mouse123

Paula Flox, global risk manager for Green Asset Management, wants to implement a stress testing program. She asks Richard Volk, a junior analyst, to prepare a report on stress testing. When she receives the completed report, Flox is extremely unhappy because it includes only one true conclusion. Which of Volk’s conclusions regarding stress testing is CORRECT? Stress analysis:

A) is weak when it comes to highlighting effects of inappropriate assumptions.

B) can incorporate delta risks, but fails to account for gamma risks.

C) is not useful for determining the probability of an expected loss.

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Stress analysis is useful for determining the magnitude, but not necessarily the probability, of an expected loss. This is why stress testing is such a good compliment for VAR, which determines the probability for a loss, but not the magnitude. Both remaining statements are incorrect—stress testing incorporates both delta and gamma risks, it is a good way to highlight inappropriate assumptions, and it can be used with any VAR estimate.

mouse123

Which of the following is NOT a use of stress testing?

A) It enables the risk manager to eliminate all risk from a portfolio.

B) Stress testing complements value at risk (VAR).

C) It can be used for capital allocation across business units.

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Stress testing cannot be used to eliminate all risk from a position. It only highlights the extent of losses in different states and enables contingency planning, which is one of its benefits.

mouse123

Which of the following is NOT a disadvantage of using stress testing? Stress testing:

A) reflects only normal circumstances.

B) reflects the analyst’s intentional and unintentional misspecification of the model.

C) fails to include the simultaneous adverse movements of risk factors.

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The primary purpose of stress testing is to model the effect of non-normal events that may not be reflected in the typical VAR calculation. Thus it is unlikely that stress testing would only reflect normal events. Stress testing is susceptible, however, to the analyst’s intentional and unintentional misspecification of the model, the failure to examine the by-products of major factor movements (how does a change in one factor affect the value of another), and the failure to include the simultaneous adverse movements of risk factors.

mouse123

Which of the following describes the form of stress testing referred to as factor push analysis?

A) The impact on the portfolio is measured by examining an input at an extreme level.

B) All factors are examined at levels that inflict the most damage on the portfolio.

C) The effect on the portfolio from simultaneous changes in several factors is examined.

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In factor push analysis, a factor or factors are pushed to an extreme to examine the impact on the portfolio. In scenario analysis, the effect on the portfolio from simultaneous changes in several factors is examined, which provides several different scenarios. In maximum loss optimization, the risk factors that have the greatest potential impact on the portfolio are identified. Once the factors are identified, procedures are put in place to limit their impact. In worst-case scenario analysis, all factors are pushed to their most damaging impact on the portfolio. Factor push analysis, maximum loss optimization, and worst-case scenario analysis are all forms of stressing models.

mouse123

John Nicholson is in charge of the risk management committee for Beta Portfolio Managers. Beta has a variety of bonds in their portfolio of differing durations, call features, and coupons. He is worried about the impact on the firm’s bond portfolio from simultaneous changes in interest rates, the shape of the yield curve, and interest rate volatilities. Which of the following forms of stress testing is he most likely to utilize?

A) Factor push analysis.

B) Stylized scenarios.

C) Worst-case scenario analysis.

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In stylized scenarios, one or more risk factors are changed to measure their impact on the portfolio. Some forms of stylized scenarios are similar to industry standards. The risk factors mentioned in the question are from those specified by the Derivatives Policy Group. In factor push analysis, a factor or factors are pushed to an extreme to examine the impact on the portfolio. In worst-case scenario analysis, all factors are pushed to their most damaging impact on the portfolio.

mouse123

Which of the following statements best describes the uses of stress analysis?

A) Scenario analysis, which is a special case of stress analysis, suffers from limitations on implementing a consistent and manageable approach.

B) Stress analysis has several advantages over a value at risk (VAR) only approach that includes: highlighting inappropriate assumptions, hidden vulnerabilities, and the ability to be able to forecast probability of rare but damaging events.

C) Stress analysis can be used to enhance VAR analysis by focusing on the extent of loss in an extreme event.

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This is the only valid use of stress analysis among the statements listed. Both remaining statements either do not pertain to uses, even if true in some other context, or are not true.

mouse123

Sheila Myers, CFA, has recently been promoted from analyst to Senior Vice President of Risk Management at Treetop Investment Inc. Myers recently attained her CFA charter. While studying for the exams, she became very interested in risk measurement and management. Previously, the focus of her career was on fundamental equity analysis.
Myers recently attended a conference on risk measurement techniques including the concept of value at risk (VAR). She learned that many managers and finance professionals are using VAR as a measure of asset, project, and portfolio risk. Rick Bishop, the key presenter at the conference on topics related to VAR, defined VAR as “the minimum amount of money that a firm could expect to lose with a given probability over a specific period of time.” One participant asked “I thought VAR was the maximum loss the firm could expect. Am I incorrect in this assumption?” Bishop replied that in its most basic form, VAR is defined as the largest potential portfolio loss over a given period of time with a certain level of probability. He went on to explain that a portfolio manager might compute the value at risk for his portfolio over the next 3 months at $5 million with 1 percent probability. What this means is that over the next 3 months, there is a 1 percent probability that the portfolio will lose $5 million or more. Alternatively, it can be said that over the next three months there is a 99 percent chance that the most the portfolio will lose is $5 million.
Sarah George asked Bishop “Is VAR comparable across various asset classes managed by the firm?” A second participant, Ben Cooper, says that he has heard that VAR is “relatively incomparable across managers”.
Myers attended a session on the use of VAR to evaluate credit risk. The session leader, Justin Banks, said that while it is possible to use VAR in credit risk analysis, the interpretation is somewhat different. He said, “Credit risk increases as the value of positions held increases.” Myers then replied “I see what you’re implying. We must thus focus on the lower tail of the distributions of gains on positions held when using VAR to evaluate credit risk.”
Blake Smith held a panel session on stress testing. He indicated that the best use of stress testing in VAR analysis is to “vary the inputs to the VAR estimation process a little bit and analyze the impact of this movement on the computed VAR.” Georgia Burns said that it is “stress testing the return generating process used to develop the scenarios or paths in Monte Carlo analysis”.
An entire session was devoted to estimating VAR. There are several methods that may be used including the historical method, the Monte Carlo simulation method, and the variance-covariance method. Session panel members were asked to discuss the advantages and disadvantages of each method of estimation. Jane Blatt said “the key disadvantage of the historical method is that we have to assume normally distributed returns.” Jim McAdams said “a key advantage of the Monte Carlo simulation method is that it can accommodate the required assumptions for complex relationships.” Finally, Beth Berry said “the key disadvantage of the variance-covariance method is that it assumes that past performance is representative of what can occur in the future.”
After the seminar, Myers was intrigued by the power of VAR but was apprehensive about actually adopting VAR as a risk measurement tool. She asked Bishop to identify the most fundamental problem with estimating VAR.Bishop, in response to George’s question regarding comparability across asset classes, is most likely to respond that VAR:

