Market Risk

True/False Questions

T F 1. Market risk is the uncertainty of an FI's earnings resulting from changes in market conditions
such as interest rates and asset prices.
Answer: True

T F 2. Regulators usually view tradable assets as those held for horizons of less than one year.
Answer: True

T F 3. An FI's trading portfolio can be differentiated from its investment portfolio by liquidity and time
horizon.
Answer: True

T F 4. Assets, liabilities, and derivative contracts that are considered to require extensive time to
liquidate normally are placed in the investment portfolio.
Answer: True

T F 5. Market risk management is important as a source of information on risk exposure for senior
management.
Answer: True

T F 6. Considering the market risk of traders' portfolios for the purpose of establishing restrictions on
positions per trader in each area of trading is resource allocation.
Answer: False

T F 7. Comparing returns to market risks in different areas of trading for the purpose of identifying
those areas with the greatest profit potential into which more capital can be directed is performance
evaluation.
Answer: False

T F 8. Market risk is the potential gain caused by an adverse movement in market conditions.
Answer: False

T F 9. Daily earnings at risk is defined as the dollar value of a position times price sensitivity.
Answer: False

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T F 10. Market value at risk (VAR) is defined as the daily earnings at risk (DEAR) times the number of
days (N).
Answer: False

T F 11. Price volatility is the price sensitivity times the potential adverse move in yield.
Answer: True

T F 12. Price volatility of a bond can be estimated by multiplying the bond's modified duration by the
adverse daily yield move.
Answer: True

T F 13. In estimating price sensitivity, the JPM model prefers to use modified duration over the present
value of cash flow changes.
Answer: False

T F 14. In a well-diversified portfolio, unsystematic risk can be largely diversified away.

Answer: True

T F 15. Market risk is often considered to be undiversifiable in the risk analysis of equities.
Answer: True

T F 16. If the stock portfolio replicates the stock market index portfolio, the beta of the portfolio should
be less than 1.0.
Answer: False

T F 17. Calculating the risk of a multi-asset trading portfolio requires the consideration of the
correlations of returns between the different assets.
Answer: True

T F 18. The dollar value of a foreign exchange portfolio equals the FX position times the spot exchange
rate.
Answer: True

T F 19. The long hand method used to estimate the foreign exchange exposure of a bank's trading
portfolio takes into account the correlation among the different currencies.
Answer: False

T F 20. The JPM RiskMetrics model is based on the assumption of a binomial distribution of asset
returns.
Answer: False

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T F 21. The back simulation approach to estimating market risk exposure requires normally distributed
asset returns, but does not require correlations of asset returns.
Answer: False

T F 22. The back simulation approach to estimating market risk exposure requires the use of daily
prices or returns for some period of immediately recent history.
Answer: True

T F 23. One advantage of RiskMetrics over back simulation is that RiskMetrics provides a worst- case
scenario value.
Answer: False

T F 24. A disadvantage of the back simulation approach to estimate market risk exposure is the limited
confidence level based on the number of observations.
Answer: True

T F 25. A problem with using more observations in the back simulation approach is that more distant
observations have less relevance in predicting VAR estimates of the future.
Answer: True

T F 26. Monte-Carlo simulation is a process of creating asset returns based on actual trading days so
that the probabilities of occurrence are consistent with recent historical experience.
Answer: True

T F 27. One of the reasons for the development of internal risk measurement models is due to the
proposal of the BIS to impose capital requirements on the trading portfolios of FIs.
Answer: True

T F 28. Banks in the countries that are members of the BIS must use the standardized framework to
measure market risk exposures.
Answer: False

T F 29. In the BIS standardized framework model, the specific risk charge attempts to measure the
decline in the liquidity or credit risk quality of the trading portfolio over the holding period.
Answer: True

T F 30. In the BIS standardized framework model, the general market risk weights reflect the product of
the modified durations and interest rate shocks.
Answer: True

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T F 31. In the BIS standardized framework model, vertical offsets are disallowance factors caused by
basis risk between the returns of different types of assets.
Answer: True

T F 32. The capital requirements of the internally generated market risk exposure estimates can be met
with three types of capital.
Answer: True

