Dena Pearson is a recent hire at a large international bank. She is working in the risk management group where she receives several assignments.
Pearson’s first assignment is to address an inquiry from a client, Joseph Varnet. Varnet is seeking the following information about value at risk or VAR:
?This month’s report states that using a 95 percent confidence level, the portfolio has an average daily VAR of $1 million. Please clarify what this means. I would like to know what happens to the VAR measure if the confidence level is increased to 99 percent and if the frequency is changed from daily to monthly.
In the notes, the report states that the VAR is based on the analytical or variance-covariance method. Has the bank considered using other methods of calculating VAR??
Pearson’s responds to Varnet’s inquiry as follows:
?The VAR calculation in the monthly report assumes 250 trading days in a year and indicates that the daily portfolio loss will likely exceed $1 million approximately twelve to thirteen times over a one year period. A change to a 99 percent confidence level would provide a lower VAR estimate.
The bank uses the analytical method because other methods have significant disadvantages. For example, the disadvantages of the historical simulation method are that the model:
1) is nonparametric; and
2) applies historical price changes to the current portfolio.?
Pearson’s second assignment is to evaluate the credit risk of the following positions:
1. A call option the bank purchased for $30. The current market price of the option is $35; and
2. A short position in a one-year forward contract with a forward price of $200 and six months remaining until expiry. The forward price was determined based on a risk-free rate of 5.5 percent. The current spot price of the underlying asset is $207.
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13. Pearson’s clarification of the meaning of the VAR measure in Varnet’s monthly report is
most likely:
A. correct.
B. incorrect because VAR represents a maximum loss that will not be exceeded.
C. incorrect because over a full year, the VAR will be exceeded on 5 or fewer days.
To address Varnet’s question regarding a change to a monthly VAR measure, Pearson’s
mostappropriate response would be that the VAR estimate for the portfolio would:
A. increase.
B. decrease.
C. not change.
An advantage of the bank’s method for estimating VAR is the:
A. simplicity of the method.
B. assumption returns are normally distributed.
C. ability to incorporate optionality into the analysis.
Are Pearson’s statements regarding the disadvantages of the historical method for estimating VAR
most likelycorrect?
A. Yes.
B. No, the first statement is not a disadvantage.
C. No, the second statement is not a disadvantage.
For the bank’s call option position, the amount at risk of a credit loss is
closestto:
A. $0.
B. $30.
C. $35.
The amount of potential credit risk in the forward contract position is
closestto:
A. $0.
B. $1.53.
C. $12.28.