4.5 Market Risk Measurement and Management
Question 1
PE2018Q84 / PE2019Q84/ PE2020Q84 / PE2021Q84 / PE2022Q84
Assume that portfolio daily returns are independently and identically normally distributed. A new quantitative analyst has been asked by the portfolio manager to calculate portfolio
VaRs
\text{VaRs}
VaRs for 10-, 15-, 20-, and 25-day periods. The portfolio manager notices something amiss with the analyst’s calculations displayed below. Which one of following Vas on this portfolio is inconsistent with the others?
A.
VaR
10
−
d
a
y
=
USD
316
million
\text{VaR}_{10-day} = \text{USD}\; 316\;\text{million}
VaR10−day=USD316million
B.
VaR
15
−
d
a
y
=
USD
465
million
\text{VaR}_{15-day} = \text{USD}\; 465\;\text{million}
VaR15−day=USD465million
C.
VaR
20
−
d
a
y
=
USD
537
million
\text{VaR}_{20-day} = \text{USD}\; 537\;\text{million}
VaR20−day=USD537million
D.
VaR
25
−
d
a
y
=
USD
600
million
\text{VaR}_{25-day} = \text{USD}\; 600\;\text{million}
VaR25−day=USD600million
Answer: A
Learning Objective: Explain and apply approaches to estimate long horizon volatility/VaR and describe the
process of mean reversion according to a
GARCH
(
1
,
1
)
\text{GARCH}(1,1)
GARCH(1,1) model.
Calculate VaR(1-day) from each choice:
VaR
10
−
d
a
y
=
316
→
VaR
1
−
d
a
y
=
316
/
10
≈
100
\text{VaR}_{10-day} = 316\to \text{VaR}_{1-day}=316/\sqrt{10} \approx 100
VaR10−day=316→VaR1−day=316/10≈100
VaR
15
−
d
a
y
=
465
→
VaR
1
−
d
a
y
=
465
/
15
≈
120
\text{VaR}_{15-day} = 465\to \text{VaR}_{1-day}=465/\sqrt{15} \approx 120
VaR15−day=465→VaR1−day=465/15≈120
VaR
20
−
d
a
y
=
537
→
VaR
1
−
d
a
y
=
537
/
20
≈
120
\text{VaR}_{20-day} = 537\to \text{VaR}_{1-day}=537/\sqrt{20} \approx 120
VaR20−day=537→VaR1−day=537/20≈120
VaR
25
−
d
a
y
=
600
→
VaR
1
−
d
a
y
=
600
/
25
≈
120
\text{VaR}_{25-day} = 600\to \text{VaR}_{1-day}=600/\sqrt{25} \approx 120
VaR25−day=600→VaR1−day=600/25≈120
VaR 1 − d a y \text{VaR}_{1-day} VaR1−day from A is different from those from other answers
Question 2
What is a limitation of the mean-variance framework for measuring financial risk?
A. The mean-variance approach ignores the first two moments of the underlying distribution.
B. The mean-variance approach ignores the skewness and kurtosis of the underlying distribution.
C.The mean-variance approach restricts the underlying distribution to a non-negative Fishburn measure.
D. The mean-variance approach requires that the underlying distribution have an entropy measure between
0
0
0 and
1
1
1.
Question 3
A risk manager is measuring the VaR \text{VaR} VaR of a portfolio of investment securities for a regional bank. The portfolio has a current market value of USD 10 10 10 million with a mean daily return of 0 % 0\% 0% and variance of daily returns of 0.0005 0.0005 0.0005. Assuming there are 250 250 250 trading days in a year and that the portfolio returns a normal distribution; the estimated annual 90 % 90\% 90% VaR \text{VaR} VaR is closest to:
A. USD
101
,
000
101,000
101,000
B. USD
287
,
000
287,000
287,000
C. USD
4
,
531
,
000
4,531,000
4,531,000
D. USD
5
,
815
,
000
5,815,000
5,815,000
Answer: C
VaR ( X % ) dollar = ∣ E ( R ) − Z X % × σ ∣ × Asset Value \text{VaR}(X\%)_{\text{dollar}}=|E(R)-Z_{X\%}\times \sigma| \times \text{Asset Value} VaR(X%)dollar=∣E(R)−ZX%×σ∣×Asset Value
Annual VaR = ∣ 0 − 1.28 × 0.0005 ∣ × 250 × 10 , 000 , 000 ≈ 4 , 525 , 483 million \text{Annual VaR}=|0-1.28 \times\sqrt{0.0005}|\times \sqrt{250}\times10,000,000\approx 4,525,483\;\text{million} Annual VaR=∣0−1.28×0.0005∣×250×10,000,000≈4,525,483million
Question 4
There exist two portfolios A and B. Each has their individual VaR. When putting them together in a new portfolio C, which of the following will be always true?
