mouse123

Which of the following is a source of market risk?

A) Taxes.

B) Equity prices.

C) Operations.

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

mouse123

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.

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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.

mouse123

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

A) Risk factor limit.

B) Liquidity limit.

C) Position limit.

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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.

mouse123

Which of the following is a type of market risk?

A) Interest rate risk.

B) Operations risk.

C) Accounting risk.

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

mouse123

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.

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

mouse123

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 A because they had a higher return on capital.

B) Manager A because they used less VAR.

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

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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.

mouse123

Prior to expiration, the long position in a European option would have:

A) only potential credit risk.

B) zero credit risk.

C) more current credit risk than potential credit risk.

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Since the long position can only be owed money at expiration, then that is when there is current credit risk. Prior to that, there can only be potential credit risk.

mouse123

Which of the following will have the least amount of credit risk? A(n):

A) either position in a plain-vanilla currency swap.

B) short option position.

C) pay-fixed position in a plain-vanilla interest rate swap.

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The holder of a short option position has received all the income it can expect. Thus, it has no credit risk. Both remaining listed positions have some credit risk.

mouse123

The long position of a forward contract bears the credit risk if the market price of the underlying is:

A) less than the exercise price.

B) equal to the exercise price.

C) greater than the exercise price.

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This is true because the long position will be in-the-money, which means there is a possibility of not being paid what is owed.

mouse123

Which of the following is NOT a damaging consequence of not conducting proper stress analysis?

A) Inability to proactively alter assumptions about correlation structures.

B) Risk of exposure to potential big hits to a portfolio due to second order (gamma) effects of large market moves.

C) Exposure to risk of being taken over.

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Stress analysis makes the risk manager become aware of the consequences of market moves, liquidity crises, and other factors that affect the business of a firm. As a result, the manager can be prepared with proper hedges and advance contingency planning to combat adverse situations. The analysis also highlights the extent of the potential loss so that the manager can decide the extent of exposure to such risk. Risk of being taken over as a target is usually not a concern of this analysis.