Market Risk Measurement Flashcards

What does Value at Risk (VaR) measure?

Answer: The maximum loss not exceeded at a given confidence level over a specified period

VaR estimates the maximum potential loss at a specified confidence level (e.g., 95% or 99%) over a defined time horizon.

Which method of VaR calculation uses the actual historical returns of a portfolio?

Answer: Historical simulation

Historical simulation applies past observed returns directly to the current portfolio to estimate the VaR distribution without assuming normality.

What is the main limitation of VaR as a risk measure?

Answer: It does not capture losses beyond the confidence threshold (tail risk)

VaR tells you nothing about the severity of losses that exceed the confidence level, which is why Expected Shortfall (CVaR) is often used as a complement.

Expected Shortfall (ES), also called CVaR, measures which of the following?

Answer: The average loss given that the loss exceeds the VaR threshold

Expected Shortfall is the mean of all losses that fall beyond the VaR cut-off, providing a fuller picture of tail risk.

Delta-normal VaR assumes portfolio returns follow which distribution?

Answer: Normal (Gaussian) distribution

The delta-normal (parametric) approach linearizes portfolio sensitivities and assumes returns are normally distributed to compute VaR analytically.

Which risk metric is required by the Basel III/IV internal models approach to replace VaR?

Answer: Expected Shortfall (ES) at 97.5%

Basel IV's Fundamental Review of the Trading Book (FRTB) replaces 99% VaR with 97.5% Expected Shortfall to better capture tail risk.