A.
VaR
C
<
VaR
A
+
VaR
B
\text{VaR}_{\text{C}} < \text{VaR}_{\text{A}} + \text{VaR}_{\text{B}}
VaRC<VaRA+VaRB
B.
VaR
C
>
VaR
A
+
VaR
B
\text{VaR}_{\text{C}} > \text{VaR}_{\text{A}} + \text{VaR}_{\text{B}}
VaRC>VaRA+VaRB
C.
VaR
C
=
VaR
A
+
VaR
B
\text{VaR}_{\text{C}} = \text{VaR}_{\text{A}} + \text{VaR}_{\text{B}}
VaRC=VaRA+VaRB
D. None of the above
Answer: D
One important drawback of VaR is that it is not sub-additive.
Question 5
A risk manager oversees the risk measurement of two portfolios. Portfolio A has a VaR \text{VaR} VaR of USD 5 5 5 million and an E S ES ES of USD 10 10 10 million. Portfolio B has a VaR \text{VaR} VaR of USD 7 7 7 million and an E S ES ES of USD $15 $million. When combining portfolios A and B, the risk manager observes that the VaR \text{VaR} VaR of the aggregate portfolio is USD 15 15 15 million and the E S ES ES is USD 20 20 20 million. This is because:
A.
E
S
ES
ES is subadditive, while
VaR
\text{VaR}
VaR is not subadditive.
B.
VaR
\text{VaR}
VaR is subadditive, while
E
S
ES
ES is not subadditive.
C.
VaR
\text{VaR}
VaR satisfies positive homogeneity, while
E
S
ES
ES does not satisfy positive homogeneity.
D.
E
S
ES
ES satisfies positive homogeneity, while
VaR
\text{VaR}
VaR does not satisfy positive homogeneity.
Question 6
A risk manager is reviewing the benefits of diversification with her firm’s board of directors. She explains that if two securities have a 1-day 95 % 95\% 95% VaR \text{VaR} VaR of X X X and Y Y Y. then the 1-day 95 % 95\% 95% VaR \text{VaR} VaR of the combined portfolio will always be less than or equal to X + Y X+Y X+Y. Which of the following statements is consistent with the risk managers explanation?
A. The risk manager assumed that the values of the two securities are jointly normally distributed random variables.
B. The risk manager assumed that the values of the two securities are uncorrelated.
C The risk manager assumed that the values of the two securities are independent and identically distributed random variables.
D. The risk manager made no assumptions because
VaR
\text{VaR}
VaR is a coherent risk measure. which supports her statement
Question 7
PE2018Q36 / PE2019Q36 / PE2020Q36 / PE2021Q36 / PE2022Q36
Bank A and Bank B are two competing investment banks that are calculating the 1-day
99
%
99\%
99%
VaR
\text{VaR}
VaR for an at-the-money call on a non-dividend-paying stock with the following information:
- Current stock price: USD 120 120 120
- Estimated annual stock return volatility: 18 % 18\% 18%
- Current Black-Scholes-Merton option value: USD 5.20 5.20 5.20
- Option delta: 0.6 0.6 0.6
To compute VaR \text{VaR} VaR, Bank A uses the linear approximation method, while Bank B uses a Monte Carlo simulation method for full revaluation. Which bank will estimate a higher value for the 1-day 99 % 99\% 99% VaR \text{VaR} VaR?
A. Bank A.
B. Bank B.
C. Both will have the same
VaR
\text{VaR}
VaR estimate.
