Market Risk Measurement Flashcards
6 cards from real Financial Risk Management practice questions. Tap to flip, then mark Knew It or Still Learning — missed cards come back until you master them.
Read the first 6 Market Risk Measurement flashcards as text
Which of the following best describes 'stress testing' in market risk management?
Answer: Evaluating portfolio performance under extreme but plausible adverse scenarios
Stress testing examines how a portfolio performs under severe hypothetical or historical scenarios such as the 2008 financial crisis or a sudden liquidity freeze.
What is backtesting in the context of VaR models?
Answer: Comparing predicted VaR estimates to actual observed losses to validate the model
Backtesting counts how often actual losses exceed the predicted VaR threshold (exceptions) and assesses whether the exception rate aligns with the confidence level.
Under the Basel traffic-light backtesting framework, a bank in the 'red zone' (10+ exceptions in 250 days) faces which consequence?
Answer: Capital surcharge multiplication factor of up to 4.0 applied to market risk capital
The red zone triggers the highest plus factor (up to +1.0), raising the multiplication factor on the bank's market risk capital requirement to a maximum of 4.0.
What is 'liquidity-adjusted VaR' (LVaR)?
Answer: VaR that incorporates the additional cost of unwinding a position over a liquidation horizon longer than one day
LVaR scales the standard VaR to reflect the fact that large or illiquid positions may require several days to exit, amplifying potential losses.
What is the 'square root of time' rule used for in market risk?
Answer: To convert a one-day VaR estimate to a multi-day VaR estimate by scaling by the square root of the number of days
Assuming i.i.d. returns, a one-day VaR can be scaled to a T-day VaR by multiplying by √T, as variance scales linearly and standard deviation scales with the square root.
Which of the following is a key assumption underlying the parametric (variance-covariance) VaR approach?
Answer: Portfolio returns are normally distributed and positions are linear
The variance-covariance approach requires returns to be normally distributed and uses delta-approximation (linear sensitivities), making it less accurate for options or during crises.
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