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Ch10 - End of Chapter 10 Questions 1 What is meant by...

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1 End of Chapter 10 Questions 1. What is meant by market risk ? Market risk is the uncertainty of the effects of changes in economy-wide systematic factors that affect earnings and stock prices of different firms in a similar manner. Some of these market-wide risk factors include volatility, liquidity, interest-rate and inflationary expectation changes. 2. Why is the measurement of market risk important to the manager of a financial institution? Measurement of market risk can help an FI manager in the following ways: a. Provide information on the risk positions taken by individual traders. b. Establish limit positions on each trader based on the market risk of their portfolios. c. Help allocate resources to departments with lower market risks and appropriate returns. d. Evaluate performance based on risks undertaken by traders in determining optimal bonuses. e. Help develop more efficient internal models so as to avoid using standardized regulatory models. 3. What is meant by daily earnings at risk (DEAR) ? What are the three measurable components? What is the price volatility component? DEAR or Daily Earnings at Risk is defined as the estimated potential loss of a portfolio's value over a one-day unwind period as a result of adverse moves in market conditions, such as changes in interest rates, foreign exchange rates, and market volatility. DEAR is comprised of (a) the dollar value of the position, (b) the price sensitivity of the assets to changes in the risk factor, and (c) the adverse move in the yield. The product of the price sensitivity of the asset and the adverse move in the yield provides the price volatility component. 4. Follow bank has a $1 million position in a five-year, zero-coupon bond with a face value of $1,402,552. The bond is trading at a yield to maturity of 7.00 percent. The historical mean change in daily yields is 0.0 percent, and the standard deviation is 12 basis points. a. What is the modified duration of the bond? MD = 5 ÷ (1.07) = 4.6729 years b. What is the maximum adverse daily yield move given that we desire no more than a 5 percent chance that yield changes will be greater than this maximum?
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2 Potential adverse move in yield at 5 percent = 1.65 σ = 1.65 x 0.0012 = .001980 c. What is the price volatility of this bond?
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