D. Insufficient information to determine.
Answer: A
Learning Objective: Compare delta-normal and full revaluation approaches for computing
VaR
\text{VaR}
VaR.
The option’s return function is convex with respect to the value of the underlying. Therefore, the linear approximation method will always underestimate the true value of the option for any potential change in price. Therefore the VaR \text{VaR} VaR will always be higher under the linear approximation method than a full revaluation conducted by Monte Carlo simulation analysis. The difference is the bias resulting from the linear approximation, and this bias increases in size with the change in the option price and with the holding period.
Question 8
The hybrid method is a combination of historical simulation and
A. Historical Standard Deviation
B. MDE
C. EWMA
D. GARCH
Answer: C
The hybrid approach combines the two simplest approaches, historical simulation and risk metrics, by estimating the percentiles of the return directly (similar to historical simulation), and using exponentially declining weights on past data (similar to risk metrics).
Question 9
The historical simulation approach is more likely to provide an accurate estimate of the VaR \text{VaR} VaR than the Risk Metrics approach for a portfolio that consists of:
A. A small number of emerging market securities.
B. A small number of broad market indexes.
C. A large number of emerging market securities.
D. A large number of board market indexes.
Answer: A
The Risk Metrics approach is a delta-normal model that requires the returns to be approximately normally distributed, while the historical simulation model requires much less stringent assumptions. The returns on a portfolio with small number of securities is less likely to be normally distributed than a larger portfolio and an emerging markets index is less likely to be normally distributed than a broad market index. Therefore the historical simulation approach will most likely provide a better
VaR
\text{VaR}
VaR estimate than Risk Metrics for a portfolio with a small number of emerging market securities.
Question 10
Which of the following is a disadvantage of the historical simulation method over the Risk Metrics model? The historical method requires:
I. A worst-case scenario as an input.
I. The future is determined by the past.
Ill. Standard deviations and correlations.
IV. The assumption of normal distributions for asset returns.
A. l and Ill only
B. ll only
C. Il and IV only
D. Ill only
Question 11
Which of the following is not a disadvantage of nonparametric methods compared to parametric methods?
A. Data is used more efficiently with parametric methods than nonparametric methods.
B. Identifying market regimes and conditional volatility increases the amount of usable data as well as the estimation error for historical simulations.
C. MDE may lead to data snooping or over-fitting in identifying required assumptions regarding an appropriate kernel function.
D. MDE requires a large amount of data that is directly related to the number of conditioning variables used in the model.
Answer: B
The use of market regimes and identifying conditional means and volatility actually reduces not increases the amount of data from the full sample. The full sample of data is split into subgroups used to estimate conditional volatility. Therefore, the amount of data available for estimating future volatility is significantly reduced.
Question 12
The hybrid approach for estimating VaR \text{VaR} VaR is the combination of a parametric and a nonparametric approach. It specifically combines the historical simulation approach with:
A. The delta normal approach.
B. The exponentially weighted moving average approach.
C. The multivariate density estimation approach.
D. The generalized autoregressive conditional heteroskedasticity approach.
Answer: B
Learning Objective: Compare and contrast different parametric and non-parametric approaches for estimating conditional volatility.
The hybrid approach combines two approaches to estimating VaR \text{VaR} VaR, the historical simulation and the exponential smoothing approach (i.e. an EWMA approach). Similar to a historical simulation approach, the hybrid approach estimates the percentiles of the return directly, but it also uses exponentially declining weights on past data similar to the exponentially weighted moving average approach.
Question 13
A risk manager is considering switching from using historical volatility to using implied volatility in VaR \text{VaR} VaR calculations. Which of the following statements about implied volatility is correct?
A. Implied volatility estimates are model dependent and a misspecified model can result in erroneous forecasts.
B. Implied volatility estimates require that historical returns are indicative of future returns.
C. Implied volatility estimates tend to underestimate future volatility as a result of mean reversion
D. Implied volatility estimates are generally accurate even if there is only one trade in the option used to calculate an estimate.
