LOS j: Demonstrate the use of risk budgeting, position limits, and other methods for managing market risk.

Q1. Using the following information from a firm that uses enterprise risk management, which portfolio manager has superior performance and why?

A)   Manager B because their return is higher in a risk budgeting context.

B)   Manager A because they had a higher return on capital.

C)   Manager A because they used less VAR.

Q2. Which of the following is the most widely accepted definition of market risk?

A)   Duration.

B)   The potential loss from investing in stocks and bonds.

C)   The potential change of value in an asset or derivative in response to a change in some basic source of uncertainty.

Q3. Which of the following is a type of market risk?

A)   Operations risk.

B)   Accounting risk.

C)   Interest rate risk.

Q4. For a firm that uses enterprise risk management, what type of limit should be used to ensure firm diversification?

A)   Risk factor limit.

B)   Position limit.

C)   Liquidity limit.

Q5. For a firm that uses enterprise risk management, how should a deviation from a risk budget be dealt with?

A)   The deviation should be reported immediately to upper management.

B)   Each portfolio manager should have the discretion to determine the correct response.

C)   The manager should take steps to hedge the position that caused the violation of the risk budget.

Q6. Which of the following is a source of market risk?

A)   Equity prices.

B)   Taxes.

C)   Operations.

LOS j: Demonstrate the use of risk budgeting, position limits, and other methods for managing market risk. fficeffice" />

Q1. Using the following information from a firm that uses enterprise risk management, which portfolio manager has superior performance and why?

	Manager A	Manager B
Capital	$150,000,000	$590,000,000
VAR	$7,500,000	$21,000,000
Profit	$2,000,000	$7,000,000

A)   Manager B because their return is higher in a risk budgeting context.

B)   Manager A because they had a higher return on capital.

C)   Manager A because they used less VAR.

Correct answer is A)

Using risk budgeting in enterprise risk management, we would divide the profit by the VAR allowed to generate a risk-adjusted performance measure. For manager A it is 26.7% (2,000,000 / 7,500,000). For Manager B it is 33.3% (7,000,000 / 21,000,000). Thus Manager B has better risk-adjusted performance. Note that the return on capital for each manager tells a different story. For manager A it is 1.3% (2,000,000 / 150,000,000) and it is 1.2% (7,000,000 / 590,000,000) for Manager B. So although the percentage return generated is higher for Manager A, we would conclude that Manager B has better performance when risk is considered.

Q2. Which of the following is the most widely accepted definition of market risk?

A)   Duration.

B)   The potential loss from investing in stocks and bonds.

C)   The potential change of value in an asset or derivative in response to a change in some basic source of uncertainty.

Correct answer is C)

Risk is generally equated with uncertainty, which includes both positive and negative changes in value.

Q3. Which of the following is a type of market risk?

A)   Operations risk.

B)   Accounting risk.

C)   Interest rate risk.

Correct answer is C)

There are three types of market risk: interest rates, exchange rates, and equity prices.

Q4. For a firm that uses enterprise risk management, what type of limit should be used to ensure firm diversification?

A)   Risk factor limit.

B)   Position limit.

C)   Liquidity limit.

Correct answer is B)

A position limit places a dollar nominal cap on a given position. By placing a maximum dollar amount on each position, the firm will diversify its capital across a greater number of sectors. A liquidity limit is a position limit that is based on trading volume so that liquidity risk is minimized. Risk factor limits restrict the exposure of the portfolio to individual risk factors.

Q5. For a firm that uses enterprise risk management, how should a deviation from a risk budget be dealt with?

A)   The deviation should be reported immediately to upper management.

B)   Each portfolio manager should have the discretion to determine the correct response.

C)   The manager should take steps to hedge the position that caused the violation of the risk budget.

Correct answer is A)

Using risk budgeting in enterprise risk management, a firm will allocate capital and the associated VAR to each manager depending upon management’s desired exposure to each sector. An effective enterprise risk management system should monitor violations of a risk budget so that any violations are immediately reported to upper management.

Q6. Which of the following is a source of market risk?

A)   Equity prices.

B)   Taxes.

C)   Operations.

Correct answer is A)

There are three types of market risk: interest rates, exchange rates, and equity prices.