Financial Risk Management Financial Risk Management 3 — Questions and Answers
Question 1: In stress testing, what is the main advantage of scenario analysis over sensitivity analysis?
- It is computationally simpler and faster
- It simultaneously assesses the impact of multiple risk factors changing together (Correct answer)
- It provides exact probability estimates for tail events
- It relies purely on historical data without any assumptions
Correct answer: It simultaneously assesses the impact of multiple risk factors changing together
Scenario analysis evaluates the combined effect of multiple correlated risk factors changing at once, reflecting real-world crisis dynamics.
Question 2: What is the key distinction between 'systematic risk' and 'idiosyncratic risk'?
- Systematic risk can be eliminated through diversification; idiosyncratic risk cannot
- Idiosyncratic risk is market-wide; systematic risk is company-specific
- Systematic risk is market-wide and non-diversifiable; idiosyncratic risk is company-specific and diversifiable (Correct answer)
- They are identical concepts with different names in different regulatory frameworks
Correct answer: Systematic risk is market-wide and non-diversifiable; idiosyncratic risk is company-specific and diversifiable
Systematic risk (market risk) affects all assets and cannot be diversified away, while idiosyncratic risk is specific to individual securities and can be reduced through diversification.
Question 3: A firm's asset correlation increases during a financial crisis. What is the most significant implication for a diversified portfolio?
- Portfolio VaR decreases as assets move together
- Diversification benefits are reduced precisely when they are most needed (Correct answer)
- The portfolio becomes less sensitive to interest rate changes
- Credit risk in the portfolio is transferred to market risk
Correct answer: Diversification benefits are reduced precisely when they are most needed
Crisis-driven correlation increases mean assets that normally move independently begin moving together, destroying the diversification benefit when losses are largest.
Question 4: Which liquidity risk metric measures the time required to liquidate a position without significantly impacting market prices?
- Liquidity Coverage Ratio (LCR)
- Net Stable Funding Ratio (NSFR)
- Liquidation horizon (Correct answer)
- Bid-ask spread
Correct answer: Liquidation horizon
The liquidation horizon is the estimated time needed to unwind a position at fair value without causing material price impact.
Question 5: Under the CAPM framework, what does beta greater than 1.0 indicate about a stock?
- The stock is less volatile than the overall market
- The stock moves in the opposite direction of the market
- The stock is more volatile than the market and amplifies market movements (Correct answer)
- The stock has no correlation with market returns
Correct answer: The stock is more volatile than the market and amplifies market movements
A beta above 1.0 means the stock tends to amplify market moves — if the market falls 10%, a beta-1.5 stock is expected to fall 15%.
Question 6: What is the primary risk associated with a 'wrong-way risk' in derivatives transactions?
- The counterparty's creditworthiness improves when the trade is in-the-money
- The counterparty's default risk increases precisely when the exposure on the trade is largest (Correct answer)
- Interest rates move against the expected hedge direction
- The derivative is mispriced due to model error
Correct answer: The counterparty's default risk increases precisely when the exposure on the trade is largest
Wrong-way risk occurs when counterparty credit quality deteriorates at the same time the trade's mark-to-market exposure increases, compounding losses.
Question 7: What does the 'convexity' of a bond measure?
- The bond's sensitivity to credit spread changes
- The curvature in the price-yield relationship, measuring duration's rate of change (Correct answer)
- The bond's exposure to prepayment risk
- The correlation between bond price and equity market returns
Correct answer: The curvature in the price-yield relationship, measuring duration's rate of change
Convexity measures the rate of change of duration as yields change, capturing the non-linear (curved) relationship between bond prices and yields.
Financial Risk Management Financial Risk Management 3
In stress testing, what is the main advantage of scenario analysis over sensitivity analysis?