Hull: Options, Futures, and Other Derivatives, Tenth Edition

Chapter 22: Value at Risk and Expected Shortfall

Multiple Choice Test Bank: Questions with Answers

1. Which of the following is true of the 99.9% value at risk?

A. There is 1 chance in 10 that the loss will be greater than the value of risk
B. There is 1 chance in 100 that the loss will be greater than the value of risk
C. There is 1 chance in 1000 that the loss will be greater than the value of risk
D. None of the above

Answer: C

A 99.9% VaR means that there is a 0.1% chance of the loss exceeding the VaR level. This is 1
chance in 1000.

2. The gain from a project is equally likely to have any value between -$0.15 million and +$0.85
million. What is the 99% value at risk?
A. $0.145 million
B. $0.14 million
C. $0.13 million
D. $0.10 million

Answer: B

The gain is uniformly distributed between −0.15 and +0.85 million dollars. The probability
that it will be between −0.15 and −0.14 million dollars is therefore 1%. This means that
there is a 99% chance that the loss will not be greater than $0.14 million. This is the 99%
VaR.

3. The gain from a project is equally likely to have any value between −$0.15 million and +$0.85
million. What is the 99% expected shortfall?
A. $0.145 million
B. $0.14 million
C. $0.13 million
D. $0.10 million

Answer: A

As explained in the answer to the previous question the VaR level is $0.14 million.
Conditional on the loss being greater than $0.14 million it is equally likely to have any value
between $0.14 million and $0.15 million. The expected loss conditional that it is greater
than $0.14 million is therefore $0.145 million. This is the expected shortfall.

4. Which of the following is true of the historical simulation method for calculating VaR?
A. It fits historical data on the behavior of variables to a normal distribution
B. It fits historical data on the behavior of variables to a lognormal distribution
C. It assumes that what will happen in the future is a random sample from what has
 happened in the past
D. It uses Monte Carlo simulation to create random future scenarios

Answer: C

The historical simulation method assumes that the percentage changes in all market
variables during the next day is a random sample from the percentage changes in a certain
number of past days.

5. The 10-day VaR is often assumed to be which of the following

A. The 1-day VaR multiplied by 10
B. The 1-day VaR multiplied by the square root of10
C. The 1-day VaR divided by 10
D. The 1-day VaR divided by the square root of 10

Answer: B

The Basel committee rules allow the 10-VaR to be calculated as the one-day VaR multiplied
by the square root of 10. This is exactly true when losses on successive days have
independent normal distributions with mean zero.

6. Which was the minimum capital requirement for market risk in the 1996 BIS Amendment?
A. At least 3 times the 10-day VaR with a 99% confidence level
B. At least 3 times 7-day VaR with a 97% confidence level
C. At least 2 times 5-day VaR with a 95% confidence level
D. 1-day VaR with a 99% confidence level

Answer: A

The 1996 amendment calculated capital as k times the 10-day 99% VaR where k was at least
3.

7. An investor has $2,000 invested in stock A and $5,000 in stock B. The daily volatilities of A and B
are 1.5% and 1% respectively and the coefficient of correlation is 0.8. What is the one day 99%
VaR? Assume that returns are multivariate normal (Note that N(-2.326)=0.01)
A. $177
B. $135
C. $215
D. $331

Answer: A

The standard deviation of the change in the stock A position in one day is 2,000×0.015= $30.
The standard deviation of the change in the value of the stock B position in one day is
5,000×0.01 = $50. The variance of the combined position is 30 2+502+2×0.8×30×50 = 5,800.
The standard deviation is the square root of this or 76.16 and the 99% VaR is therefore 2.326
 times 76.16 this or about $177.

8. What is the method of testing how often a VaR with a certain confidence level was exceeded in
the past called?
A. Stress testing
B. Back testing
C. EWMA
D. The model-building approach

Answer: B

Back testing involves examining how well a particular VaR methodology would have worked
in the past. It counts exceptions, which are situations where the VaR level that would have
been calculated, was exceeded.

9. Which of the following is true when delta, but not gamma, is used in calculating VaR for option
positions?
A. VaR for a long call is too low and VaR for a long put is too low
B. VaR for a long call is too low and VaR for a long put is too high
C. VaR for a long call is too high and VaR for a long put is too low
D. VaR for a long call is too high and VaR for a long put is too high

Answer: D

When gamma is ignored, VaR for long option positions is too high and VaR for short option
positions is too low. This is demonstrated for calls in Figures 22.5 and 22.6. The same can
easily be seen to be true for puts.

