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risk management financial

Questions and Answers of Risk Management Financial

7. Downgrade risk is the risk that an issue will be downgraded, resulting in an increase in the credit spread.
6. At the micro level, the analysis of a potential change in the credit spread focuses on the fundamental factors that have changed the individual issuer’s ability to meet its debt obligations.
5. At the macro level, the empirical evidence suggests that economic cycle affects credit spreads—in general, spreads tighten during the early stages of an economic expansion, and spreads widen
4. Credit spread risk is the risk of financial loss or underperformance resulting from changes in the level of credit spreads used in the marking-to-market of a product.
3. The credit spread is the excess premium over the government or risk-free rate required by the market for taking on a certain assumed credit exposure.
2. Credit default risk is the risk that an issuer of debt (obligor) is unable to meet its financial obligations.
1. There are two main forms of credit risk: credit spread risk and credit default risk.
10. Explain how tracking error due to quality risk and tracking error due to nonsystematic risk can be used to assess the exposure of a bond portfolio to credit risk.
9. Introduce how to integrate credit risk and interest rate risk using VaR.
8. Discuss applications of credit VaR.
7. Explain the concepts for calculating a credit value-at-risk (credit VaR).
6. Describe the different methodologies used in two credit risk measurement models, CreditMetrics and CreditRisk+.
5. Introduce the concept of modeling credit risk and how credit returns exhibit different patterns than market returns that reflect only interest rate risk.
4. Describe default rates, recovery rates, and default loss rate.
3. Describe a rating transition table and how it can be used to assess the risk of a change in credit rating of an issuer or a bond issue.
2. Describe credit ratings and their role.
1. Introduce the various types of credit risk–credit default risk and credit spread risk.
26. A flattening yield curve reduces the value of an interest rate cap, and therefore a cap has negative slope elasticity; an interest rate floor benefits if the yield curve flattens and therefore
25. Since yield curve options can be structured in numerous ways, a portfolio manager has flexibility in controlling slope risk.
24. An interest rate swap can have either positive or negative slope elasticity, depending on the maturity of the swap.
23. Both the yield curve slope elasticity and effective duration of futures contracts have slope sensitivities that differ in magnitude as well as direction and therefore a portfolio manager should
22. A portfolio manager who has a long position in an MBS derivative with positive slope elasticity could establish a position that would gain if the curve flattens, simply by shorting bonds.
21. The slope exposure of potential hedging instruments must be estimated in order to control yield curve risk.
20. Yield curve slope risk and duration risk can, for the most part, be managed independently because the correlation of changes in the level of rates and yield curve slope is very low.
19. Given the exposure of each MBS derivative in a portfolio, a manager should be able to make an informed decision about what kind of hedge to put on or how to manage that risk.
18. A PO strip increases in value if the yield curve flattens, and decreases in value if the yield curve steepens.
17. An IO strip is one of the few bonds that a portfolio manager can use to counteract positive slope elasticity.
16. IOs are a good hedge for a portfolio that has considerable positive slope elasticity (i.e., a portfolio that benefits if the curve flattens and loses if it steepens).
15. The two most important factors to consider in evaluating the slope exposure of an inverse floater are its price (i.e., its tendency to benefit/suffer if prepayment rates increase) and the
14. The primary effect of a change in yield curve slope on a floater is through the value of embedded options.
13. Only two of the three components determining net slope exposure are relevant for a pro rata Libor floater since the value of a floater is relatively unaffected by the impact on discount rates
12. An interesting feature of many MBS derivatives is that slope exposure tends to be asymmetric.
11. The net slope exposure of an MBS derivative is the sum of the three slope components.
10. To examine the slope exposure of a particular MBS derivative, the impact of changes in discount rates, projected prepayment rates(cash flows), and embedded caps and floors on the bond’s value
9. It is difficult to generalize about the slope exposure of individual MBS derivatives because the exposure is specific to the actual deal or structure from which the bond was created.
8. CMO and mortgage strips (IOs and POs) are particularly sensitive to changes in the yield curve.
7. Yield curve risk is defined as the exposure of the bond to changes in the slope of the yield curve.
6. A bond or portfolio that benefits when the yield curve flattens is said to have positive slope elasticity; a bond or a portfolio that benefits when the yield curve steepens is said to have
5. The slope elasticity is defined as the approximate negative percentage change in a bond’s price resulting from a 100-basis-point change in the slope of the curve.
4. Changes in the yield curve can be defined as follows: Half of any basis point change in the yield curve slope results from a change in the 3-month yield and half from a change in the 30-year yield.
3. The yield curve slope can be defined as the spread between the long-term Treasury (i.e., the 30-year on-the-run issue) and the short-term Treasury (i.e., the 3-month on-the-run issue).
2. A simple approach to quantify the yield curve risk of an MBS portfolio is the slope elasticity measure.
1. Duration and convexity can be used to measure the level risk exposure of an MBS portfolio.
6. Demonstrate the steps that a manager can follow to measure and control level and yield curve risk exposures of an MBS portfolio.
5. Look at the yield curve risk for different potential hedging instruments.
4. Look at the yield curve risk for different types of MBS derivative products.
3. Demonstrate the importance of yield curve risk for an MBS.
2. Explain what is meant by positive and negative slope elasticity.
1. Review the slope elasticity measure of yield curve risk.
42. Floors can be used by buyers of floating-rate instruments to set a floor on the periodic interest earned and the sale of a cap can reduce the cost of a floor.
41. Combining a cap and a floor creates a collar for funding costs.
40. Interest rate caps can be used in liability management to create a cap for funding costs.
