FRM Market Risk Flashcards

What is basis risk in the context of hedging?

Answer: The risk that the hedge instrument does not perfectly offset the exposure being hedged

Basis risk arises when the price movements of the hedging instrument and the hedged exposure are not perfectly correlated.

Under a normal distribution assumption, approximately what percentage of daily returns fall outside 2 standard deviations?

Answer: 5%

Under the normal distribution, approximately 95% of observations fall within 2 standard deviations, leaving about 5% in the tails.

What is the key difference between systematic risk and idiosyncratic risk?

Answer: Systematic risk affects the entire market and cannot be diversified away, while idiosyncratic risk is firm-specific and can be diversified

Systematic risk is driven by broad market factors affecting all securities, while idiosyncratic risk is specific to an individual firm or asset and diminishes with diversification.

Which model is commonly used to estimate time-varying volatility by weighting recent observations more heavily?

Answer: EWMA (Exponentially Weighted Moving Average)

EWMA assigns exponentially declining weights to older observations, so recent returns have greater influence on the volatility estimate.

What does a correlation of -1 between two assets imply for portfolio risk?

Answer: The assets move in perfectly opposite directions, allowing complete risk elimination when combined in the right proportions

Perfect negative correlation means combining two assets in appropriate proportions can create a zero-risk portfolio by offsetting gains and losses.

In the context of options, what does 'delta hedging' involve?

Answer: Continuously rebalancing a position in the underlying asset to offset changes in option value

Delta hedging involves taking an offsetting position in the underlying asset equal to the option's delta, which must be rebalanced as the delta changes.