) $54 450.00
D) Not enough information to solve the question.

Question 6

Assume the dollar market value of an FI's position is $200 000 with a modified duration of 4 years. The potential adverse move in the yield is 16.5 basis points. What is the VAR of the position if the FI is required to hold the position for 6 days (round to two decimals)?

A) $1 320.00
B) $3 233.33
C) $330.00
D) $200 000.00

Question 7

Which of the following statements is true?

A) Daily earnings at risk are defined as the dollar market value of a position plus the price sensitivity of the position plus the potential adverse move in yield.
B) Daily earnings at risk are defined as the dollar market value of a position multiplied by the price sensitivity of the position multiplied by the potential adverse move in yield.
C) Daily earnings at risk are defined as (the dollar market value of a position plus the price sensitivity of the position) multiplied by the potential adverse move in yield.
D) Daily earnings at risk are defined as the dollar market value of a position divided by (the price sensitivity of the position plus the potential adverse move in yield).

Question 8

Which of the following statements is true?

A) The relative illiquidity of a market reduces an FI's losses.
B) The relative illiquidity of a market exposes an FI to magnified losses.
C) The relative illiquidity of a market does not influence an FI's loss size.
D) None of the listed options are correct.

Question 9

Which of the following statements is true?

A) The major models used by banks in calculating market risk exposures are RiskMetrics, Monaco simulation and Historic (back) calculation.
B) The major models used by banks in calculating market risk exposures are CreditMetrics, Monte Carlo simulation and Historic (back) calculation.
C) The major models used by banks in calculating market risk exposures are RiskMetrics, Monte Carlo simulation and Historic (back) calculation.
D) The major models used by banks in calculating market risk exposures are CreditMetrics, Monte Carlo simulation and Forward calculation.

Question 10

Assume that the dollar market value of a position is $100 000 and the price volatility is 1.50 per cent. What are the daily earnings at risk for this position (round to two decimals)?

A) $150.00
B) $1500.00
C) $15 000.00
D) Not enough information to solve the question.

Question 11

Assume an FI's daily earnings at risk are $5000 and that the FI is required to hold its position for 10 days. What is the position's VAR (round to two decimals)?

A) $5000 $\times$ $\sqrt{10}$ = $15 811.39
B) $5000 $\times$ $\sqrt{(10 - 1)}$ = $15 000.00
C) $\sqrt{\$5000}$ $\times$ 10 = $707.11
D) $\sqrt{\$5000}$ $\times$ (10 - 1) = $636.40

Question 12

Reasons why market risk measurement is important include:

A) management information.
B) resource allocation.
C) performance evaluation.
D) All of the listed options are correct.

Question 13

Which of the following statements best describes the relationship between total risk, systematic risk and unsystematic risk?

A) Total risk is the product of systematic and unsystematic risk.
B) Total risk is the sum of systematic and unsystematic risk.
C) Total risk is the quotient of systematic and unsystematic risk.
D) Total risk is the difference between systematic and unsystematic risk.

Question 14

Assume an FI holds a foreign exchange position of EUR 200 000 and further assume that the dollar per unit of EUR rate is $1.053/EUR. What is the dollar value of the position (round to two decimals)?

A) EUR 200 000 $\times$ 1.053 = $210 600.00
B) EUR 200 000 $\times$ 1.053 = EUR 210 600.00
C) EUR 200 000 / 1.053 = $189 933.52
D) EUR 200 000 / 1.053 = EUR 189 933.52

Question 15

Suppose an FI holds a $2 000 000 trading portfolio with an average beta of 1.0. Over the last year, the daily return on the stock market index was 3 per cent. How much does the FI stand to lose in earnings if adverse stock market returns materialise tomorrow?

A) $2 000 000 $\times$ 0.03 = $60 000
B) $2 000 000 $\times$ 1.0 $\times$ 0.03 = $60 000
C) $2 000 000 $\times$ 1.65 $\times$ 0.03 = $99 000
D) $2 000 000 $\times$ 2.33 $\times$ 0.03 = $139 800

Question 16

Which of the following statements is true?