39. An asset swap can be created by an investor by buying a creditrisky bond and entering into an interest rate swap as the fixed-rate payer or by an investor selling a credit-risky bond purchased to
38. An asset swap allows an investor to alter the cash flow character of an asset.
37. A position in a swap can expose a position to greater interest rate risk if it is not coupled with a swaption.
36. An interest rate swap can be used to hedge interest rate risk by altering the cash flow characteristics of a portfolio of assets so as to match asset and liability cash flows.
35. When using Treasury bond futures options, the hedge ratio is based on the relative dollar duration of the current portfolio, the cheapestto-deliver issue, and the futures contract at the option
34. For a cross hedge, the manager will want to convert the strike price on the options that are actually bought or sold into an equivalent strike price for the actual bonds being hedged.
33. The best options contract to use depends upon the option price, liquidity, and correlation with the bond(s) to be hedged.
32. A collar strategy is a combination of a protective put strategy and a covered call writing strategy that eliminates part of the portfolio’s downside risk by giving up part of its upside
31. It is not possible to say that the protective put strategy or the covered call writing strategy is necessarily the better or more correct options’hedge since it depends upon the manager’s
30. A covered call writing strategy entails much more downside risk than buying a put to protect the value of the portfolio and many portfolio managers do not consider covered call writing a hedge.
29. A covered call writing strategy involves selling call options against the bond portfolio.
28. A manager can use a protective put buying strategy—a combination of a long put option with a long position in a cash bond—to hedge against rising interest rates.
27. Three popular hedge strategies are the protective put buying strategy, the covered call writing strategy, and the collar strategy.
26. After a target is determined and a hedge is established, the hedge must be monitored during its life and evaluated after it is over and the sources of error in a hedge should be determined in
25. Hedging non-Treasury securities with Treasury bond futures requires that the hedge ratio consider two relationships: (1) the cash price of the non-Treasury security and the cheapest-to-deliver
24. Hedging substitutes basis risk for price risk.
23. Basis risk refers only to the uncertainty associated with the target rate basis or target price basis.
22. The proper target for a hedge that is to be lifted prior to the delivery date depends on the basis.
21. When a hedge is lifted prior to the delivery date, the effective rate (or price) that is obtained is much more likely to approximate the current spot rate than the futures rate the shorter the
20. Hedging with Treasury bond futures and Treasury note futures is complicated by the delivery options embedded in these contracts.
19. In general, when hedging to the delivery date of the futures contract, a manager locks in the futures rate or price.
18. The basis is the difference between the spot price (or rate) and the futures price (or rate).
17. The hedge ratio is the number of futures contracts needed for the hedge.
16. The target rate, the hedge effectiveness, and the residual hedging risk determine the basic trade-off between risk and expected return and these statistics give the manager the information needed
15. The manager should estimate the residual hedging risk, which is the absolute level of risk in the hedged position and indicates how much risk remains after hedging.
14. The manager should estimate the hedge effectiveness, which indicates what percent of risk is eliminated by hedging.
13. The manager should determine the target rate or target price, which is what is expected from the hedge.
12. A short or sell hedge is used to protect against a decline in the cash price of a bond; a long or buy hedge is employed to protect against an increase in the cash price of a bond.
11. Cross hedging occurs when the bond to be hedged is not identical to the bond underlying the futures contract.
10. Hedging is a special case of controlling interest rate risk in which the target duration or target dollar duration is zero.
9. Hedging with futures calls for taking a futures position as a temporary substitute for transactions to be made in the cash market at a later date, with the expectation that any loss realized by
8. The number of futures contracts needed to achieve the target dollar duration depends on the current dollar duration of the portfolio without futures and the dollar duration per futures contract.
7. The general principle in controlling interest rate risk with futures is to combine the dollar exposure of the current portfolio and that of a futures position so that it is equal to the target
6. The advantages of adjusting a portfolio’s duration using futures rather than cash market instruments are transactions costs are lower, margin requirements are lower, and it is easier to sell
5. Buying an interest rate futures contract increases a portfolio’s duration; selling an interest rate futures contract decreases a portfolio’s duration.
4. The key factor to determine which derivative instrument or instruments to use is the degree of correlation between the rate underlying the derivative instrument and the rate that creates the risk
3. There are four preliminary steps that should be taken before a risk control strategy is initiated so that a manager can assess what a hedge strategy can and cannot accomplish.
2. A micro risk control strategy can be implemented to control the risk of an individual bond or a group of bonds with similar characteristics.
1. A macro risk control strategy is one used to control the interest rate risk of a portfolio without regard to the price movement of any individual bond comprising the portfolio.
4. Assess the potential outcome of the risk control strategy.
3. Determine the position that should be taken in a risk control instrument.
2. Determine the objectives of the strategy.
1. Determine which instruments are the most appropriate to employ to control risk.
10. Explain how caps and floors can be used.
9. Explain what an asset swap is.
8. Illustrate how an interest rate swap and a swaption can be used to alter the risk exposure of a position.
7. Illustrate the complexities associated with hedging with futures options.
6. Explain the basic principles of three common hedge strategies employing options—the protective put buying strategy, covered call writing strategy, and collar strategy.

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