Deck 15: Market Risk

Question 1

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

Answer 1

True

Question 2

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

Answer 2

True

Question 3

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

Answer 3

False

Question 4

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

Question 5

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

Question 6

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 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 Volker Rule is intended to reduce market risk at depository institutions.

Question 9

Price volatility is the price sensitivity times the potential adverse move in yield.

Question 10

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

Question 11

The Volker Rule became effective in early 2013.

Question 12

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

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

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

Question 15

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 16

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

Question 17

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

Question 18

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

Question 19

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

Question 20

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

Question 21

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

Question 22

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

Question 23

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

Question 24

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

Question 25

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

Question 26

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 27

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

Question 28

In the BIS standardized framework model, the general market risk weights reflect the product of the modified durations and interest rate shocks.

Question 29

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

Question 30

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

Question 31

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

Question 32

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

Question 33

In the BIS standardized framework model, the specific risk charge attempts to measure the decline in the liquidity or credit risk quality of the trading portfolio over the holding period.

Question 34

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 35

One advantage of RiskMetrics over back simulation is that RiskMetrics provides a worst case scenario value.

Question 36

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

Question 37

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

Question 38

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

Question 39

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 40

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

Question 41

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 42

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 43

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 44

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 45

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 46

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 47

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)Answers A and B only.

Question 48

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 49

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 50

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 above.

Question 51

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

Question 52

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 53

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 above.

Question 54

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

Question 55

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 above.
E)Answers B and C only.

Question 56

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

Question 57

In the BIS framework, horizontal offsets within time zones are used to adjust residual positions between zones.

Question 58

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 59

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 60

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 61

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)Answers B and C only.

Question 62

Which of the following is a method that may overcome weaknesses in the historic or back simulation model?

A)The use of smaller sample sizes to estimate return distributions.
B)Weight sample size observations so that the more recent observations contribute a larger amount to the model.
C)Decrease the number of assets in the trading portfolio so that past returns will provide more accuracy to the model.
D)Increase the number of assets in the trading portfolio in order to benefit from higher levels of diversification.
E)The weaknesses in the model cannot be overcome.

Question 63

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 64

The DEAR of a bank's trading portfolio has been estimated at $5,000. It is assumed that the daily earnings are independently and normally distributed.
What is the 20-day VAR?

A)$5,000.
B)$10,000.
C)$15,811.
D)$22,361.
E)$50,000.

Question 65

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 66

To measure market risk at the 1 percent level of risk, what is the the scaling factor for the value at risk (VAR) and the expected shortfall (ES) respectively?

A)2.33 and 2.665
B)1.65 and 2.063
C)1.65 and 2.665
D)2.33 and 2.063
E)none of the above is the correct scaling factor.

Question 67

The DEAR of a bank's trading portfolio has been estimated at $5,000. It is assumed that the daily earnings are independently and normally distributed.
What is the 10-day VAR?

A)$5,000.
B)$10,000.
C)$15,811.
D)$22,361.
E)$50,000.

Question 68

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 69

The mean change in the value of a portfolio of trading assets has been estimated to be 0 with a standard deviation of 20 percent. Yield changes are assumed to be normally distributed.
What is the maximum yield change expected if a 90 percent confidence (one-tailed) limit is used?

A)3.30%.
B)20.0%.
C)33.0%.
D)39.2%.
E)46.6%.

Question 70

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 71

The use of expected shortfall (ES) to measure market risk of a portfolio assumes which of the following?

A)There is a very small sample size (<30 observations) used to estimate probability distributions.
B)That the probability distribution is skewed to the left.
C)That changes in asset prices are normally distributed but with fat tails.
D)That the probability distribution is skewed to the right.
E)That changes in asset prices follow a standard normal probability distribution.

Question 72

The mean change in the value of a portfolio of trading assets has been estimated to be 0 with a standard deviation of 20 percent. Yield changes are assumed to be normally distributed.
What is the maximum yield change expected if a 95 percent confidence (one-tailed) limit is used?

A)3.30%.
B)20.0%.
C)33.0%.
D)39.2%.
E)46.6%.

Question 73

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.

Question 74

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 75

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 above.

Question 76

The use of expected shortfall (ES) is most appropriate when

A)there is a small sample size used to estimate probability distributions.
B)the VAR indicates there is no possibility of losses so another method must be used to determine market risk.
C)the probability distribution is skewed to the right.
D)a continuous probability distribution cannot be constructed.
E)The probability distribution indicates there is a possibility of a "fat tail" loss.

Question 77

The mean change in the value of a portfolio of trading assets has been estimated to be 0 with a standard deviation of 20 percent. Yield changes are assumed to be normally distributed.
What is the maximum yield change expected if a 98 percent confidence (one-tailed) limit is used?

A)3.30%.
B)20.0%.
C)33.0%.
D)39.2%.
E)46.6%.

Question 78

City bank has six-year zero coupon bonds with a total face value of $20 million. The current market yield on the bonds is 10 percent.
What is the modified duration of these bonds?

A)5.45 years.
B)6.00 years.
C)6.60 years.
D)10.0 years.
E)10.9 years.

Question 79

Which approach to measuring market risk, in effect, amounts to simulating or creating artificial trading days and FX rate changes?

A)Back simulation approach.
B)Variance/covariance approach.
C)Monte Carlo simulation approach.
D)RiskMetrics Model.
E)All of the above.

Question 80

A disadvantage of the historic or back simulation model for quantifying market risk includes

A)calculation of a standard deviation of returns is not required.
B)calculation of the correlation between asset returns is not required.
C)estimates of past returns used in the model may not be relevant to the current market returns.
D)it accounts for non-standard return distributions.
E)None of the above.