A) The assumption that yield changes are normally distributed will result in an exact estimation of extreme outcomes.
B) The assumption that yield changes are normally distributed will generally result in overestimating extreme outcomes.
C) The assumption that yield changes are normally distributed will generally result in underestimating extreme outcomes.
D) Assumptions regarding the distribution of yields are not significant in market risk measurement models.

Question 17

Which of the following statements is true?

A) Technically, 90 per cent of the area under a normal distribution lies between +/- 1.65 $\sigma$ from the mean.
B) Technically, 90 per cent of the area under a normal distribution lies between +/- 2.33 $\sigma$ from the mean.
C) Technically, 99 per cent of the area under a normal distribution lies between +/- 1.65 $\sigma$ from the mean.
D) Technically, 99 per cent of the area under a normal distribution lies between +/- 2.33 $\sigma$ from the mean.

Question 18

Assume the dollar market value of an FI's position is $200 000 and the calculated price volatility is 1.25 per cent. What is the VAR of the position if the FI is required to hold the position for 6 days (round to two decimals)?

A) $2 683.28
B) $6 123.72
C) $200 000.00
D) $489 897.95

Question 19

Market risk is defined as the risk related to the uncertainty of an FI's:

A) earnings on its trading portfolio caused by changes in market conditions.
B) reputation caused by changes in market conditions.
C) solvency caused by the default by specific markets (industries).
D) funding capacity in money markets or in capital markets.

Question 20

Assume that the modified duration of a bond is 2.45 years and that the potential adverse move in yield is 16.5 basis points. What is the bond's price volatility (round to two decimals)?

A) 2.45 $\times$ 0.00165 = 0.40%.
B) -2.45 $\times$ 0.00165 = -0.40%.
C) 2.45 $\times$ 0.0165 = 4.04%.
D) -2.45 $\times$ 0.0165 = -4.04%.

Question 21

Which of the following statements is true?

A) There are no major flaws associated with VAR models like RiskMetrics.
B) One problem associated with VAR models such as RiskMetrics is the assumption of a normal distribution, that is, a skew of 1.
C) One problem associated with VAR models such as RiskMetrics is that these models ignore the risk in the payments of accrued interest on an FI's debt securities.
D) None of the listed options are correct.

Question 22

Which of the following statements is true?

A) Systematic risk reflects the co-movement of a stock with the market portfolio, reflected by the stock's vega and the volatility of the market portfolio.
B) Unsystematic risk reflects the co-movement of a stock with the market portfolio, reflected by the stock's vega and the volatility of the market portfolio.
C) Systematic risk reflects the co-movement of a stock with the market portfolio, reflected by the stock's beta and the volatility of the market portfolio.
D) Unsystematic risk reflects the co-movement of a stock with the market portfolio, reflected by the stock's beta and the volatility of the market portfolio.

Question 23

Which of the following statements is true?

A) Under BIS, the capital charge is calculated as DEAR multiplied by the square root of 10 multiplied by 3.
B) The idea of a minimum multiplication factor of 3 is to create a scheme that is 'incentive compatible'.
C) Regulators can punish FIs that underestimate their capital charges by raising the multiplication factor to as high as 5.
D) Under BIS, the capital charge is calculated as DEAR multiplied by the square root of 10 multiplied by 3 and the idea of a minimum multiplication factor of 3 is to create a scheme that is 'incentive compatible'.

Question 24

What is meant by horizontal offset?

A) The deduction of capital charges because long and short positions of the same maturities have durations that more than perfectly hedge each other.
B) The assignment of additional capital charges because long and short positions of the same maturities have durations that do not perfectly hedge each other.
C) The deduction of additional capital because long and short positions of different maturities more than perfectly hedge each other.
D) The assignment of additional capital charges because long and short positions of different maturities do not perfectly hedge each other.

Question 25

Assume an FI holds three different positions. The following DEAR information is available for the positions. Position 1 is a five-year zero coupon bonds with DEAR of $12 500, position 2 is a CHF spot contract with DEAR of $9500 and the third position are Australian equities with DEAR of $34 500. Which of the following statements is true in relation to these positions?

A) The DEAR of the portfolio can be calculated by simply adding up the individual DEARs.
B) The DEAR of the portfolio can be calculated by simply multiplying the individual DEARs.
C) The DEAR of the portfolio can be calculated by simply adding up the individual DEARs and adjusting the sum by an error factor gamma.
D) None of the listed options are correct.