T F 33. As compared to the BIS standardized framework model for measuring market risk, the internal
models allowed by the large banks are subject to audit by the regulators.
Answer: True

T F 34. A charge reflecting the risk of the decline in the liquidity or credit risk quality of the
trading portfolio is the general market risk charge in the BIS framework.
Answer: False

T F 35. In the BIS framework, vertical offsets are charges that reflect the modified duration and interest
rate shocks for each maturity.
Answer: False

T F 36. In the BIS framework, horizontal offsets within time zones are used to adjust residual positions
between zones.
Answer: False

T F 37. In the early 2000s the market risk capital requirement uniformly was a large proportion of the
total risk capital requirements for the largest US banks.
Answer: False

Multiple Choice Questions

38. The portfolio of a bank that contains assets and liabilities that are relatively illiquid and held for
longer holding periods is
A) is the trading portfolio.
B) is the investment portfolio.
C) contains only long term derivatives.
D) is subject to regulatory risk.
E) cannot be differentiated on the basis of time horizon and liquidity.
Answer: B

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39. Providing senior management with information on the risk exposure taken by FI traders is considered
to be which of the following reasons for the importance of MRM?
A) Regulation
B) Resource allocation
C) Management information
D) Setting limits
E) Performance evaluation
Answer: C

40. Using MRM to identify the potential return per unit of risk in different areas by comparing returns to
market risk in the areas is considered to be which of the following?
A) Regulation
B) Resource allocation
C) Management information
D) Setting limits
E) Performance evaluation
Answer: B

41. A reason for the use of MRM for the purpose of identifying potential misallocations of resources
caused by prudential regulation is which of the following?
A) Regulation
B) Resource allocation
C) Management information
D) Setting limits
E) Performance evaluation
Answer: A

Use the following to answer questions 42-43:

The DEAR of a bank's trading portfolio has been estimated at $5,000. It is assumed that the daily earnings
are independently and normally distributed.

42. What is the day VAR?

A) $5,000
B) $10,000
C) $15,811
D) $22,361
E) $50,000
Answer: C

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43. What is the 20-day VAR?
A) $5,000
B) $10,000
C) $15,811
D) $22,361
E) $50,000
Answer: D

44. The earnings at risk for an FI is a function of

A) the time necessary to liquidate assets.
B) the potential adverse move in yield.
C) the dollar market value of the position.
D) the price sensitivity of the position.
E) all of the above.
Answer: E

45. In calculating the VAR of fixed-income securities,

A) the VAR is related in a linear manner to the DEAR.
B) the price volatility is the product of the modified duration and the adverse yield change.
C) the yield changes are assumed to be normally distributed.
D) all of the above are correct.
E) b and c are correct.
Answer: E

46. Daily earnings at risk (DEAR) is calculated as

A) the price sensitivity times an adverse daily yield move.
B) the dollar value of a position times the price volatility.
C) the dollar value of a position times the potential adverse yield move.
D) the price volatility times the N.
E) more than one of the above is correct.
Answer: B

47. Price volatility is calculated as

A) the price sensitivity times an adverse daily yield move.
B) the dollar value of a position times the price volatility.
C) the dollar value of a position times the potential adverse yield move.
D) the price volatility times the N.
E) more than one of the above is correct.
Answer: A

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48. VAR is calculated as
A) the price sensitivity times an adverse daily yield move.
B) the dollar value of a position times the price volatility.
C) the dollar value of a position times the potential adverse yield move.
D) the price volatility times the N.
E) DEAR times the N.
Answer: E

Use the following to answer questions 49-51:

The mean change in the value of a portfolio of trading assets has been estimated to be 0 with a standard
deviation of 20 percent. Yield changes are assumed to be normally distributed.

49. What is the maximum yield change expected if a 90 percent confidence (one-tailed) limit is
used?
A) 3.30%
B) 20.0%
C) 33.0%.
D) 39.2%
E) 46.6%
Answer: C

50. What is the maximum yield change expected if a 95 percent confidence (one-tailed) limit is
used?
A) 3.30%
B) 20.0%
C) 33.0%
D) 39.2%
E) 46.6%
Answer: D

51. What is the maximum yield change expected if a 99 percent confidence (one-tailed) limit is
used?
A) 3.30%
B) 20.0%
C) 33.0%
D) 39.2%
E) 46.6%
Answer: E

Use the following to answer questions 52-55:

City bank has six-year zero coupon bonds with a total face value of $20 million. The current market yield
on the bonds is 10 percent.