A) does not measure risk comparably across asset classes.

B) measures risk comparably across asset classes that have normal distributions (i.e., there are no embedded options).

C) measures risk comparably across asset classes.

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VAR measures risk comparably across asset classes. The result is that with VAR, the risk of a bond portfolio can be compared against the risk of an equity portfolio. It is quite versatile in a portfolio management context. This is one of VAR’s key strengths. (Study Session 14, LOS 34.g)

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In response to Cooper’s statement regarding VAR’s incomparability across managers, Myers is most likely to:

A) agree and add that it is because of the complexity of the calculations involved.

B) disagree and add that the characteristics of a competitor's portfolio can be estimated through VAR modeling techniques.

C) agree and add that this is due to its inherent model risk.

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VAR is relatively incomparable across managers due to its inherent model risk. For example, two people can be given an assignment to compute the VAR for the same underlying asset and the results will likely be different due to the use of different methodologies and model assumptions. Neither answer is necessarily wrong. The bottom line here is that peer group evaluation using VAR is not very useful unless one can be sure that the same VAR techniques and assumptions are used to evaluate all portfolios. (Study Session 14, LOS 34.g)

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With respect to the use of stress testing in VAR analysis, Burns and Smith are, respectively:

A) incorrect; incorrect.

B) incorrect; correct.

C) correct; incorrect.

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Burns is incorrect and Smith is incorrect. A particular VAR estimate is based on a given model and its parameters. In stress testing (or scenario analysis), the analyst varies the inputs to the VAR estimation process sometimes to the extreme and analyzes the impact of this movement on the computed VAR. Stress testing is "what if" analysis, and its main contribution is that it shows how reliable a particular VAR estimate is. (Study Session 14, LOS 34.h)

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In response to Myers’ question about the most fundamental problem associated with estimating VAR, Bishop is most likely to reply that the main problem is:

A) the lack of available data to compute VAR.

B) the inability to accurately derive the "true" probability distribution for the asset or portfolio under evaluation.

C) that VAR calculations depend on symmetrical payout profiles.

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The fundamental problem with VAR analysis is that the analyst must estimate the "true" probability distribution for the asset or portfolio under evaluation. This means that in order to give the analyst reliable results, the quantitative model must accurately describe the price process of the asset. (Study Session 14, LOS 34.g)

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Regarding credit risk and VAR, Banks and Myers are, respectively:

A) incorrect; correct.

B) correct; correct.

C) correct; incorrect.

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Banks is correct but Myers’ conclusion is incorrect. Since credit risk increases when the value of the position held increases, we should focus on the upper not lower tail of the distributions of gains on positions held. (Study Session 14, LOS 34.g)

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McAdams, Blatt and Berry are, respectively:

A) correct; correct; incorrect.

B) correct; incorrect; incorrect.

C) incorrect; correct; incorrect.

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A key advantage of Monte Carlo simulation is the ability to deal with the assumptions required to handle complex relationships. McAdams’ statement is correct. The key advantage of the historical method is that you do not have to assume a particular distribution. Therefore, Blatt is incorrect. A major disadvantage of the historical method is that we have to assume that past performance is representative of future performance; it is not a disadvantage of the variance-covariance method. Therefore, Berry is also incorrect. (Study Session 14, LOS 34.f)

mouse123

The accuracy of a value at risk (VAR) measure:

A) is included in the statistic.

B) is one minus the probability level.

C) can only be ascertained after the fact.

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This is a weakness of VAR. The reliability can only be known after some time has passed to see if the number and size of the losses is congruent with the VAR measure.

mouse123

An investor hires a portfolio manager and stipulates a maximum value at risk for the portfolio. This is an example of the use of the value at risk framework to:

A) measure performance.

B) build portfolios.

C) set risk limits.

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The investor has used the value at risk framework to set risk limits for the portfolio.

mouse123

Which of the following statements describes the most unique and practical application of value at risk (VAR) for comparing risky assets? VAR can be used to compare risk:

A) across bond market sectors.

B) across asset classes such as bonds and stocks.

C) between different style equity portfolios.

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VAR measures risk comparably across asset classes. Thus, the risk of a bond portfolio can be compared to that of an equity portfolio. This type of comparison is not very meaningful using other risk measures.