Question 26

Which of the following is an adequate definition of the term general market risk charge?

A) A charge reflecting the risk of the decline in the liquidity of the trading portfolio.
B) A charge reflecting the modified duration and interest rate shocks for each maturity.
C) A charge reflecting the risk of the decline in the credit risk quality of the trading portfolio.
D) A charge reflecting the duration and interest rate gaps for each maturity.

Question 27

Consider the following hypothetical foreign exchange portfolio: What are the daily earnings at risk for the portfolio?

A) $200 / 0.45 = $444.44
B) $200 $\times$ 0.45 = $90.00
C) ($200 / 0.45) / 100 = $4.44
D) ($200 $\times$ 0.45) / 100 = $0.90

Question 28

Which of the following statements is true?

A) The BIS charges for unsystematic risk by adding the long and short positions in any given share and applying a 4 per cent charge against the gross position in the share.
B) The BIS charges for unsystematic risk by adding the long and short positions in any given share and applying an 8 per cent charge against the gross position in the share.
C) The BIS charges for unsystematic risk by adding the long and short positions in any given share and applying a 4 per cent charge against the net position in the share.
D) The BIS charges for unsystematic risk by adding the long and short positions in any given share and applying an 8 per cent charge against the net position in the share.

Question 29

Which of the following statements is true?

A) In CAPM, it is assumed that systematic and unsystematic risk are positively correlated.
B) In CAPM, it is assumed that systematic and unsystematic risk are negatively correlated.
C) In CAPM, it is assumed that systematic and unsystematic risk are independent of each other.
D) None of the listed options are correct.

Question 30

Which of the following statements is true?

A) Beta is a measure of systematic risk reflecting the co-movement of the returns on a specific share with returns on shares in the same industry
B) Beta is a measure of unsystematic risk reflecting the co-movement of the returns on a specific share with returns on shares in the same industry.
C) Beta is a measure of unsystematic risk reflecting the co-movement of the returns on a specific share with returns on the market portfolio.
D) Beta is a measure of systematic risk reflecting the co-movement of the returns on a specific share with returns on the market portfolio.

Question 31

Which of the following are problems associated with the BIS approach to calculating capital requirements for equities?

A) The approach assumes the same systematic risk factor for every stock.
B) The approach assumes the same unsystematic risk factor for every stock.
C) The approach does not fully consider the benefits from portfolio diversification.
D) The approach assumes the same systematic risk factor for every stock and the approach does not fully consider the benefits from portfolio diversification.

Question 32

Assume an FI holds three different positions. The following DEAR information is available for the positions. Position 1 is a five-year zero coupon bonds with DEAR of $12 500, position 2 is a CHF spot contract with DEAR of $9500 and the third position are Australian equities with DEAR of $34 500. The five-year zero coupon bonds and the CHF spot position have a negative correlation of 0.5, the correlation between the zero coupon bonds and the Australian equities is positive 0.5 and the correlation between the CHF spot contract and the Australian equities is positive 0.2. What is the DEAR of the portfolio?

A) 12 500 + 9500 + 34 500 = $56 500.
B) 12 500(-0.5) + 9500(0.5) + 34 500(0.2) = $5400.
C) [12 500² + 9500² + 34 500² - 2(-0.5)(12 500)(9500) - 2(0.5)(12 500)(34 500) - 2(0.2)(9500)(34 500)]^1/2 = $31 514.
D) [$12 500² + $9500² + $34 500² + 2(-0.5)(12 500)(9500) + 2(0.5)(12 500)(34 500) + 2(0.2)(9500)(34 500)]^1/2 = $43 363.

Question 33

Which of the following is a measure of systematic risk?

A) alpha
B) beta
C) gamma
D) sigma

Question 34

Which of the following statements is true?

A) In a well-diversified portfolio, unsystematic risk can be largely diversified away, leaving behind systematic.
B) In a well-diversified portfolio, systematic risk can be largely diversified away, leaving behind unsystematic.
C) In a well-diversified portfolio, both systematic and unsystematic risk can be largely diversified away.
D) No matter how well diversified a portfolio is, unsystematic and systematic are always existent.