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52. What is the modified duration of these bonds?
A) 5.45 years
B) 6.00 years
C) 6.60 years
D) 10.0 years
E) 10.9 years
Answer: A

53. What is the price volatility if the maximum potential adverse move in yields is estimated at 20 basis
points?
A) -1.32 percent
B) -2.00 percent
C) -2.18 percent
D) -1.09 percent
E) -1.20 percent
Answer: D

54. What is the daily earnings at risk (DEAR) of this bond portfolio?
A) -$246,110.63
B) -$123,055.32
C) -$135,473.74
D) -$149,021.12
E) -$225,789.57
Answer: B

55. What is the day VAR assuming the daily returns are independently distributed?
A) -$714,009.31
B) -$778,270.16
C) -$389,135.09
D) -$428,405.58
E) -$471,246.16
Answer: C

Use the following to answer questions 56-61:

Sumitomo Bank's risk manager has estimated that the DEARs of two of its major assets in its trading
portfolio, foreign exchange and bonds, are -$150,000 and -$250,000, respectively.

56. What is the total DEAR of Sumitomo's trading portfolio if the correlations among assets are ignored?
A) -$100,000
B) -$291,548
C) -$350,000
D) -$380,789
E) -$400,000
Answer: E

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57. What is the total DEAR of Sumitomo's trading portfolio if the correlation among assets is assumed to
be 1.0?
A) -$100,000
B) -$291,548
C) -$350,000
D) -$380,789
E) -$400,000
Answer: E

58. What is the total DEAR of Sumitomo's trading portfolio if the correlation among assets is assumed to
be 0.80?
A) -$100,000
B) -$291,548
C) -$350,000
D) -$380,789
E) -$400,000
Answer: D

59. What is the total DEAR of Sumitomo's trading portfolio if the correlation among assets is assumed to
be 0.0?
A) -$100,000
B) -$291,548
C) -$350,000
D) -$380,789
E) -$400,000
Answer: B

60. What is the total DEAR of Sumitomo's trading portfolio if the correlation among assets is assumed to
be -1.0?
A) -$100,000
B) -$291,548
C) -$350,000
D) -$380,789
E) -$400,000
Answer: A

61. What is the day VAR of Sumitomo's trading portfolio if the correlation among assets is assumed to
be -1.0?
A) -$100,000
B) -$316,228
C) -$1,106,797
D) -$1,204,161
E) -$1,264,911
Answer: B

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62. Which of the following items is not considered to be an advantage of using back imulation over the
RiskMetrics approach in developing market risk models?
A) Back simulation is less complex.
B) Back simulation creates a higher degree of confidence in the estimates.
C) Asset returns do not need to be normally distributed.
D) The correlation matrix does not need to be calculated.
E) A worst-case scenario value is determined by back simulation.
Answer: B

Use the following to answer questions 63-65:

On December 31, 2001 Historic Bank had long positions of 200,000,000 Japanese Yen and 50,000,000
Swiss Francs. The closing exchange rates were ¥92/$ and Swf1.89/$.

63. What were the respective positions of the two currencies in dollars?
A) $2,173,913 and $94,500,000
B) $18,400,000,000 and $26,455,026
C) $2,173,913 and $26,455,026
D) $18,400,000,000 and $94,500,000
E) None of the above.
Answer: C

64. What is the value of delta for the respective positions of the two currencies in dollars?
A) -$200,000,000 and -$50,000,000
B) -$21,524 and -$261,930
C) -$21,524 and -$50,000,000
D) -$200,000,000 and -$261,640
E) -$21,524 and -$317,642
Answer: B

65. Over the past 500 days, the 25th worst day for adverse exchange rate changes saw a change in the
exchange rates of 0.78 percent for the Yen and 0.30 percent for the Swiss . Franc. What is the expected
VAR exposure on December 31?
A) -$95,952
B) -$2,157,088
C) -$26,375,899
D) -$109,233
E) -$314,848
Answer: A

