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risk management financial

Questions and Answers of Risk Management Financial

7. A discrete probability distribution is one in which the random variable can only take on specific values, while a random variable can take on any possible value within the range of outcomes for a
6. The greater the standard deviation, the greater the variability of the random variable around the expected value.
5. The standard deviation is the square root of the variance.
4. Variance is a measure of the dispersion of the random variable around its expected value.
3. The expected value of a probability distribution is the weighted average of the distribution.
2. A probability distribution describes all the values that the random variable can take on and the probability associated with each.
1. A random variable is a variable for which a probability can be assigned to each possible value that can be taken by the variable.
6. Describe how a probability distribution can be obtained using Monte Carlo simulation.
5. Describe what a skewed distribution is.
4. Demonstrate several applications of the normal probability distribution.
3. Describe the fundamental properties of the normal probability distribution.
3. Explain how to calculate the variance and standard deviation.
2. Describe what a probability distribution is.
1. Explain what is meant by a random variable.
14. Using principal component analysis, a portfolio manager can determine likely yield curve shifts and use those shifts to assess the exposure of a portfolio to yield curve risk.
13. With slope elasticity, changes in the yield curve are 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
12. Slope elasticity looks at the sensitivity of a position or portfolio to changes in the slope of the yield curve and is defined as the approximate negative percentage change in a bond’s price
11. Key rate duration measures how changes in Treasury yields at different points on the spot rate curve affect the value of a bond.
10. A simple approach to measuring yield curve risk, an approach commonly used by index managers, is an analysis of the cash flow distribution of a portfolio relative to a benchmark.
9. One of the systematic factors that affects forward-looking tracking error is term structure factor risk and it is this risk that measures a bond portfolio’s exposure to yield curve risk.
8. Backward-looking tracking error measures the tracking error based on actual active returns; forward-looking tracking error measures the potential tracking error of a portfolio.
7. Tracking error measures the standard deviation of the active returns of a portfolio relative to a benchmark.
6. Exposure of a portfolio or position to a shift in the yield curve is called yield curve risk.
5. For a nonparallel shift in the yield curve, duration and convexity do not provide adequate information about the interest rate risk exposure.
4. When using a portfolio’s duration and convexity to measure the exposure to interest rates, it is assumed that the yield curve shifts in a parallel fashion.
3. A parallel shift in the yield curve means that the yield for all maturities change by the same number of basis points.
2. Historically, the types of yield curve shifts that have been observed are a parallel shift, a change in slope of the yield curve, and a change in the curvature of the yield curve.
1. Four shapes have been observed for the Treasury yield curve:upward sloping, inverted, flat, and humped.
7. Explain the likely yield curve shift approach to managing yield curve risk.
6. Explain the slope elasticity measure of yield curve risk.
5. Explain key rate duration as a measure of yield curve risk.
4. Describe the cash flow distribution analysis approach for measuring yield curve risk.
3. Explain what tracking error is and how yield curve risk can be measured in terms of tracking error.
2. Demonstrate why duration and convexity do not provide information about the interest rate risk of a portfolio if the yield curve does not shift in a parallel fashion.
1. Describe the types of shifts that have been observed for the yield curve.
27. When contemplating an intermarket spread swap or a substitution swap, it is critical to keep the dollar duration of the portfolio constant.
26. For a manager pursuing a rate expectations strategy, the portfolio duration relative to the bond index will be increased if interest rates are expected to fall and the duration will be reduced
25. A rate expectations strategy involves positioning the duration of a portfolio based on whether rates are expected to increase or decrease.
24. The greater the expected yield volatility, the greater the interest rate risk for a given duration and current value of the position.
23. The yield value of a price change is determined by calculating the difference between the yield to maturity if the bond’s price was increased/decreased by one tick.
22. The price value of a basis point is the absolute value of the change in the price of a bond for a 1-basis-point change in yield.
21. The convexity measure means nothing in isolation; it is the convexity adjustment that is important.
20. The estimate of a bond’s price sensitivity based on duration can be improved by using a bond’s convexity measure.
19. Empirical duration uses historical price series for MBS and data on Treasury yields to statistically estimate duration.
18. A portfolio’s duration is obtained by calculating the weighted average of the durations of the bonds in the portfolio.
17. The duration measure is only as good as the valuation model from which it is derived.
16. The difference between modified duration and effective duration for bonds with embedded options can be significant.
15. Effective duration is the approximate percentage price change of a bond for a 100-basis-point parallel shift in the yield curve allowing the cash flow to change in response to the change in yield.
14. Modified duration is not a useful measure of the price sensitivity for bonds with embedded options.
13. The dollar duration of a bond measures the dollar price change when the required yield changes.
12. The size of the interest rate shock is unimportant for approximating the duration of option-free bonds.
11. Modified duration is the slope of a tangent line to the price/yield relationship.
10. Modified duration is the approximate percentage change in a bond’s price for a 100-basis-point parallel shift in the yield curve assuming that the bond’s cash flow does not change when the