Question 35

Which of the following statements is true?

A) The BIS requires banks to define an adverse change in rates as being the 95th percentile.
B) The BIS requires banks to define an adverse change in rates as being the 97.5th percentile.
C) The BIS requires banks to define an adverse change in rates as being the 99th percentile.
D) The BIS requires banks to define an adverse change in rates as being the 99.5th percentile.

Question 36

Which of the following statements is true?

A) The All Ordinaries index is Australia's premier market indicator, which represents the 100 largest companies listed on the Australian Stock Exchange.
B) The All Ordinaries index is Australia's premier market indicator, which represents the 300 largest companies listed on the Australian Stock Exchange.
C) The All Ordinaries index is Australia's premier market indicator, which represents the 500 largest companies listed on the Australian Stock Exchange.
D) The All Ordinaries index is Australia's premier market indicator, which represents all companies listed on the Australian Stock Exchange.

Question 37

What is meant by vertical offset?

A) The deduction of capital charges because long and short positions in the same maturity bucket but in different instruments more than offset each other.
B) The assignment of additional capital charges because long and short positions in the same maturity bucket but in different instruments cannot perfectly offset each other.
C) The deduction of capital charges because long and short positions in different maturity buckets but in the same instrument more than offset each other.
D) The assignment of additional capital charges because long and short positions in different maturity buckets but in the same instrument cannot perfectly offset each other.

Question 38

Which of the following statements is true?

A) Unsystematic risk is specific to a particular firm.
B) Unsystematic risk is specific to a particular industry.
C) Unsystematic risk is specific to a particular geographical area.
D) Unsystematic risk relates to the whole market.

Question 39

Which of the following is an advantage of the back simulation approach?

A) simplicity
B) assumption of normally distributed asset returns
C) calculation of correlations of asset returns
D) All of the listed options are correct.

Question 40

How can basis risk arise in an FI's operations?

A) Basis risk arises because loan rates and deposit rates are inversely related in their movements over time.
B) Basis risk arises because loan rates and deposit rates are perfectly correlated in their movements over time.
C) Basis risk arises because loan rates and deposit rates are not correlated in their movements over time.
D) Basis risk arises because loan rates and deposit rates are not perfectly related in their movements over time.

Question 41

RiskMetrics weights more recent observations more highly than past observations, which allows more recent news to be more heavily reflected in the calculation of the standard deviation.

Question 42

Define the following terms within the context of the BIS standardised framework:
a. specific risk charge
b. general market risk charge
c. vertical offsets
d. horizontal offset.

Question 43

In sequential order, the steps involved in back simulation are as follows: measure exposures, measure sensitivity, measure risk, measure risk again, rank days by risk from worst to best, VAR.

Question 44

Explain the basic concept of the RiskMetric model. What are the major disadvantages? How can the major disadvantages be addressed?

Question 45

One benefit of the historic or back simulation approach is that it does not need calculation of standard deviations and correlations (or assume normal distributions for asset returns) to calculate the portfolio risk figures.

Question 46

A major advantage is that RiskMetrics directly provides a worst-case scenario number, while this is not the case for back simulation.

Question 47

Vertical offsets are calculated using the sum of the general market risk charges from long and short positions in each time zone.

Question 48

Specific risk charge is a charge reflecting the risk of the decline in the liquidity or credit risk quality of the trading portfolio.

Question 49

Daily earnings at risk (DEAR) is the market risk exposure over the next 72 hours.

Question 50

Market risk is defined as the risk related to the uncertainty of an FI's earnings on its trading portfolio caused by changes in market conditions.

Question 51

Monte Carlo simulations address the problems imposed by a limited number of actual observations, by generating additional observations.

Question 52

Why is market risk measurement important?

Question 53

Consider a VAR of $100 000 for a 95 per cent confidence level. A problem with this information is that while we know that we will lose more than the VAR amount on 5 days out of every 100, we do not know the maximum amount we can lose.

Question 54

From 1998 to 2010 the market risk capital requirement was uniformly a large proportion of the total risk capital requirements for Australian banks, and losses due to market risk continued to increase during and post the global financial crisis.

Question 55

The general market risk charges reflect the product of the modified durations and interest rate shocks expected for each maturity.