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66. The specific risk charge in the BIS standardized framework of market risk measurement
A) reflects the product of the modified durations and the interest rate shocks.
B) measures the credit risk quality of the trading portfolio.
C) measures the vertical offsets of the portfolio.
D) measures the decline in liquidity of the portfolio.
E) More than one of the above is correct.
Answer: E

67. The general market risk charge in the BIS standardized framework of market risk measurement
A) reflects the product of the modified durations and the interest rate shocks.
B) measures the credit risk quality of the trading portfolio.
C) measures the vertical offsets of the portfolio.
D) measures the decline in liquidity of the portfolio.
E) More than one of the above is correct.
Answer: A

68. The additional capital charge for basis risk

A) reflects the product of the modified durations and the interest rate shocks.
B) measures the credit risk quality of the trading portfolio.
C) measures the vertical offsets of the portfolio.
D) measures the decline in liquidity of the portfolio.
E) More than one of the above is correct.
Answer: C

Use the following to answer questions 69-70:

Swiss Bank USA has the following foreign exchange positions in its trading portfolio, reported in dollars:
$40 long in Swiss francs (SF), $20 million short in Swiss francs, $35 million long in Euros (€) and $20
million short in €, $30 million long in British pounds (£) and $50 million short in £. It uses the
standardized framework proposed by the Bank for International Settlements (BIS) to estimate its capital
charge for its foreign exchange positions.

69. What are the net positions for each foreign exchange held in the portfolio?
A) $20 million short in SF, $15 million long in €, and $20 million short in £.
B) $20 million short in SF, $15 million long in €, and $20 million long in £.
C) $20 million long in SF, $15 million long in €, and $20 million long in £.
D) $20 million long in SF, $15 million long in €, and $20 million short in £.
E) $20 million long in SF, $15 million short in €, and $20 million short in £.
Answer: D

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70. What is the capital charge for its foreign exchange holdings using the BIS short hand
method?
A) $1.6 million
B) $2.8 million
C) $3.2 million
D) $4.0 million
E) $4.4 million
Answer: B

Use the following to answer questions 71-73:

An FI has the following stocks.

71. What is the capital charge for unsystematic risk (x-factor) under the BIS proposals?
A) $1.2 million
B) $2.4 million
C) $3.2 million
D) $6.4 million
E) $12.8 million
Answer: D

72. What is the capital charge for systematic risk (y-factor) under the BIS proposals?
A) $1.2 million
B) $4.8 million
C) $3.2 million
D) $6.4 million
E) $12.8 million
Answer: B

73. What is the total capital charge for its portfolio of stocks under the BIS proposals?
A) $7.6 million
B) $8.8 million
C) $9.6 million
D) $12.8 million
E) $11.2 million
Answer: E

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74. What is the day VAR using the previous day's DEAR estimate?
A) $1.28 million
B) $3.24 million
C) $4.05 million
D) $10.05 million
E) $12.80 million
Answer: C

75. Using the BIS internal guidelines, what is the total capital (Tier I, II and III) required to lower market
risk?
A) $1.28 million
B) $3.24 million
C) $4.05 million
D) $5.25 million
E) $12.80 million
Answer: D

76. Is there sufficient capital to meet the BIS proposed standards?

A) Yes, Tier I capital alone is more than sufficient to meet the minimum requirements.
B) Yes, Tier I and II capital is more than sufficient to meet the minimum requirements; Tier III is not
necessary.
C) Yes, Tier I, II and III capital is more than sufficient to meet the minimum requirements, but Tier II
must be included.
D) No, Tier I and II capital is not sufficient to meet the minimum requirements.
E) No, Tier I, II and III capital is not sufficient to meet the minimum requirements.
Answer: B

77. The BIS plan allowing internal models by the BIS allows the following except
A) An adverse change is defined as the 95th percentile instead of the 90 th percentile.
B) The minimum holding period for VAR estimation is 10 days.
C) Empirical correlations can be estimated for broad categories of assets.
D) Empirical correlations cannot be estimated for assets within a category.
E) The average estimated VAR will be multiplied by a minimum factor of 3.
Answer: A

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