Practice Question #87.2 (Dowd Ch 3, 4, 5, &7)

[mcarthur724]

I have a quick question about question #87.2 in the Market Risk practice questions. I couldn't figure out why I was getting the question wrong, and then I noticed in your spreadsheet solution that the threshold (u) = 4.0% needs to be entered into the equation as "4" instead of as ".04". Once I changed this accordingly in my formula then I was able to get the answer that you gave of 7.40% for the POT VaR. I just want to confirm with you that this treatment of the (u) = 4.0% that is shown in the answer is accurate, and that it isn't an error in the answer, because it seems strange to me that we wouldn't add .04 in the end of the formula for the 4% threshold, especially since all of the other inputs that are percentages (such as the confidence of 99.5% and the Nu/N of 10% we do treat as percentages in the formula). If you could just verify for me that the answer is correct as given and that the method shown in the answer is accurate that would be great. I want to make sure that I do it correctly if this type of question appears on the exam. Thanks David!

 

[David Harper CFA FRM]

Hi Mcarthur,

Good point, I think my answer is at least correct in the sense it matches the assignment, Dowd page 203. I'm not original: I just wrote a variation on his example 7.5 which uses his formula 7.22.
I noticed this too, and frankly, I am not sure exactly why he does it this way. You will see that I included, in the the second tab of the XLS, the replication of Dowd's example 7.5 (it's there because on difficult questions like these i try not to vary from the source or i will easily create new mistakes.). My second tab matches Dowd's output EXACTLY, and there he has a threshold of 2.0% yet it becomes an input of 2.0. (I remain satisfied my backup XLS must be correct as i match all four of his answers to three decimals!)

You are right, of course, about the inconsistency with the other inputs. Although, on casual inspection, they appear to cancel in two sets of numerator/denominator. I think, my raw guess, is that either (i) the threshold really should be 4.0 (and example 7.5 should be threshold = 2.0 rather than 2.0%) or (ii) one of the other parameters is implicitly re-scaled (i.e., as suggested by your calcs I'd imagine, you can't just replace the 4 with 0.04 and get a 7.404 ... and i don't see an obviously similar rescaling).

I haven't spent the time to re-derive his original equation. So, for the moment my "weak defense" is that i am following Dowd because i'm unsure how to easily make the input, in this case the 0.04 that (I agree) it really seems like it should be. Thanks, David

 

[mcarthur724]

Thanks for the explanation David!