Question 14
PE2018Q15 / PE2010Q15 / PE2020Q15 / PE2021Q15/ PE2022Q15
A portfolio manager bought
600
600
600 call options on a non-dividend-paying stock, with a strike price of USD
60
60
60, for USD
3
3
3 each. The current stock price is USD
62
62
62 with a daily stock return volatility of
1.82
%
1.82\%
1.82%, and the delta of the option is
0.5
0.5
0.5. Using the delta-normal approach to calculate
VaR
\text{VaR}
VaR, what is an approximation of the 1-day
95
%
95\%
95%
VaR
\text{VaR}
VaR of this position?
A. USD
54
54
54
B. USD
557
557
557
C. USD
787
787
787
D. USD
1
,
114
1,114
1,114
Answer: B
Learning Objective: Describe the delta-normal approach for calculating
VaR
\text{VaR}
VaR for non-linear derivatives.
The delta of the option is 0.5 0.5 0.5.
The 1-day 95 % 95\% 95% VaR \text{VaR} VaR of 1 share of the underlying equals to 1.82 % × 1.645 × 62 = 1.8562 1.82\% \times1.645\times62 = 1.8562 1.82%×1.645×62=1.8562
Therefore, the VaR \text{VaR} VaR of one option equals to 0.5 × 1.8562 = 0.9281 0.5\times1.8562 = 0.9281 0.5×1.8562=0.9281, and multiplying by 600 600 600 units provides the 1-day 95 % 95\% 95% VaR \text{VaR} VaR of the entire position 556.86 556.86 556.86.
A is incorrect. USD 53.8902 53.8902 53.8902 is the result obtained by ignoring delta and using the call option price, not stock price, to determine VaR \text{VaR} VaR of position: VaR = 0.0182 × 1.645 × 600 × 3 = 53.8902 \text{VaR} = 0.0182\times1.645\times600\times3 = 53.8902 VaR=0.0182×1.645×600×3=53.8902.
C is incorrect. USD 787.40 787.40 787.40 is the result obtained when the VaR \text{VaR} VaR of the position is incorrectly calculated at the 99 % 99\% 99% confidence level ( VaR = 0.0182 × 2.326 × 62 × 0.5 × 600 = 787.3975 \text{VaR} = 0.0182\times2.326\times62\times0.5\times600 = 787.3975 VaR=0.0182×2.326×62×0.5×600=787.3975).
D is incorrect. USD 1 , 113.72 1,113.72 1,113.72 is the result obtained when delta is not applied to the formula ( VaR = 1.8562 × 600 = 1 , 113.72 \text{VaR} = 1.8562\times600 = 1,113.72 VaR=1.8562×600=1,113.72).
Question 15
PE2018Q52
An at-the-money European call option on the DJ EURO STOXX 50 Index with a strike of
2
,
800
2,800
2,800 and maturing in 1 year is trading at EUR
350
350
350, where contract value is determined by EUR
10
10
10 per index point. The risk-free rate is
3
%
3\%
3% per year, and the daily volatility of the index is
2.05
%
2.05\%
2.05%. If we assume that the expected return on the DJ EURO STOXX 50 Index is
0
%
0\%
0%, the
99
%
99\%
99% 1-day
VaR
\text{VaR}
VaR of a short position on a single call option calculated using the delta-normal approach is closest to:
A. EUR
8
8
8
B. EUR
53
53
53
C. EUR
84
84
84
D. EUR
669
669
669
Answer: D
Learning Objective: Compare delta-normal and full revaluation approaches for computing
VaR
\text{VaR}
VaR,
The 99 % 99\% 99% VaR of the index is VaR index = ∣ 0 − 2.33 × 0.0205 ∣ × 2800 × 10 ≈ 1 , 337.42 \text{VaR}_{\text{index}}=|0-2.33\times 0.0205|\times2800\times10\approx 1,337.42 VaRindex=∣0−2.33×0.0205∣×2800×10≈1,337.42
Since the option is at-the-money, the delta is close to 0.5 0.5 0.5.
