Chapter 09 Testbank Key

 1. 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
 
2. 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.
 
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.

4. 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.
 
5. 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).
 
6. 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.
 
7. 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.
 
8. 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 0.00165 = 0.40%
B.  –2.45 0.00165 = –0.40%
C. 2.45 0.0165 = 4.04%
D.  –2.45 0.0165 = –4.04%

9. Assume that the dollar market value of a position is $100 000 and the price volatility is 1.50%. 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.

10. 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.  There is not enough information to solve the question.
 
11. 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
 
12. 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.
 
13. 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 10 = $15 811.39
B.  $5000 (10 – 1) = $15 000.00
C. $5000 10 = $707.11
D. $5000 (10 – 1) = $636.40

 14. Assume the dollar market value of an FI's position is $200 000 and the calculated price volatility is 1.25%. 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.  $6123.72
C.  $200 000.00
D.  $489 897.95
 
15. Assume the dollar market value of an FI's position is $200 000 with a modified duration of four 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.  $1320.00
B.  $3233.33
C.  $330.00
D.  $200 000.00
 16. 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.
 
17. 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%. How much does the FI stand to lose in earnings if adverse stock market returns materialise tomorrow?
A.  $2 000 000 0.03 = $60 000
B.  $2 000 000 1.0 0.03 = $60 000
C.  $2 000 000 1.65 0.03 = $99 000
D.  $2 000 000 2.33 0.03 = $139 800
 
18. 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 1.053 = $210 600.00
B.  EUR 200 000 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

19. Which of the following statements is true?

A. Technically, 90% of the area under a normal distribution lies between +/– 1.65 from the mean.
B.Technically, 90% of the area under a normal distribution lies between +/– 2.33 from the mean.
C. Technically, 99% of the area under a normal distribution lies between +/– 1.65 from the mean.
D. Technically, 99% of the area under a normal distribution lies between +/– 2.33 from the mean.

20. 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.
 
21. 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.

22. 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.
 
23. 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 0.45 = $90.00
C.  ($200 / 0.45) / 100 = $4.44
D.  ($200 0.45) / 100 = $0.90

24. Which of the following statements is true?

A.  In a well-diversified portfolio, unsystematic risk can be largely diversified away, leaving behind systematic risk.
B.  In a well-diversified portfolio, systematic risk can be largely diversified away, leaving behind unsystematic risk.
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 risk always exist.
 
25. Which of the following is a measure of systematic risk?
A.  alpha
B.  beta
C.  gamma
D.  sigma

26. 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.

 
27. 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.
 
28. 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.
 
29. 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.
 
30. Assume an FI holds three different positions. The following DEAR information is available for the positions. Position 1 is 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

31. 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.
 
32. 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.
 
33. ... tells us the average of the losses in the tail of the distribution beyond the 99th percentile.
A. Expected shortfall (also referred to as expected tail loss)
B. RiskMetrics method
C. Regular VaR
D. Covariance model
 
34. Which of the following statements is true?
A.  VaR corresponds to a specific point of loss on the probability distribution. It does not provide information about the
potential size of the loss that exceeds it.
B.  VaR completely ignores the patterns and the severity of the losses in the extreme tail.
C.  VaR gives only partial information about the extent of possible losses, particularly when probability distributions are non-
normal.
D.  All of the listed options are correct.
35. Which of the following statements is true?

A.  VaR corresponds to an average point of loss on the probability distribution.

B.  VaR completely takes into account the patterns and the severity of the losses in the extreme tail.
C.  VaR gives full information about the extent of possible losses, particularly when probability distributions are non-normal.
D.  None of the listed options are correct.
 
36. 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.
 
37. 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%
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%
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%
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%
charge against the net position in the share.
 
38. 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'.
 
39. 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.
 
40. 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.
 

