Kingpin804

Which of the common methods of computing value at risk relies on the assumption of normality?

A) Variance/covariance.

B) Monte Carlo simulation.

C) Historical.

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The variance/covariance method relies on the assumption of normality.

Kingpin804

Which of the methods for calculating Value At Risk (VAR) do asset managers most commonly use?

A) Variance/covariance.

B) Historical.

C) Monte Carlo simulation.

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The variance/covariance (or parametric) method is most commonly used by asset managers.

Kingpin804

Which value at risk methodology is most subject to model risk?

A) Monte Carlo simulation.

B) Parametric.

C) Variance/covariance.

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Monte Carlo simulation is subject to model risk.

Kingpin804

All of the following are advantages in Monte Carlo simulation approach to VAR estimation EXCEPT:

A) no model risk.

B) no assumption needed regarding linearity.

C) no assumption needed regarding normality.

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The historical method of VAR relies on past patterns continuing into the future thus you are extrapolating in a linear fashion into the future. The analytical method assumes a normal distribution. The Monte Carlo method relies on neither assumption and any distribution or correlation between assets can be used. This leads to modeling risk in the Monte Carlo simulation because if your inputs are inaccurate your output will also be inaccurate.

Kingpin804

A disadvantage of the Monte Carlo method for calculating value at risk is that:

A) it requires the normality assumption.

B) all of these choices are correct.

C) it is computationally intensive.

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For the Monte Carlo method, the advantages are that it does not require the normality assumption, and it is flexible insofar as it can accommodate a variety of assumptions regarding complex relationships. The main disadvantage is that it is often computationally intensive.

Kingpin804

Assuming that adequate daily data is available, a criticism of the Monte Carlo value at risk (VAR) methodology, but not the other VAR methodologies is that it:

A) requires a normal distribution of returns.

B) is relatively inflexible.

C) is exposed to model risk.

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The Monte Carlo VAR methodology uses a returns generation model to develop a set of returns scenarios or paths. If the model is incorrect, the validity of the VAR estimates is questionable. The historical VAR methodology will suffer model risk only if insufficient daily data is available, and a model is employed to derive estimates.

Kingpin804

Gregory Chambers is interested in estimating the daily VAR (with 99% probability) of bank's fixed income portfolio, currently valued at $30 million. The portfolio has the following returns over the past 200 days (ranked from high to low).

1.9%, 1.87%, 1.85%, 1.79%......-1.78%, -1.81%, -1.84%, -1.87%, -1.91%

What will be the VAR estimate using the historical method?

A) $570,000.

B) $978,000.

C) $561,000.

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VAR = (-0.0187)(30,000,000) = -$561,000 therefore the 1% daily value at risk is $561,000.

Kingpin804

John Dumas is in charge of $100 million of equity portfolio.  He expects a return of 10% with a standard deviation of 8%.  What will be the minimum value of portfolio at 95% probability.  Z scores from standard normal distribution are:

• 10% = 1.28
• 5% = 1.65
• 2.5% = 1.96
• 1% = 2.33

A) 92.8 million.

B) 96.80 million.

C) 98.4 million.

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Maximum possible loss at 95% probability = 10 − 1.65 × 8 = −3.2 million.
Minimum value of portfolio at 95% probability = 100 − 3.2 = 96.80 million.

Kingpin804

Robert Meznar is currently employed as a senior software architect in a large established software company. He is 38 years old, and his current salary is $80,000 after tax. Meznar recently sold his stock (acquired through stock options) in an Internet start up company. The entire proceeds of $2 million is held in treasury securities.
John Snow, CFA, of Capital Associates has been forwarded the file of Meznar to suggest an appropriate portfolio. Snow relies heavily on the following forecasts, furnished by the firm, for long term returns for different asset classes. He has already developed three possible portfolios for Meznar.

Asset Class	Return	Standard Deviation	X	Y	Z
U.S. Stock	12.0%	16%	40%	30%	25%
Non U.S. Stocks	14.0	24%	0	15	25%
U.S. Corporate bonds	7.0	10%	60	15	0
Municipal Bonds	5.0	8%	0	20	25
REIT	14	14%	0	20	25

What may be the lowest value of portfolio Z within the next one year according to value at risk, at 95% probability given the standard deviation of portfolio Z is 22%?

A) $1,900,000.

B) $1,760,000.

C) $1,499,000.

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VAR = Vp[Expected return-(z)(standard deviation)]
Expected return = (0.25)(12) + (0.25)(14) + (0.25)(5) + (0.25)(14) = 11.25%
VAR = 2,000,000[0.1125 − (1.65)(0.22)] = −501,000
2,000,000 − 501,000 = 1,499,000

Kingpin804

Which of the following statements exhibits a weakness of historical value at risk (VAR)?

A) The manager of the Matrix Small Cap Index Fund calculates a historical daily VAR at the 95% confidence level of $4,080 using Russell 2000 Index returns from 1987-2001. The manager of the Smith Small Cap Index Fund, which is the same size as the Matrix Small Cap Index Fund, calculates a historical daily VAR at the 95% confidence level of $4,210 using Russell 2000 Index returns from 1990-2001.

B) The manager of the Quality Value Fund has a normal distribution of returns and calculates a historical daily VAR of $300. The manager of the Pinnacle Fund has a negatively skewed return distribution and calculates a daily VAR of $360.

C) In order to account for instability in the standard deviation of fund returns, the manager of the Spencer Fund uses a decay factor in her VAR calculation.

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The manager of the Matrix Small Cap Fund uses index data from 1987-2001, while the manager of the Smith Small Cap Index Fund uses index data from 1990-2001, and each comes up with a different VAR calculation. This discrepancy illustrates that historical VAR is sample driven in that different samples of the same data, in this case Russell 2000 Index returns, may lead to different VAR’s. Both remaining answer choices describe situations where VAR may differ, but none are the result of a weakness in historical VAR.