The 99 % 99\% 99% VaR of the call option is VaR option = 0.5 × 1 , 337.42 = 668.71 \text{VaR}_{\text{option}}=0.5\times 1,337.42=668.71 VaRoption=0.5×1,337.42=668.71
Question 16
PE2018Q91 / PE2019Q91 / PE2020Q91/ PE2021Q91 / PE2022PSQ23 / PE2022Q91
A portfolio of investment securities for a regional bank has a current market value equal to USD
7
,
444
,
000
7,444,000
7,444,000 with a daily variance of
0.0002
0.0002
0.0002. Assuming there are
250
250
250 trading days in a year and that the portfolio returns follow a normal distribution, the estimate of the annual
VaR
\text{VaR}
VaR at the
95
%
95\%
95% confidence level is closest to which of the following?
A. USD
32
,
595
32,595
32,595
B. USD
145
,
770
145,770
145,770
C. USD
2
,
297
,
507
2,297,507
2,297,507
D. USD
2
,
737
,
737
2,737,737
2,737,737
Answer: D
Learning Objective: Explain and apply approaches to estimate long horizon volatility/
VaR
\text{VaR}
VaR, and describe the process of mean reversion according to a
GARCH
(
1
,
1
\text{GARCH}(1,1
GARCH(1,1) model.
Daily standard deviation: σ = 0.0002 = 0.01414 \sigma=\sqrt{0.0002}=0.01414 σ=0.0002=0.01414
VaR ( X % ) dollar = ∣ E ( R ) − Z X % × σ ∣ × Asset Value \text{VaR}(X\%)_{\text{dollar}}=|E(R)-Z_{X\%}\times \sigma| \times \text{Asset Value} VaR(X%)dollar=∣E(R)−ZX%×σ∣×Asset Value
Annual VaR = ∣ 0 − 1.645 × 0.01414 ∣ × 250 × 7 , 444 , 000 = 2 , 737 , 737 \text{Annual VaR}=|0-1.645 \times 0.01414|\times \sqrt{250}\times 7,444,000=2,737,737 Annual VaR=∣0−1.645×0.01414∣×250×7,444,000=2,737,737
Question 17
PE2018Q83 / PE2019Q83 / PE2020Q83 / PE2021Q83 / PE2022Q83
An analyst have been asked to estimate the
VaR
\text{VaR}
VaR of an investment in Big Pharma Inc. The company’s stock is trading at USD
26
26
26 and the stock has a daily volatility of
1.5
%
1.5\%
1.5%. Using the delta-normal method, the
VaR
\text{VaR}
VaR at the
95
%
95\%
95% confidence level of a long position in an at-the-money put on this stock with a delta of
−
0.5
-0.5
−0.5 over a 1-day holding period is closest to which of the following choices?
A. USD
0.28
0.28
0.28
B. USD
0.32
0.32
0.32
C. USD
0.57
0.57
0.57
D. USD
2.84
2.84
2.84
Answer: B
Learning Objective: Describe the delta-normal approach to calculating VaR for non-linear derivatives.
VaR stock = ∣ 0 − 1.645 × 0.015 ∣ × 26 ≈ 0.642 \text{VaR}_{\text{stock}}=|0-1.645\times0.015|\times26\approx0.642 VaRstock=∣0−1.645×0.015∣×26≈0.642
VaR option = ∣ Δ ∣ × VaR stock = 0.5 × 0.642 ≈ 0.32 \text{VaR}_{\text{option}}=|\Delta|\times \text{VaR}_{\text{stock}}=0.5 \times 0.642 \approx 0.32 VaRoption=∣Δ∣×VaRstock=0.5×0.642≈0.32
Question 18
PE2020Q41 / PE2021Q41 / PE2022Q41
A junior risk analyst is modeling the volatility of a certain market variable and is trying to decide between
EWMA
\text{EWMA}
EWMA and
GARCH
(
1
,
1
)
\text{GARCH}(1,1)
GARCH(1,1) models. Which of the following statements about the two models is correct?
A. The
EWMA
\text{EWMA}
EWMA model is a special case of the
GARCH
(
1
,
1
)
\text{GARCH}(1,1)
GARCH(1,1) model with the additional assumption that the long-run volatility is zero.
