Financial Risk Management Risk Measurement and Analytics 1 — Questions and Answers
Question 1: What is the difference between 'expected loss' and 'unexpected loss' in risk management?
- Expected loss is for credit risk only; unexpected loss applies to market and operational risk
- Expected loss is the average anticipated loss priced into products; unexpected loss requires capital as a buffer (Correct answer)
- Expected loss uses historical data; unexpected loss uses scenario analysis exclusively
- Expected loss triggers provisioning; unexpected loss is written off immediately
Correct answer: Expected loss is the average anticipated loss priced into products; unexpected loss requires capital as a buffer
Expected loss is the average loss built into pricing and provisions; unexpected loss is the deviation above expected that economic capital is designed to absorb.
Question 2: Backtesting a VaR model involves:
- Running VaR calculations backward in time using current market parameters
- Comparing VaR forecasts against actual trading P&L to assess model accuracy (Correct answer)
- Re-running historical stress scenarios with updated portfolio compositions
- Testing whether VaR captures more risk than Expected Shortfall for the same portfolio
Correct answer: Comparing VaR forecasts against actual trading P&L to assess model accuracy
Backtesting compares the VaR estimate with actual daily P&L outcomes to assess whether exceptions (losses exceeding VaR) occur at the modeled frequency.
Question 3: In risk management, what is the concept of 'fat tails' (leptokurtosis)?
- A distribution where extreme losses occur more frequently than predicted by a normal distribution (Correct answer)
- A portfolio that has excessive exposure to long-dated assets at the far end of the yield curve
- The widening of credit spreads on bonds with long maturities during risk-off periods
- A characteristic of VaR models that causes them to overstate small, frequent losses
Correct answer: A distribution where extreme losses occur more frequently than predicted by a normal distribution
Fat tails describe return distributions with excess kurtosis where extreme events occur more often than a normal distribution would predict, understating risk if normality is assumed.
Question 4: What is economic capital in the context of financial risk management?
- The total equity capital raised by a financial institution from shareholders
- The capital a firm estimates it needs to absorb unexpected losses at a specified confidence level (Correct answer)
- The minimum capital required by regulators under Basel III Pillar 1 rules
- The difference between book value of equity and market capitalization
Correct answer: The capital a firm estimates it needs to absorb unexpected losses at a specified confidence level
Economic capital is internally calculated based on the firm's own risk models to absorb unexpected losses at a high confidence level (e.g., 99.9%), independent of regulatory minima.
Question 5: Which measure captures how much a single position contributes to overall portfolio VaR?
- Marginal VaR
- Incremental VaR
- Component VaR (Correct answer)
- Diversified VaR
Correct answer: Component VaR
Component VaR allocates total portfolio VaR to individual positions, showing each position's contribution including diversification effects.
Question 6: The 'correlation coefficient' in portfolio risk is important because:
- It determines the exact probability of simultaneous defaults in a credit portfolio
- It measures the degree to which two asset returns move together, affecting portfolio diversification (Correct answer)
- It is used to calculate the VaR of non-linear instruments like options
- It quantifies the sensitivity of a bond's price to interest rate changes
Correct answer: It measures the degree to which two asset returns move together, affecting portfolio diversification
Portfolio variance and diversification benefits depend heavily on the correlation between asset returns; lower correlations yield greater risk reduction.
Financial Risk Management Risk Measurement and Analytics 1
What is the difference between 'expected loss' and 'unexpected loss' in risk management?