Frank Meinrod is in charge of the risk management committee for Alpha Portfolio Managers. Recently, the value of one of the company’s bond positions has decreased due to a potential steep rate hike by the Federal Reserve. Meinrod believes that the rate hike will be moderate and that the decline in the bond portfolio value is temporary. Which of the following is the best action for Meinrod to take? Meinrod should advise the risk management committee that they should:
A) take no action at all. B) hedge the position by selling interest rate futures. C) hedge the position by buying interest rate futures.
As a risk measurement, value at risk may be superior to standard deviation because:
A) VAR may capture market participant’s attitudes towards risk more completely. B) the statistical properties of VAR are more widely understood. C) most market participants calculate VAR in the same manner.
Stress testing approaches are not constrained by many of the constraints associated with the traditional distribution based value at risk (VAR) approaches. Which of the following is an example of a constraint associated with the traditional VAR approach but NOT the stress testing approach? The traditional VAR approach:
A) places too high a probability on extreme events. B) ignores extreme events. C) places too small a probability on extreme events.
Tough one, i want to say B because it doesn’t consider the magnitude of the downside, but it does capture the percent chance of downside, just not the percent that goes below that downside, so I will say C.
" Recently, the value of one of the company’s bond positions has decreased due to a potential steep rate hike by the Federal Reserve"
I think that market anticipating say 2% hike in int rate by fed reserve, so market value declined
Meinrod believes that the rate hike will be moderate and that the decline in the bond portfolio value is temporary.
here Meinrod thinking that rate hike won’t as much as market anitcipated & it would be rather say 1% so bond prices will go up after hearing the announcement
Still if int rate is expcetd to increase we can make money by selling IRF (aka T futures), is in it?
VAR - at least using the Variance Covariance method = Expected Return - Factor * Std Deviation.
Factor - depends on the level of risk aversion / risk tolerance of the investor (institution). At a 95% level of significance [5% VAR] (Factor = 1.65) you are more risk tolerant than at a 99% level of significance [1% VAR] (Factor = 2.33).
For the first question, the guy thinks the increase won’t be as bad as everyone else expects, but shouldn’t he hedge against the possibility that he’s wrong?
For the second question, I thought B was the answer. I wasn’t sure if VaR captures participants’ attitudes completely since it doesn’t take into account the potential loss of an extreme, unlikely event. Don’t participants care about extreme, unlikely events? Also, it only focuses on downside risk, so it’s not complete as a risk measure (but maybe the point is that participants only care about downside risk?).
Statistical properties are not understood - because
it is a minimum loss condition. If someone told you VaR was 1 Million per day - without knowing what you know about VaR - you would think Maximum Loss is 1 Mill $ per day. But that it is Minimum loss - and that the maximum loss could be much higher - makes its properties not understood.
Most market participants have different assumptions / different ways of calculating VaR. So C) is also not right.
In the first question - if you hedged and rates went the other way - you would lose. However since the condition is temporary (self reverting) - you do not need to hedge.
Thanks cpk, and regarding the first question, the investor is long a bond, so if he hedges by shorting an interest rate future, he’s fine no matter what. If his prediction pans out that rates won’t increase as much as thought, his long position goes up and his short cancels out. If his prediction doesn’t pan out and rates do increase as predicted, then nothing happens. If his prediction is way off and rates increase even more than expected, his long position goes down but his short futures goes up.
So either way, he’s protected? I see what you mean by temporary/self-reverting implying no need to hedge, but the question states that he believes it’s temporary, not that he knows it’s temporary. What if his belief is wrong?
I don’t want to be too cynical…Analytical VAR uses Standard Deviation. z-score is also based on normality assumption while R is just a return. VAR may add some value but its major input is the standard deviation. Histocal VAr and MC are no better, since they focus on the left tail only. The standard deviation reflects the volatility on both sides.
not on a futures contract. If the rate goes in the opposite direction - he pays out. If it goes in the direction he anticipates - he gets paid.
that is a key difference between a forward / future and a Option contract. In an option contract - it is one sided … but a futures / forward contract is two sided.
But if the rate goes in the opposite direction, yes he has to pay on the future, but his long bond position will increase in value too, so it cancels out?
if he had instead left it standing - his bond position would have increased … and he did not have to pay out.
that is the crucial point. Unlike with an option - he would have paid the premium and been left with a profit - since option expired OTM. But with the futures - he needs to pay out… so he loses.
that is the reason… when the change is temporary - they state - do nothing might be the better approach.
Makes sense cpk, but i don’t know, the wording says he believes the change is temporary. If it were guaranteed, then sure it makes sense to me, but in this case, his belief could turn out wrong.