B. A variance estimated from the
GARCH
(
1
,
1
)
\text{GARCH}(1,1)
GARCH(1,1) model is a weighted average of the prior day’s estimated variance and the prior day’s squared return.
C.The
GARCH
(
1
,
1
)
\text{GARCH}(1,1)
GARCH(1,1) model assigns a higher weight to the prior day’s estimated variance than the
EWMA
\text{EWMA}
EWMA model.
D. A variance estimated from the
EWMA
\text{EWMA}
EWMA model is a weighted average of the prior day’s estimated variance and the prior day’s squared return.
Answer: D
Learning Objective: Apply the exponentially weighted moving average (
EWMA
\text{EWMA}
EWMA) approach and the
GARCH
(
1
,
1
)
\text{GARCH}(1,1)
GARCH(1,1) model to estimate volatility.
The EWMA \text{EWMA} EWMA estimate of variance is a weighted average of the prior day’s variance and prior day’s squared return.
A is incorrect. EWMA \text{EWMA} EWMA is a particular case of GARCH ( 1 , 1 ) \text{GARCH}(1,1) GARCH(1,1) with the weight assigned to the long-run average variance rate as zero and the sum of the weights of the other two parameters equal to 1.
B is incorrect because there is also weight assigned to the long-run average variance rate.
C is incorrect because such a comparison can only be done under specific parameter configurations.
Question 19
PE2020Q50 / PE2021Q50 / PE2022Q50
A risk analyst is estimating the variance of stock returns on day
n
n
n, given by
σ
n
2
\sigma_n^2
σn2, using the equation:
σ n 2 = γ V L + α μ n − 1 2 + β σ n − 1 2 \sigma^2_n=\gamma V_L +\alpha\mu^2_{n-1}+\beta\sigma^2_{n-1} σn2=γVL+αμn−12+βσn−12,
where μ n − 1 \mu_{n-1} μn−1 and σ n − 1 \sigma_{n-1} σn−1 represent the return and volatility on day n − 1 n-1 n−1, respectively.
If the values of α \alpha α and β \beta β are as indicated below, which combination of values indicates that the variance follows a stable GARCH ( 1 , 1 ) \text{GARCH}(1,1) GARCH(1,1) process?
A.
α
=
0.073637
\alpha=0.073637
α=0.073637 and
β
=
0.927363
\beta=0.927363
β=0.927363
B.
α
=
0.075637
\alpha=0.075637
α=0.075637 and
β
=
0.923363
\beta=0.923363
β=0.923363
C.
α
=
0.084637
\alpha=0.084637
α=0.084637 and
β
=
0.916363
\beta=0.916363
β=0.916363
D.
α
=
0.086637
\alpha=0.086637
α=0.086637 and
β
=
0.914363
\beta=0.914363
β=0.914363
Answer:B
Learning Objective: Apply the exponentially weighted moving average (
EWMA
\text{EWMA}
EWMA) approach and the
GARCH
(
1
,
1
)
\text{GARCH}(1,1)
GARCH(1,1) model to estimate volatility.
For a GARCH ( 1 , 1 ) \text{GARCH}(1,1) GARCH(1,1) process to be stable, the sum of parameters α \alpha α and β \beta β need to be below 1 1 1.
Question 20
PE2023Q2
A risk analyst at a hedge fund is conducting a historical simulation to estimate the
ES
\text{ES}
ES of a portfolio. The value of the portfolio at market close of any given day depends on the price of a stock and the level of an interest rate at the close of that day. The analyst uses closing values of these variables on the most recent
501
501
501 trading days as the historical dataset for the simulation and collects the following data, with Day
0
0
0 representing the first data point and Day
500
500
500 representing the last data point of the historical period:
Day | Stock price (HKD) | Interest rate (%) |
---|---|---|
0 0 0 | 76.00 76.00 76.00 | 2.50 % 2.50\% 2.50% |
1 1 1 | 72.00 72.00 72.00 | 2.60 % 2.60\% 2.60% |
… \dots … | … \dots … | … \dots … |
500 500 500 | 94.00 94.00 94.00 | 3.80 % 3.80\% 3.80% |
What stock price and interest rate would be most appropriate for the analyst to use in the scenario of the historical simulation for Day 501 501 501?
