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Chapter market risk Answers+to+end-of-chapter+questions

Chapter market risk Answers+to+end-of-chapter+questions -...

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CHAPTER 12 MARKET RISK Chapter outline Market Risk Measurement Calculating Market Risk Exposure The RiskMetrics Model The Market Risk of Fixed-Income Securities Foreign Exchange Equities Portfolio Aggregation The Historic or Back Simulation Approach The Historic (Back Simulation) Model versus RiskMetrics The Monte Carlo Simulation Approach Regulatory Models: The BIS Standardized Framework Fixed Income Foreign Exchange Equities The BIS Regulations and Large Bank Internal Models Instructor’s Resource Manual t/a Financial Institutions Management 2e by Lange, Saunders, Anderson, Thomson & Cornett 1
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Answers to end-of-chapter questions QUESTIONS AND PROBLEMS 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: (i) Provides information on the risk positions taken by individual traders. (ii) Establishes limit positions on each trader based on the market risk of their portfolios. (iii) Helps allocate resources to departments with lower market risks and appropriate returns. (iv)Evaluates performance based on risks undertaken by traders in determining optimal bonuses. (v) Helps develop more efficient internal models so as to avoid using standardised 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 per cent. The historical mean change in daily yields is 0.0 per cent, 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 per cent chance that yield changes will be greater than this maximum?
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