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

RiskMetrics model (or the variance/covariance approach) developed by JPMorgan Chase, concentrates on measuring the market risk
exposure of an FI on a daily basis. That is, how much the FI will potentially lose if market conditions move adversely tomorrow. More
specifically, the RiskMetrics model calculates the daily earnings at risk (DEAR) in three trading areas—fixed income, foreign exchange
(FX) and equities—and then it estimates the aggregate risk of the entire trading portfolio. Measuring the risk exposure for periods longer
than a day (Value at risk—VAR) is, under certain assumptions, simply the transformation of the daily risk exposure number.
Most FIs establish limits for value at risk, daily earnings at risk, position limits and dollar trading loss limits for their trading portfolios.
Actual activity compared with these limits is then monitored daily. Should a risk exposure level exceed approved limit levels, management
must provide a strategy for bringing risk levels within approved limits.
A major criticism of RiskMetrics is the need to assume a symmetric (normal) distribution for all asset returns. Clearly, for some assets,
such as options and short-term securities (bonds), this is highly questionable. For example, the most an investor can lose if he or she
buys a call option on an equity is the call premium; however, the investor’s potential upside returns are unlimited. In a statistical sense, the
returns on call options are non-normal since they exhibit a positive skew. Another disadvantage is that the model assumes that the
correlations of asset returns be observed and calculated.
One way of addressing these disadvantages is to use the historic or back simulation approach which does not require that asset returns
be normally distributed and does not require that the correlations or standard deviations of asset returns be calculated. Implementation
requires the calculation of the value of the current portfolio of assets based on the prices or yields that were in place on each of the
preceding 500 days (or some large sample of days). These data are rank-ordered from worst to best case and percentile limits are
determined. For example, the 5% worst-case scenario provides an estimate with 95% confidence that the value of the portfolio will not fall
more than this amount.

59. Describe the process of the partial risk factor approach. 

The partial risk factor approach applies risk weights to the market values of trading portfolio securities, with enhancements to prudently
reflect hedging of and diversification across securities. Particularly, the partial risk factor approach requires the following process be
followed by FIs to determine capital requirements:

1.             Assign instruments to asset 'buckets'. Instruments are placed in one of 20 asset buckets across each of five risk classes
according to their risk similarity. The five risk classes include FX, interest rates, equities, credit (including securitizations), and
commodities.

2.             Calculate each bucket's risk measure. A risk measure is calculated for each bucket using a regulator-specified formula based on
ES estimates. The market values of the assets in each bucket are then multiplied by the risk weight.

3.             Aggregate the buckets. The risk measures of the individual asset buckets are aggregated to obtain the capital requirement for
the trading portfolio.

60. Describe the process of the fuller risk factor approach. 

 The fuller risk factor approach requires the following process be followed by FIs to determine capital requirements:

1.             Assign each instrument to applicable risk factors. Using a BIS-provided description of the mapping of securities to each risk
factor, FIs determine which risk factors influence the value of their trading portfolio securities.

2.             Determine the size of the net risk position in each risk factor. Once the FI determines the risk factors that apply to each of its
trading portfolio securities, it uses a pricing model to determine the size of the risk positions from each security with respect to the
applicable risk factors. The size of the risk positions is based on the sensitivity of the instruments to the prescribed risk factors. The FI
then aggregates all negative and positive gross risk positions to determine the net risk position. For non-hedgeable risk factors, the gross
risk position would equal the net risk position.

3.             Aggregate overall risk position across risk factors. To compute the overall capital requirement for each risk factor class, the net
risk positions determined in step 2 are aggregated. One option offered by the BIS is to assume that all risk factors of the same risk factor
class are independently distributed. Thus, the overall portfolio standard deviation is calculated using a sum of squares multiplied by a
scalar that approximates the average across the loss tail of the portfolio distribution (i.e. the ES). The ES scalar factor implemented by
regulators in Basel III is four. Thus, the overall capital requirement is four times the overall portfolio standard deviation.

 
61. 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 
 a. Specific risk charge: a charge reflecting the risk of the decline in the liquidity or credit risk quality of the trading portfolio over the FI's
holding period.
b. General market risk charge: a charge reflecting the modified duration and interest rate shocks for each maturity.
c. Vertical offsets: 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.
d. Horizontal offsets: the assignment of additional capital charges because long and short positions of different maturities do not
perfectly hedge each other.