mouse123

Which of the following risk measures does NOT assume a normal distribution of returns?

A) Standard Deviation.

B) RoMAD.

C) Sortino ratio.

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The RoMAD (return over maximum drawdown) is the average portfolio return divided by the maximum drawdown. Drawdown refers to the percentage difference between the highest and lowest portfolio values during a period. For example, if the maximum portfolio value during a year was $1000 and the minimum was $900, the drawdown would be 10% [($1000 − $900) / $1000]. This measure does not make an assumption of normality in the returns. The Sharpe ratio (which uses the standard deviation in the denominator) assumes a normal distribution of returns. The Sortino ratio examines the downside risk of returns and also assumes a normal distribution of returns.

mouse123

In the Sortino ratio, the excess return is divided by the:

A) standard deviation using only the returns below a minimum level

B) maximum drawdown.

C) standard deviation.

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The Sortino ratio examines the downside risk of returns. It is calculated as the portfolio return minus the minimum acceptable return (MAR) divided by a standard deviation that only uses returns below the MAR. It is similar to the target semivariance. Both remaining responses refer to other measures of risk-adjusted performance. The Sharpe ratio divides the excess return above the risk-free rate by the standard deviation. An example of a risk-adjusted return on invested capital (RAROC) measure would be to divide the portfolio’s expected return by the VAR. The RoMAD (return over maximum drawdown) is the average portfolio return divided by the maximum drawdown. Drawdown refers to the percentage difference between the highest and lowest portfolio values during a period.

mouse123

Which of the following most accurately describes the relationship between computing internal capital requirements using a stress testing approach versus a value at risk (VAR) capital strength approach? Stress testing approaches:

A) are substitutes for VAR approaches since they better measure the entire spectrum of potential outcomes.

B) complement VAR approaches since they account for scenarios that may not be properly considered in VAR approaches.

C) can never be combined with VAR approaches because they are based on different probability distributions.

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Since VAR often relies on common probability distributions, it may not properly capture extreme, but possible, events. Stress testing involves evaluating the effects that these events would have on the institution and then establishing capital requirement based on the findings. The two approaches are natural complements.

mouse123

Stress testing approaches are not constrained by many of the constraints associated with the traditional distribution based value at risk (VAR) approaches. Which of the following is an example of a constraint associated with the traditional VAR approach but NOT the stress testing approach? The traditional VAR approach:

A) places too small a probability on extreme events.

B) places too high a probability on extreme events.

C) ignores extreme events.

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Common probability distributions (i.e., normal distributions) tend to place extreme low probabilities on extreme events.

mouse123

Which of the following describes the best way to resolve the differences between the stress testing approach to computing capital requirements and the value at risk (VAR) approach?

A) Ignore the VAR approach since it ignores extreme events.

B) Use both approaches and then use the larger of the two capital requirements.

C) Integrate the two approaches by using an optimization algorithm.

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Where the stress testing approach is weak, the VAR approach is strong and vice versa. A possible way to combine the two approaches would be to compute the capital requirements using each method and then use the larger of the two values. This ensures that the capital requirement meets the needs of both approaches.