HKUST

ISOM4520 Statistics for Financial Risk Management

SAMPLE Midterm examination

Mar 21, 2023

Answer ALL 5 questions

Time allowed: 60 minutes

Guidelines

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Declaration of Academic Integrity

I confirm that I have answered the questions using only materials specifically approved for
use in this examination, that all the answers are my own work, and that I have not received
any assistance during the examination.

Signature: _______________________

Question No. Marks

1 /20
Student Name: ___________________ 2 /22
3 /10
Student Number: ___________________ 4 /28
5 /20
Total /100

Page 1 of 10
1. [20 marks; 4 marks each]
Read each statement below carefully. Circle The Best Answer T (True) Or F (False)

(a) The innovations in GARCH(1,1) are assumed to be autocorrelated. T / F

The innovations should be iid.

(b) Given the same return random variable 𝑅 and the tail probability 𝑝, the T / F
expected shortfall is always smaller than the value at risk.

The expected shortfall is always LARGER than the value at risk. Note
that both of them are positive.

(c) The following Q-Q plot corresponds to a right-skewed data. T / F

(d) The covariance matrix estimated from the single index model is the same T / F
as the sample covariance matrix whose (i,j)-th element is

∑$#%&(𝑅!# − 𝜇̂ ! )(𝑅"# − 𝜇̂ " )

𝜌$!" =
,∑$#%&(𝑅!# − 𝜇̂ ! )' ∑$#%&(𝑅!# − 𝜇̂ ! )'

The SIM restricts the covariance structure with the inclusion of market
index. Thus, the covariance matrix under SIM and the sample covariance
matrix are not the same in general.

(e) The QLIKE loss function penalizes overestimation more heavily than T / F
underestimation.

The QLIKE loss function penalizes underestimation more heavily than

overestimation.

Page 2 of 10
(Q1 Scratch work)

Page 3 of 10
2. [Total: 22 marks] Consider the daily returns on the stocks AAPL, MSFT and TSLA from
Dec 01, 2022 to Mar 01, 2023 (𝑛 = 60 trading days). The daily returns on the NASDAQ
Composite are used as the market returns. Single index models are fitted on each of the
stocks and the outputs are given below.
Output 1: Regressing AAPL on NASDAQ

Output 2: Regressing MSFT on NASDAQ

Output 3: Regressing TSLA on NASDAQ

Output 4: Average daily return of the market index is -0.00181, and the variance of the
market return is 2.143.

(a) (3 marks) Any of these stocks significantly outperform the market during the
observed period? Justify your answer.

(b) Calculate the following summary statistics.

(i) (3 marks) Calculate the systematic variance for AAPL.
(ii) (3 marks) Calculate the covariance between MSFT and TSLA.
(iii) (3 marks) Calculate the firm-specific variance of AAPL.

(c) (10 marks) Consider the portfolio 𝐰 = (0.3,0.3,0.4)( for AAPL, MSFT and TSLA.
Calculate the mean portfolio return.

Page 4 of 10
(Q2 continued)

Answer to (a):

All p-values of the intercepts (i.e., alpha) are larger than 0.05, then, we cannot reject the
hypothesis 𝐻) : 𝛼 = 0 for each of the models. None of these stocks outperforms the market.

Answer to (b)(i):
'
𝛽**+, 𝜎-' = 1.019235' × 2.143 = 2.226

Answer to (b)(ii):

𝛽-./( 𝛽(.,* 𝜎-' = 1.10769 × 1.76151 × 2.143 = 4.1814

Answer to (b)(iii):
'
𝑠**+, = 0.916' = 0.839056

Answer to (c):

Under SIM, 𝑅0# = 𝛼0 + 𝛽0 𝑅-# , where

𝛼0 = 0.3(−0.002606) + 0.3(−0.03161) + 0.4(0.09487) = 0.02768

and

𝛽0 = 0.3(1.019235) + 0.3(1.10769) + 0.4(1.76151) = 1.34268

thus

𝐸E𝑅0# F = 𝛼0 + 𝛽0 𝐸(𝑅-# ) = 0.02768 + 1.34268(−0.00181) = 0.0252

Page 5 of 10
3. [Total: 10 marks] Consider the risk measure 𝜌(𝑋) = −𝐸(𝑋) + 𝑘𝑉𝑎𝑟(𝑋), where 𝑘 > 0.
Check if 𝜌(𝑋) is a coherent risk measure.

(Homogeneity)

𝜌(𝑏𝑋) = −𝐸(𝑏𝑋) + 𝑘𝑉𝑎𝑟(𝑏𝑋) = −𝑏𝐸(𝑋) + 𝑘𝑏 ' 𝑉𝑎𝑟(𝑋) ≠ 𝑏𝜌(𝑋).

Thus, 𝜌(𝑋) is not a coherent risk measure.

Page 6 of 10
4. [Total: 28 marks]
(a) (8 marks) Consider the nonlinear GARCH model for asset returns:

𝑅#1& = 𝜎#1& 𝑍#1& , where 𝑍#1& ’s are iid N(0,1),

'
𝜎#1& = 𝑤 + 𝛼(𝑅# − 𝜃𝜎# )' + 𝛽𝜎#' .

MLEs of the parameters and their standard errors are given below.

Parameter Estimate Standard error

𝜔 0.025 0.021
𝛼 0.033 0.017
𝛽 0.941 0.021
𝜃 0.179 0.486

Test, at 5% level, if the leverage effect is significant.

