Financial Risk Management Market Risk Measurement 3

Question 1

Which of the following best describes 'stress testing' in market risk management?

Accepted Answer

Evaluating portfolio performance under extreme but plausible adverse scenarios

Answer

Stress testing examines how a portfolio performs under severe hypothetical or historical scenarios such as the 2008 financial crisis or a sudden liquidity freeze.

Question 2

What is backtesting in the context of VaR models?

Accepted Answer

Comparing predicted VaR estimates to actual observed losses to validate the model

Answer

Backtesting counts how often actual losses exceed the predicted VaR threshold (exceptions) and assesses whether the exception rate aligns with the confidence level.

Question 3

Under the Basel traffic-light backtesting framework, a bank in the 'red zone' (10+ exceptions in 250 days) faces which consequence?

Accepted Answer

Capital surcharge multiplication factor of up to 4.0 applied to market risk capital

Answer

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.

Question 4

What is 'liquidity-adjusted VaR' (LVaR)?

Accepted Answer

VaR that incorporates the additional cost of unwinding a position over a liquidation horizon longer than one day

Answer

LVaR scales the standard VaR to reflect the fact that large or illiquid positions may require several days to exit, amplifying potential losses.

Question 5

What is the 'square root of time' rule used for in market risk?

Accepted 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

Answer

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.

Financial Risk Management Practice Test

Financial Risk Management Practice Test

Financial Risk Management Market Risk Measurement 3