9. The percentage price change of a bond can be estimated by changing the yield by a small number of basis points and observing how the price changes.
8. For a given change in yield, price volatility is lower when yield levels in the market are high than when yield levels are low.
7. For a given coupon rate and initial yield, the longer the term to maturity, the greater the price volatility.
6. For a given term to maturity and initial yield, the lower the coupon rate the greater the price volatility of a bond.
5. The coupon and maturity of an option-free bond affect its price volatility.
4. A property of an option-free bond is that for a given change in basis points, the percentage price increase is greater than the percentage price decrease.
3. A property of an option-free bond is that for a large change in yield, the percentage price change is not the same for an increase in yield as it is for a decrease in yield.
2. A property of an option-free bond is that for a small change in yield, the percentage price change is roughly the same whether the yield increases or decreases.
1. The price/yield relationship for an option-free bond is convex.
11. Explain how to control interest rate risk in active bond portfolio strategies.
10. Explain price value of a basis point and yield value of a price change.
9. Explain market-based approaches for estimating duration of a mortgagebacked security.
8. Explain how the duration of a floater and inverse floater are determined.
7. Describe the relationship between Macaulay duration and modified duration.
6. Explain what the convexity measure of a bond is and the distinction between modified convexity and effective convexity.
5. Explain what is meant by negative convexity for a callable bond, a mortgage passthrough security, and asset-backed securities backed by residential mortgages.
4. Distinguish between modified duration, effective duration, and dollar duration.
3. Explain why the traditional duration measure, modified duration, is of limited value in determining the duration of a security with an embedded option.
2. Provide a general formula that can be used to calculate the duration of any security.
1. Illustrate the price volatility properties of an option-free bond.
35. Information about the distribution of the present value for the interest rate paths provides guidance as to the degree of uncertainty associated with the theoretical value derived from the Monte
34. In the Monte Carlo method, the option-adjusted spread is the spread that, when added to all the spot rates on all interest rate paths, will make the average present value of the paths equal to
33. The theoretical value of a security is the average of the theoretical values over all the interest rate paths.
32. The theoretical value of a security, on any interest rate path, is the present value of the cash flow on that path where the spot rates are those on the corresponding interest rate path.
31. The Monte Carlo method applied to mortgage-backed securities involves randomly generating a set of cash flows based on simulated future mortgage refinancing rates.
30. The random paths of interest rates should be generated from an arbitrage-free model of the future term structure of interest rates.
29. The Monte Carlo method involves randomly generating many scenarios of future interest rate paths based on some volatility assumption for interest rates.
28. The cash flow of mortgage-backed securities is path dependent and consequently the Monte Carlo method is commonly used to value these securities.
27. The option-adjusted spread is the constant spread that when added to the short rates in the binomial interest rate tree will produce a valuation for the bond equal to the market price of the bond.
26. In valuing a bond using the binomial interest rate tree, the cash flows at a node are modified to take into account any embedded options.
25. The uncertainty of interest rates is introduced into the model by introducing the volatility of interest rates.
24. The binomial method involves generating a binomial interest rate tree based on (1) an issuer’s on-the-run yield curve, (2) an assumed interest rate generation process, and (3) an assumed
23. The user of a valuation model is exposed to modeling risk and should test the sensitivity of the model to alternative assumptions.
22. The spread is option adjusted because it allows for future interest rate volatility to affect the cash flows.
21. The option-adjusted spread (OAS) converts the cheapness or richness of a bond into a spread over the future possible spot rate curves.
20. The methodologies seek to determine the fair or theoretical value of the bond.
19. There are two valuation methodologies that are being used to value bonds with embedded options: the binomial method and the Monte Carlo simulation method.
18. The zero-volatility spread is a measure of the spread that the investor would realize over the entire Treasury spot rate curve if the bond were held to maturity.
17. The nominal spread is the difference between the yield of a non-Treasury and the yield on a comparable maturity benchmark Treasury security.
16. Adding the zero-coupon credit spread for a particular credit quality within a sector to the Treasury spot rate curve gives the benchmark spot rate curve that should be used to value a security.
15. Evidence suggests that the credit spread increases with maturity and the lower the credit rating, the steeper the curve.
14. To value a security with credit risk, it is necessary to determine a term structure of credit risk or equivalently a zero-coupon credit spread.
13. The economic force that assures that Treasury securities will be priced based on spot rates is the opportunity for government dealers to profitably strip Treasury securities or for investors to
12. From a Treasury spot rate curve, the value of any default-free security can be determined.
11. One approach to constructing the spot rate curve is bootstrapping, the basic principle of which is that the value of the cash flow from an on-the-run Treasury issue when discounted at the spot
10. Since the U.S. Treasury does not issue zero-coupon securities with a maturity greater than one year, a theoretical spot rate (i.e., zerocoupon rate) curve must be constructed from the yield curve.
9. The Treasury yield curve indicates the relationship between the yield on Treasury securities and maturity. However, the securities included are a combination of zero-coupon instruments, that is,

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