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8 Cards in this Set
- Front
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Why is theassumption that asset returns are normally distributed very useful whencalculating VaR? |
Ifasset returns are normally distributed, then the whole of the distribution isknown once we know the mean and standard deviation of asset returns. Hence, wedo not need the complete distribution of returns to calculate VaR, only estimatesof the mean and standard deviation. |
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What is meant bya credit default swap (CDS)? Why might a portfolio manager buy a CDS? Are thereany downsides or risks? Explain. |
Acredit default swap (CDS) is a contract that provides insurance against therisk of default by a particular company. The buyer makes periodic payments tothe seller until maturity of the CDS or until default. Portfoliomanagers may want to buy CDS contracts if they want to create a risk-free bond.However, they must make periodic payments to the seller. Moreover, theportfolio manager has the risk that the seller might not pay out. Consider AIG,for instance, which was a big provider of CDS contracts for AAA-rated tranchesof CDOs, an institution that eventually had to be bailed out by the USgovernment. |
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What are the 6Cs of credit? Which do you think is the most important? Would you accept one withoutthe others? Explain. |
The6Cs of credit are: -Character – refers to the borrower’sknowledge and experience -Capacity – refers to the ability toservice debt -Capital – refers to the net value of theborrower’s assets which form back-up liquidity needed to make repayments -Collateral – refers to the security aborrower can pledge to a lender against a loan -Conditions – refers to the impact ofeconomic conditions on a borrower’s prospect -Covenants – refers to the covenant termsagreed by the borrower and lender Allof the above are important. However, you could argue that capacity to repay ismost important, since ultimately this is what determines the likelihood ofrepayment by the borrower. However, you may accept lower capacity to repay byimposing more covenants on the borrowing firm, as covenants serve as a tripwireand allow the lender to intervene if the borrower does not meet agreed targets.Thus, the lender can intervene in the firm before an actual default. |
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What is VaR?What are the main approaches for measuring VaR? What are the advantages anddisadvantages? |
VaRis the maximum loss which can occur with X% confidence over a period of htrading days. The three main approaches to measuring VaR are: Variance-covariance, or parametricapproach – useful for measuring the VaR where asset correlations change overtime. But the model is very sensitive to the inputs, leaving little room forestimation error. Historical simulation – intuitivelysound, and asks what would happen if we ran today’s portfolio through pastreturns. However, past returns may not be a reliable indicator of futureoutcomes. -Monte Carlo simulation – useful thatmany simulations can be run and so allows a large range of scenarios to becovered. However, large-scale movements can be hard to capture. |
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What methods areavailable to capture the fat-tail nature of asset returns? Are there anydrawbacks to these approaches? |
Extremevalue theory and student-t methods are useful for capturing fat tails. However,these methods can actually overestimate potential losses, leading to greaterrisk-aversion than necessary. Hence, portfolio managers may miss out on asuperior risk-return trade-off and underperform competitors. |
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What riskmanagement lessons do you believe can be learned from the financial crisis?Does this matter for portfolio construction? Explain. R-H-I F-C-O |
Riskmanagement lessons from the financial crisis: -Reliance on only one or two models.· Poor risk reporting. -Human biases such as conformity andgreed led to firms overlooking investment fundamentals. -Implementation failures. Thesepast lessons matter for today’s portfolio managers. More emphasis should begiven to analysing portfolio positions under fat-tail events, with managers notrelying on only one or two risk metrics. Moreover, there should be proper andeffective communication of risk management procedures, in addition to clear,concise, and accurate risk management reporting. Finally, managers should alsogive weight to their own judgement and not solely rely on models. |
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CANT DO Q2. |
c |
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Spot rate formula = |
S(t)/(1-r) Recall that 100 basis points is 1% |
