Kingpin804

The method for calculating value at risk that uses the fewest assumed inputs is the:

A) Monte Carlo method.

B) delta-normal method.

C) historical method.

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The historical method uses past values and makes no explicit assumptions about inputs. It assumes that past patterns are indicative of future patterns.

Kingpin804

The method for calculating value at risk that is the simplest and rests heavily on means and variances is the:

A) historical method.

B) Monte Carlo method.

C) delta-normal method.

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The delta-normal method uses means and variances and makes calculations under the assumption that the distribution of returns is normal.

Kingpin804

Which of the following factors is the common weakness in historical and Monte Carlo Simulation approach to VAR estimation?

A) Both assume that historical variance-covariance matrix is stable.

B) A lot of data is needed for the time period of interest.

C) For some assets you may face model risk.

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The historical method uses actual returns for the position in question. An advantage of the historical method is not having to assume any particular distribution. A disadvantage is that it assumes past performance is representative of what can occur in the future, which may not be the case. The Monte Carlo simulation method for calculating VAR usually involves generating random numbers with a computer. The generated numbers represent possible returns of the asset or portfolio. An advantage is that Monte Carlo simulation does not require the normality assumption and can accommodate the required assumptions for complex relationships.  A disadvantage is the requirement for many managerial assumptions and a great deal of computer time and calculations. The historical method and Monte Carlo Simulation both suffer from modeling risk.

Kingpin804

All of the following are considered to be weaknesses of the variance/covariance value at risk (VAR) methodology EXCEPT:

A) the variance/covariance matrix may not be stable over time.

B) market data necessary to compute VAR is often not available.

C) the VAR computation becomes complex as portfolio complexity increases.

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One of the strengths of the variance/covariance VAR is that the required market data is readily available in most cases.

Kingpin804

All of the following are considered to be strengths of the historical value at risk (VAR) methodology EXCEPT:

A) no assumption regarding a normal returns distribution is required.

B) minimal data is needed.

C) no variance/covariance matrix is required.

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Historical VAR requires a lot of returns data, which may not be available for some asset classes.

Kingpin804

Value at risk (VAR) is a benchmark associated with a given probability. The actual loss:

A) may be much greater.

B) cannot exceed this amount.

C) is expected to be the average of the expected return of the portfolio and VAR.

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VAR is a benchmark that gives an estimate of what magnitude of loss would not be unusual. The actual loss for any given time period can be much greater.

Kingpin804

The minimum amount of money that one could expect to lose with a given probability over a specific period of time is the definition of:

A) value at risk (VAR).

B) delta.

C) the hedge ratio.

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This is an often-used definition of VAR.

Kingpin804

If the one-day value at risk of a portfolio is $50,000 at a 95 percent probability level, this means that we should expect that in one day out of:

A) 20 days, the portfolio will decline by $50,000 or more.

B) 20 days, the portfolio will decline by $50,000 or less.

C) 95 days, the portfolio will lose $50,000.

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This means that 5 out of 100 (or one out of 20) days, the value of the portfolio will experience a loss of $50,000 or more.

Kingpin804

BigBank engages in foreign exchange transactions. They have just provided a forward contract to a major multinational corporation that allows the corporation to sell Swiss francs in 90 days. They have also entered into a currency swap that allows them to receive Japanese yen in exchange for paying U.S. dollars. Furthermore, they are in the process of selling a large position in Canadian dollars in the spot market. Which of the following risks is NOT explicitly mentioned in these series of transactions by BigBank?

A) Operations risk.

B) Herstatt risk.

C) Liquidity risk.

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Operations risk is the potential for failures in the firm’s operating systems due to personnel, technological, mechanical, or other problems. Although BigBank is sure to have exposure to operations risk, it is not explicitly described in these transactions. Herstatt risk or settlement risk is the possibility that one party could default on a contract while the other is settling. This has been a problem in foreign exchange markets due to time differences and is certainly possible in BigBank’s currency swap. Liquidity risk refers to the potential for sustaining losses due to the inability to sell or buy a position quickly. BigBank’s sale of the Canadian dollars is subject to liquidity risk.

Kingpin804

When describing the risk exposures that an analyst should examine as part of an enterprise risk management system, what terms describe the risks pertaining to the factors that directly affect firm or portfolio values and the risks associated with external capital markets?

Firm/Portfolio Value

External Capital Market

A) [td=1,1,136]Market risk Factor risk [/td]

B) [td=1,1,136]Systematic risk Financial risk [/td]

C) [td=1,1,136]Market risk Financial risk [/td]

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Financial and non-financial risk factors are general terms. Financial risk factors are those associated with external capital markets and the transactions within external markets. Non-financial risk factors capture other types of risk. Financial risk factors include market risk, liquidity risk, credit risk, and sovereign risk. Market risk pertains to the factors that affect firm or portfolio values (e.g. interest rates, exchange rates, equity prices, commodity prices, etc.). Non-financial risk factors include settlement (Herstatt) risk, operations risk, model risk, sovereign risk, regulatory risk, and other miscellaneous risk factors. Note that sovereign risk has both financial and non-financial risk components.