Financial Risk Management Market Risk Management 1 — Questions and Answers
Question 1: What does Value at Risk (VaR) measure in market risk management?
- The maximum expected loss over a given time horizon at a specified confidence level (Correct answer)
- The average return of a portfolio over one year
- The total notional value of all derivative positions
- The minimum capital required by regulators
Correct answer: The maximum expected loss over a given time horizon at a specified confidence level
VaR quantifies the maximum potential loss a portfolio could face over a defined period at a given confidence level, such as 95% or 99%.
Question 2: Which of the following best describes delta in the context of options market risk?
- The sensitivity of an option's price to changes in volatility
- The rate of change of an option's price relative to a $1 change in the underlying asset (Correct answer)
- The time decay of an option's premium per day
- The second-order sensitivity to interest rate changes
Correct answer: The rate of change of an option's price relative to a $1 change in the underlying asset
Delta measures how much an option's price changes for each $1 move in the underlying asset price.
Question 3: A 10-day VaR at 99% confidence is $1 million. What does this mean?
- The firm will lose exactly $1 million over 10 days
- There is a 1% chance losses will exceed $1 million over the next 10 days (Correct answer)
- The firm expects to gain $1 million with 99% probability
- Losses will average $1 million per trading day
Correct answer: There is a 1% chance losses will exceed $1 million over the next 10 days
A 99% VaR of $1 million means there is only a 1% probability that losses over the 10-day period will exceed $1 million.
Question 4: What is the primary limitation of VaR as a risk measure?
- It is too conservative for regulatory purposes
- It does not capture losses beyond the confidence threshold (tail risk) (Correct answer)
- It cannot be applied to fixed income portfolios
- It overestimates risk during normal market conditions
Correct answer: It does not capture losses beyond the confidence threshold (tail risk)
VaR tells you nothing about the magnitude of losses that exceed the confidence threshold, which is the key tail risk concern.
Question 5: Which market risk factor primarily affects the value of fixed income securities?
- Equity beta
- Interest rate changes (Correct answer)
- Foreign exchange volatility
- Commodity price shifts
Correct answer: Interest rate changes
Fixed income securities are most sensitive to interest rate movements, as their prices move inversely with yields.
Question 6: Stress testing in market risk is used to:
- Determine the exact probability of extreme market events
- Evaluate portfolio performance under hypothetical or historical extreme scenarios (Correct answer)
- Calculate daily margin requirements for derivatives
- Replace VaR as the sole risk measure under Basel III
Correct answer: Evaluate portfolio performance under hypothetical or historical extreme scenarios
Stress testing assesses how a portfolio would perform under severe but plausible market conditions beyond normal VaR assumptions.
Financial Risk Management Market Risk Management 1
What does Value at Risk (VaR) measure in market risk management?