Financial Risk Management Financial Risk Management 2 — Questions and Answers
Question 1: What does the 'Greeks' measure Delta represent in options pricing?
- The rate of change of option price relative to underlying asset price (Correct answer)
- The sensitivity of option price to changes in volatility
- The time decay of an option's value
- The sensitivity of option price to interest rate changes
Correct answer: The rate of change of option price relative to underlying asset price
Delta measures how much an option's price changes for a $1 move in the underlying asset's price.
Question 2: Which risk measure quantifies the potential loss beyond the Value at Risk (VaR) threshold?
- Beta
- Expected Shortfall (CVaR) (Correct answer)
- Standard deviation
- Tracking error
Correct answer: Expected Shortfall (CVaR)
Expected Shortfall (Conditional VaR) measures the average loss in the tail beyond the VaR confidence level.
Question 3: A bank has a loan portfolio with a 99% 10-day VaR of $5 million. What does this mean?
- Losses will never exceed $5M
- There is a 1% chance losses will exceed $5M over 10 days (Correct answer)
- There is a 99% chance losses will exceed $5M over 10 days
- Average losses equal $5M over any 10-day period
Correct answer: There is a 1% chance losses will exceed $5M over 10 days
A 99% VaR of $5M means there is a 1% probability that losses will exceed $5M over the 10-day horizon.
Question 4: What is the primary purpose of a Credit Default Swap (CDS)?
- To speculate on interest rate movements
- To transfer credit risk from one party to another (Correct answer)
- To hedge against currency fluctuations
- To manage liquidity risk in bond portfolios
Correct answer: To transfer credit risk from one party to another
A CDS allows one party (protection buyer) to transfer the credit risk of a reference entity to the protection seller in exchange for periodic payments.
Question 5: Under Basel III, what is the minimum Common Equity Tier 1 (CET1) capital ratio requirement?
- 2.0%
- 4.5% (Correct answer)
- 6.0%
- 8.0%
Correct answer: 4.5%
Basel III requires banks to maintain a minimum CET1 ratio of 4.5% of risk-weighted assets.
Question 6: Which of the following best describes 'basis risk' in a hedging strategy?
- The risk that a counterparty will default on the hedge contract
- The imperfect correlation between the hedging instrument and the hedged exposure (Correct answer)
- The risk of adverse interest rate movements on a hedge
- The risk of regulatory changes invalidating a hedge position
Correct answer: The imperfect correlation between the hedging instrument and the hedged exposure
Basis risk arises when the hedging instrument does not perfectly track the exposure being hedged, leaving residual risk.
Question 7: What is the Sharpe Ratio used to measure in portfolio risk management?
- Total portfolio volatility
- Risk-adjusted return per unit of total risk (Correct answer)
- Correlation between two assets
- Maximum drawdown relative to portfolio value
Correct answer: Risk-adjusted return per unit of total risk
The Sharpe Ratio measures excess return (above the risk-free rate) per unit of total portfolio standard deviation.
Financial Risk Management Financial Risk Management 2
What does the 'Greeks' measure Delta represent in options pricing?