Risk & Return Analysis

• Topic 01

  Risk & Return Analysis

  99 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. What is Value at Risk (VaR) and what does a 1-day 95% VaR of £10,000 mean?

   • A
     VaR estimates the maximum loss over a time period at a given confidence level; a 1-day 95% VaR of £10,000 means there is a 5% probability of losing more than £10,000 in a single day
     Correct answer
   • B
     A 1-day 95% VaR of £10,000 means there is a 95% probability of losing more than £10,000 in a single day
   • C
     VaR provides a threshold such that losses exceeding £10,000 in a single day are extremely unlikely to occur
   • D
     A 1-day 95% VaR of £10,000 means losses of exactly £10,000 will occur on 5% of trading days
   Explanation

   Value at Risk (VaR) is a widely used risk measure that estimates the potential loss on a portfolio over a specified time period at a specified confidence level. A 1-day 95% VaR of £10,000 means that under normal market conditions, there is a 5% probability of losing MORE than £10,000 in a single trading day (or equivalently, a 95% probability that losses will not exceed £10,000 in a day). Key limitation: VaR says nothing about the SIZE of losses beyond the threshold — losses could be £11,000 or £100,000, and VaR does not distinguish. This is addressed by Conditional VaR (CVaR or Expected Shortfall), which measures the expected loss given that VaR has been breached.

2. What is Conditional VaR (CVaR, also known as Expected Shortfall) and what limitation of standard VaR does it address?

   • A
     CVaR is the VaR calculated using historical simulation rather than the parametric method; it addresses the normal distribution assumption in standard VaR
   • B
     CVaR is the Value at Risk calculated for a portfolio held for one year rather than one day; it addresses the limitations of short time horizons in standard VaR
   • C
     CVaR is the conditional probability that a loss will occur, given current market conditions; it improves on VaR by incorporating real-time market data
   • D
     CVaR is the expected average loss in scenarios where the loss exceeds the VaR threshold; it addresses VaR's key limitation of saying nothing about the magnitude of losses beyond the threshold (tail risk)
     Correct answer
   Explanation

   Standard VaR (e.g., '1-day 95% VaR = £100,000') tells you the loss level that will NOT be exceeded 95% of the time, but says nothing about how large losses could be in the remaining 5% of scenarios — the tail. CVaR (Expected Shortfall) addresses this by calculating the expected (average) loss in those worst 5% of scenarios. If the worst 5% of scenarios involve losses of £150,000 to £1,000,000, CVaR gives the average of these, say £300,000. CVaR is considered a more complete risk measure and is required under Basel III for trading book capital requirements.

3. Which of the following best illustrates regulatory risk as an investment risk factor?

   • A
     A pharmaceutical company loses a patent challenge, allowing generic competitors to enter the market
   • B
     A central bank raises interest rates, increasing borrowing costs across the economy
   • C
     A rise in global oil prices increases costs for an airline, reducing its profitability
   • D
     A government introduces a windfall tax on energy company profits, reducing dividend payments and depressing the share prices of energy stocks
     Correct answer
   Explanation

   Regulatory risk arises when changes in laws, regulations, or government policy adversely affect an investment. The windfall tax directly illustrates this: a legislative decision reduces returns for investors in the energy sector. Rising oil prices is commodity/input cost risk; patent loss is business risk; interest rate rises represent monetary policy/interest rate risk.