AIMs: Explain the following lessons on VaR implementation: time horizon over which VaR is estimated, the recognition of time varying volatility in VaR risk factors, and VaR backtesting. Describe exogenous and endogenous liquidity risk and explain how they might be integrated into VaR models.
Questions:
404.1. According to to the Basel Committee, each of the following is true as a lesson on value at risk (VaR) implementation EXCEPT which is false?
a. There is no unique solution to the problem of the appropriate or ideal time horizon for risk measurement; i.e., the horizon depends on characteristics of the asset portfolio and the economic purpose of measuring its risk
b. Scaling of short-horizon VaR to a longer time horizon with the commonly used square-root of-time scaling rule (e.g., one day to ten days per regulatory capital requirements) does tend to produce an accurate approximation
c. Incorporating time-varying volatility in VaR appears to be necessary given that it is prevalent in many financial risk factors
d. Backtests that focus on the number of VaR violations have low power when the number of VaR exceptions is small, but the power of backtests can be improved modestly through the use of conditional backtests.
404.2. Which is true about the endogenous component of liquidity risk?
a. It corresponds to the average transaction costs set by the market for standard transaction sizes
b. Compared to the exogenous liquidity component, it is EASIER to incorporate into the valuation of trading portfolios (and, by convention, it generally is incorporated)
c. As it is the elasticity of price to volume, it can be impacted by market conditions (e.g., flight to quality) and margin requirements
d. Compared to the exogenous liquidity component, it is LESS RELEVANT for complex or exotic positions and/or under stress (extreme) conditions
404.3. An asset with a mid-price of $390.00 has a mean spread of $3.90 or 1.0%, and the spread has a standard deviation of $0.780 (20 basis points or 0.20%). If the spread is normally distributed, which is nearest to the dollar cost of the exogenous liquidity component; i.e., the liquidity cost not including VaR, but which will be added to VaR to produce an LVaR estimate?
a. $2.86
b. $4.25
c. $7.30
d. $15.10
Answers here:
Questions:
404.1. According to to the Basel Committee, each of the following is true as a lesson on value at risk (VaR) implementation EXCEPT which is false?
a. There is no unique solution to the problem of the appropriate or ideal time horizon for risk measurement; i.e., the horizon depends on characteristics of the asset portfolio and the economic purpose of measuring its risk
b. Scaling of short-horizon VaR to a longer time horizon with the commonly used square-root of-time scaling rule (e.g., one day to ten days per regulatory capital requirements) does tend to produce an accurate approximation
c. Incorporating time-varying volatility in VaR appears to be necessary given that it is prevalent in many financial risk factors
d. Backtests that focus on the number of VaR violations have low power when the number of VaR exceptions is small, but the power of backtests can be improved modestly through the use of conditional backtests.
404.2. Which is true about the endogenous component of liquidity risk?
a. It corresponds to the average transaction costs set by the market for standard transaction sizes
b. Compared to the exogenous liquidity component, it is EASIER to incorporate into the valuation of trading portfolios (and, by convention, it generally is incorporated)
c. As it is the elasticity of price to volume, it can be impacted by market conditions (e.g., flight to quality) and margin requirements
d. Compared to the exogenous liquidity component, it is LESS RELEVANT for complex or exotic positions and/or under stress (extreme) conditions
404.3. An asset with a mid-price of $390.00 has a mean spread of $3.90 or 1.0%, and the spread has a standard deviation of $0.780 (20 basis points or 0.20%). If the spread is normally distributed, which is nearest to the dollar cost of the exogenous liquidity component; i.e., the liquidity cost not including VaR, but which will be added to VaR to produce an LVaR estimate?
a. $2.86
b. $4.25
c. $7.30
d. $15.10
Answers here:
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