A. The stock price would be HKD
89.05
89.05
89.05, and the interest rate would be
3.90
%
3.90\%
3.90%.
B. The stock price would be HKD
89.05
89.05
89.05, and the interest rate would be
3.95
%
3.95\%
3.95%
C. The stock price would be HKD
92.00
92.00
92.00, and the interest rate would be
3.90
%
3.90\%
3.90%
D. The stock price would be HKD
92.00
92.00
92.00, and the interest rate would be
3.95
%
3.95\%
3.95%
Answer: A
Learning Objective: Describe and explain the historical simulation approach for computing
VaR
\text{VaR}
VaR and
ES
\text{ES}
ES.
A is correct. In a historical simulation with a 500 500 500-day historical reference period, the 500 500 500 historical daily changes (from Day 0 0 0 through Day 500 500 500) are used to create 500 500 500 scenarios for what might happen between today and tomorrow (on Day 501 501 501).
In practice, the risk factors that may be used in a historical simulation are divided into two categories: those where the percentage change in the past is used to define a percentage change in the future, and those where the actual change in the past is used to define an actual change in the future. Stock prices are usually considered to be in the first category, while interest rates are usually considered to be in the second category.
The historical change in the stock price from Day 0 0 0 to Day 1 1 1 should therefore be measured as a 72 76 − 1 = − 5.263 % \cfrac{72}{76}-1=-5.263\% 7672−1=−5.263% change, while the change in the interest rate should be measured as a 2.60 % − 2.50 % = 0.10 % 2.60\%-2.50\%=0.10\% 2.60%−2.50%=0.10% change.
Applying these changes to the current stock price and interest rate of HKD 94 94 94 and 3.8 % 3.8\% 3.8%, respectively,produces a scenario for the historical simulation with a stock price of 94 × ( 1 − 0.05263 ) = 89.05263 94\times(1-0.05263) = 89.05263 94×(1−0.05263)=89.05263, and an interest rate of 3.80 % + 0.10 % = 3.90 % 3.80\% +0.10\%=3.90\% 3.80%+0.10%=3.90%.
Question 21
PE2022Q88
The CRO of a major bank is reviewing a new risk measure,
W
W
W, with the risk team. The CRO runs a test on the new risk measure to determine if the measure is coherent and satisfies the property of translation invariance. Which of the following tests would correctly determine that the risk measure
W
W
W exhibits translation invariance?
A. When cash is added to a portfolio, the value of
W
W
W for that portfolio should decrease by the amount of cash that is added.
B. When
W
W
W is used to measure the risk of two portfolios A and B, then
W
(
A
)
+
W
(
B
)
W(A) + W(B)
W(A)+W(B) should be less than or equal to
W
(
A
+
B
)
W(A+B)
W(A+B).
C. When
W
W
W is used to measure the risk of two portfolios A and B, and if portfolio A always produces a worse outcome than portfolio B, then
W
(
A
)
W(A)
W(A) should always be higher than
W
(
B
)
W(B)
W(B).
D. When
W
W
W is used to measure the risk of portfolio A, and if all exposures in portfolio A are increased by a constant factor, then
W
(
A
)
W(A)
W(A) should increase proportionally by that factor.
Answer: A
Learning Objective: Define the properties of a coherent risk measure and explain the meaning of each property.
A is correct. According to the property of translation invariance, adding an amount of cash, K K K, into a portfolio will decrease the risk measure by K K K. Therefore, choice A correctly describes translation invariance.
B is incorrect. This is a test for subadditivity. According to the property of subadditivity, given two portfolios A and B, the risk measure for the portfolio formed by merging A and B will be less than or equal to the sum of the risk measures for A and B.
C is incorrect. This is a test for monotonicity. According to the property of monotonicity, a portfolio that produces consistently worse results in comparison to another portfolio will have a higher risk measure.
D is incorrect. This is a test of homogeneity. According to the property of homogeneity,
changing the size of a portfolio by multiplying the amount of all components by
λ
\lambda
λ results in the risk measure being multiplied by
λ
\lambda
λ.