Answer to 4(a):

The hypothesis is 𝐻) : 𝜃 = 0 versus 𝐻) : 𝜃 > 0.

The test statistics is

𝜃R − 0 0.179
𝑧= = = 0.3683 < 1.645
𝑠. 𝑒. (𝜃R) 0.486

Thus, we fail to reject 𝐻) at 𝛼 = 0.05. The leverage effect is not significant.

Page 7 of 10
(Q4, continued)
(b) Alternatively, a GARCH(1,1) model is fitted to the asset returns:

𝑅#1& = 𝜎#1& 𝑍#1& , where 𝑍#1& ’s are iid N(0,1),

'
𝜎#1& = 𝑤 + 𝛼𝑅#' + 𝛽𝜎#' .
MLEs of the parameters and their standard errors are given below.

Parameter Estimate Standard error

𝜔 0.026 0.022
𝛼 0.032 0.016
𝛽 0.941 0.023

The covariance between the estimators of 𝛼 and 𝛽 is zero.

(i) (10 marks) Test the hypothesis 𝐻) : 𝛼 + 𝛽 = 1 versus 𝐻) : 𝛼 + 𝛽 < 1.
(ii) (6 marks) Test the hypothesis 𝐻) : 𝜔 = 0 versus 𝐻) : 𝜔 > 0.
(iii) (4 marks) Using the results in (b)(i) and (b)(ii), can we reject the hypothesis that
'
the true model is a RiskMetrics model 𝜎#1& = (1 − 𝜆)𝑅#' + 𝜆𝜎#' ?

Answer to (b)(i):
The test statistic is
E𝛼$ + 𝛽XF − 1 0.032 + 0.941 − 1 −0.027
𝑧= = = = −0.96 > −1.645
𝑠. 𝑒. E𝛼$ + 𝛽XF √0.016' + 0.023' − 0 0.028

We fail to reject 𝐻) at 𝛼 = 0.05.

'
Note: 𝑠. 𝑒. E𝛼$ + 𝛽XF = Z𝑠. 𝑒. (𝛼$)' + 𝑠. 𝑒. E𝛽XF + 2𝑠. 𝑒. (𝛼$)𝑠. 𝑒. E𝛽XF𝐶𝑜𝑟𝑟(𝛼$, 𝛽X )

Answer to (b)(ii):
The test statistic is
𝜔
]−0 0.026
𝑧= = = 1.18 < 1.645
𝑠. 𝑒. (𝜔
]) 0.022

We fail to reject 𝐻) at 𝛼 = 0.05.

Answer to (b)(iii):
From (i), we do not have evidence that 𝛼 + 𝛽 < 1. From (ii), we do not have evidence
that 𝜔 > 0. Thus, the cannot reject the hypothesis that the volatility model is a
RiskMetrics model, when 𝜔 = 0 and 𝛼 + 𝛽 = 1.

Note: Note that, if you conduct two independent tests at 5% level, then the probability of
committing a Type I error in at least one test is 1 − (1 − 0.05)' = 0.0975. The
Bonferroni correction states that the probability of committing a Type I error in at least
one test in 𝑚 tests can be controlled at 𝛼 if you reject each hypothesis at 𝛼/𝑚 levels. But
we did not teach this in our class, so you may choose freely to test (i) and (ii) at 𝛼 =
0.025 or 0.05.

Page 8 of 10
5. [Total: 20 marks] The following table gives the first ten of the ranked, ascendingly, the
historical returns of the portfolio in the past 250 days. Both historical simulation (HS) and
weighted historical simulation (WHS) with 𝜂 = 0.99 are used to estimate the 2% VaR of
the portfolio returns.

Weight under
Days ago Return WHS
10 -0.128 0.99%
12 -0.100 0.97%
15 -0.079 0.95%
8 -0.053 1.01%
13 -0.050 0.96%
22 -0.045 0.88%
6 -0.044 1.03%
17 -0.035 0.93%
1 -0.034 1.09%
25 -0.034 0.85%

(a) (10 marks) Estimate the 2% VaR of the portfolio return using HS method.
(b) (10 marks) Estimate the 2% VaR of the portfolio return using WHS.

[Note: You need to conduct interpolation to find the exact VaR for HS and WHS]

Answer:
We add three columns to the table:

Weight under Cumul. weight Weight under Cumul. Weight

Days ago Return
WHS under WHS HS under HS
10 -0.128 0.99% 0.99% 0.40% 0.40%
12 -0.1 0.97% 1.96% 0.40% 0.80%
15 -0.079 0.95% 2.91% 0.40% 1.20%
8 -0.053 1.01% 3.92% 0.40% 1.60%
13 -0.05 0.96% 4.88% 0.40% 2.00%

Page 9 of 10
(Q5 continued)

Solution to 5(a):

Using HS method, all observations have the same weight 1/250 = 0.004. From the blue part
in the table, we have

𝑉𝑎𝑅'.))% = 0.05

Solution to 5(b):

−𝑉𝑎𝑅&.45% = −0.1 and −𝑉𝑎𝑅'.4&% = −0.079 from the yellow part in the table. Then,

−0.079 − (−0.1)
𝑉𝑎𝑅'.))% = − d−0.1 + (2 − 1.96)e = 0.0991
2.91 − 1.96

Page 10 of 10