10. Which of the following is true?

A. The quadratic model approximates daily changes using delta and gamma
B. The quadratic model approximates daily changes using delta, but not gamma
C. The quadratic model approximates daily changes using gamma, but not delta
D. None of the above

Answer: A

The quadratic model uses delta and gamma to approximate daily changes as described in
Section 22.5

11. Which of the following is true?

A. Cash flow mapping is a way of calculating the present value of cash flows
B. Cash flow mapping is used to handle interest rate exposures in the model building
approach
C. Cash flow mapping is used to handle interest rate exposures in the historical simulation
approach
D. None of the above
 Answer: B

Cash flow mapping is a way to handle interest rates when the model building approach is
used. (See page 506-507)

12. Which of the following describes stressed VaR?

A. It is based on movements in market variables in stressed market conditions
B. It is VaR with a very high confidence level
C. It is VaR multiplied by a factor of 3
D. None of the above

Answer: A

Stressed VaR was introduced in Basel II.5. It calculates VaR based on movements in market
variables in stressed market conditions.

13. A German bank has exposure to the S&P500. Which of the following is true
A. The S&P 500 index should be always be measured in U.S. dollars when VaR is calculated
B. The S&P 500 index should be always be measured in euros when VaR is calculated
C. Either A or B can be done
D. The S&P 500 index should be measured in euros only if the bank has not got a U.S.
subsidiary.

Answer: B

All foreign assets should be measured in the domestic currency.

14. Which of the following is true of a covariance matrix?

A. The numbers on the diagonal are variances
B. The numbers on the diagonal are standard deviations
C. The numbers on the diagonal are all one.
D. The numbers on the diagonal are all zero

Answer: A

The diagonal numbers are variances. The off-diagonal numbers show the covariance
between two variables.

15. Consider a position in options on a particular stock. The position has a delta of 12 and the stock
price is 10. Which of the following is the approximate relation between the change in the
portfolio value in one day, dP, and the return on the stock during the day, dx
A. dP=12dx
B. dP=1.2dx
C. dP=120dx
D. dP=22dx

Answer: C
 If S is the stock price and the change in the stock price is dS, from the definition of delta we
know that dP=12dS. This means that dP=12S(dS/S). dS/S is dx. In this case S=10 so that C is
correct.

16. A position in options on a particular stock has a delta of zero and a gamma of 4. The stock price
is 10. Which of the following is the approximate relation between the change in the portfolio
value in one day, dP, and the return on the stock, dx
A. dP = 4 times the square of dx
B. dP = 2 times the square of dx
C. dP = 20 times the square of dx
D. dP = 200 times the square of dx

Answer: D

If S is the stock price and the change in the stock price is dS, the change in the portfolio value is
0.5×4×(dS)2. This is 2S2(dS/S)2. dS/S is dx. In this case S=10 so that D is correct.

17. In a principal components analysis which of the following is the quantity of a particular factor in
an observation
A. Factor loading
B. Factor score
C. Factor size
D. Factor rating

Answer: B

The quantity of a particular factor in the observation of changes on a particular day is known as
the factor score.

18. In the case of interest rate movements the most important factor corresponds to
A. A parallel shift
B. A slope change
C. A bowing
D. An increase in short rates
Answer: A

The most important factor is the one corresponding to a parallel shift. This accounted for over
90% of the variance for the data in Section 22.9.

19. In the case of interest rate movements the second most important factor corresponds to
A. A parallel shift
B. A slope change
C. A bowing
D. An increase in short rates

Answer: B
 The second most important factor is a slope change (or twist). In the example in Section 22.9
this accounted for about 7% of the variance in the data.

20. Which of the following is true

A. Expected shortfall is always less than VaR
B. Expected shortfall is always greater than VaR
C. Expected shortfall is sometimes greater than VaR and sometimes less than VaR
D. Expected shortfall is a measure of liquidity risk wheras VaR is a measure of market risk

Answer: B

Expected shortfall and VaR can both measure market risk. Expected shortfall is the expected loss
level conditional on the loss level being greater than VaR. By definition expected shortfall must
be greater than VaR.