Market risk Practice questions

Formulae
𝐃𝐚𝐢𝐥𝐲 𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐚𝐭 𝐫𝐢𝐬𝐤 = ($value of the positons) x (Price volatility)
Daily price volatility = Modified Duration (MD) x adverse daily move in yield
Modified duration (MD) = Maturity/ (1+r)
Adverse daily move in yield = Z-score of the distribution x Standard deviation of the movement
VAR = DEAR x √𝑁
Dollar equivalent value of FX position = Foreign exchange position x per unit foreign currency
DEAR of foreign exchange = Dollar market value of position x FX volatility
FX volatility = Z-score x the change in foreign exchange rates
DEAR = Dollar market value of position x stock market return volatility
Stock market return volatility = Z-score x standard deviation of the stock market volatility

1. Suppose an FI has a $1 million market value positon in zero-coupon bond of 7 years maturity
with a face value of $1,631,483. Today’s yield on these bonds is 7.243% per year. These bonds
are held as part of the trading portfolio. Assume that there is 5 percent chance that the yield
next day’s will decrease. The adverse move in yield is 10 basis points or 0.001.
A. Determine the DEAR of the bond.
1st step determine the Modified duration. Modified Duration (MD) = D/ (1+r) = 7/ (1+ 0.07243)
= 7/1.07243 = 6.527 years
2nd step find the potential yield movement (the change of Yield to maturity)
= Z-score x basis points change in yield = 1.65 x 0.001 = 0.00165
The confidence interval for the distribution of the yields of the bond is 90% and there is 5% chance
that the yield will decline. Therefore, the Z-score is 1.65
3rd step is to find the price sensitivity. Price sensitivity measures by how much the price of the
bond will change if the yield changes by certain basis point.
Price volatility = MD x yield movement = 6.527 x 0.00165 = 0.01077 or 1.077%
th
4 step is to find the Daily earnings at risk (DEAR). DEAR = Market value of the investment
position x Price volatility
= $ 1million x 0.01077 = $ 10,770.
If the yield of the bond has declined by 10 basis point, the bank will lose $10,770 of its bond
investment.
B. Compute the VAR of the FI if the FI holds the bond for 5 days.
Value at risk (VAR) = DEAR x √𝑁 = $10,770 x √5 = $24,082

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If the yield is expected to decline by 10 basis point and the bank kept the bond for 5 days, the bank
will lose $24,082.

2. Assume that ABC bank holds a 10-year bond with a market value of $612,900 with a yield of
8.05%. Assume that there is 5 percent chance that the yield next day will decline and expected
to be 20 basis points (0.002 or 0.2%). The daily bond returns of the bank are normally
distributed with a 90% confidence interval.
A. Determine the daily earning at risk (DEAR)?
1st step determine the Modified duration. Modified Duration (MD) = D/ (1+r) = 7/ (1+ 0.07243)
10
=1.0805 = 9.255 years
2nd step find the potential yield movement (the change of Yield to maturity)
= Z-score x basis points change in yield = 1.65 x 0.002 = 0.0033
The confidence interval for the distribution of the yields of the bond is 90% and there is 5% chance
that the yield will decline. Therefore, the Z-score is 1.65
3rd step is to find the price sensitivity. Price sensitivity measures by how much the price of the
bond will change if the yield changes by certain basis point.
Price volatility = MD x yield movement = 9.255 x 0.0033 = 0.0305 or 3.05%
4th step is to find the Daily earnings at risk (DEAR). DEAR = Market value of the investment
position x Price volatility
= $ 612,900 x 0.0305 = $ 18,693.45
If the yield of the bond has declined by 10 basis point, the bank will lose $10,770 of its bond
investment.
B. If the bank holds the bond for 10 days, what is the market value of the bond at risk (VAR)?
Value at risk (VAR) = DEAR x √𝑁 = $18,693.45 x √10 = $59,113.88

3. Suppose that ADCB bank has a 6 years bond, which has a market value of $930,232 and a
YTM of 7.5%. The previous five days’ price changes data shows that there is only 1% chance
of a swing in price next day, with a confidence interval of 99% and the price may vary by 30
basis points or 0.003.
A. Determine the daily earning at risk (DEAR)?
1st step determine the Modified duration. Modified Duration (MD) = D/ (1+r) = 6/ (1+ 0.5
6
=1.075 = 5.58 years
2nd step find the potential yield movement (the change of Yield to maturity)
= Z-score x basis points change in yield = 2.58 x 0.003 = 0.00774

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The confidence interval for the distribution of the yields of the bond is 99% and there is 0.5%
chance that the yield will decline. Therefore, the Z-score is 2.58
3rd step is to find the price sensitivity. Price sensitivity measures by how much the price of the
bond will change if the yield changes by certain basis point.
Price volatility = MD x yield movement = 5.58 x 0.00774 = 0.043189 or 4.32%
4th step is to find the Daily earnings at risk (DEAR). DEAR = Market value of the investment
position x Price volatility
= $ 930,232 x 0.0432= $ 40,186.02

B. If the bank holds the bond for 5 days, what is the market value of the bond at risk (VAR)?
Value at risk (VAR) = DEAR x √𝑁 = $40,186.02 x √5 = $89,858.68

4. Suppose the FI had a € 1.6 million trading position in spot euros at the close of business on a
particular date. The FI wants to calculate the daily earnings at risk from this position (i.e., the
risk exposure on this position should the next day be bad day in the FX markets with respect
to the value of euro against the dollar). Assume the exchange rate is €1.6/$1 or $0.625/1€. The
volatility in daily changes in exchange rate is 56.5 basis points (0.00565) and the chance of
bad rate occurrence is 5%. What is the value of foreign exchange exposed to daily risk?
1st step determine the dollar value equivalent foreign exchange (FX) position
$ FX = FX position in foreign currency x per unit exchange rate in Foreign currency
= € 1.6 million x $ 0.625/€1 = $1 million.
Based on the given exchange rate information $ 1 = €1.6 or €1 = $0.625
2nd step find the FX volatility using Z-score x change in FX rate = 1.65 x 0.00565 = 0.00932
The confidence interval for the distribution of the FX rates is 90% and there is 5% chance that the
FX rates will decline. Therefore, the Z-score is 1.65.
3rd step is to find the Daily earnings at risk (DEAR). DEAR = Market value of the FX position x
FX volatility
= $ 1 million x 0.00932= $ 9,322
If the foreign exchange rates decline by 56.5 basis point, the bank will lose $9,322.

5. Export Bank has a trading position in Japanese Yen and Swiss Francs. At the close of business
on February 4, the bank had ¥300,000,000 and Swf 10,000,000. The exchange rates for the
most recent two days are given below:

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 Exchange Rates per U.S. Dollar at the Close of Business
2/4/18 2/3/18
Japanese Yen 112.13 112.84
Swiss Francs 1.4140 1.4175

A. Calculate the foreign exchange (FX) position in dollar equivalents using the FX rates on
February 4.
• US dollar equivalent in FX positon in Yen = FX in Yen x per unit FX
Based on the given exchange rate information $ 1 = 𝑌112.13 or 𝑌 1 = $0.00892
Therefore, US dollar equivalent in FX positon in Yen = 𝑌300,000,000 x $0.00892 =
$2,675,465.98 or 𝑌300,000,000 ÷ 𝑌 112.13 = $2,675,465.98
• US dollar equivalent in FX positon in Swiss franc (Swf) = FX in Swf x per unit FX
Based on the given exchange rate information $ 1 = 𝑆𝑤𝑓1.4140 or Swf 1 = $0.7072135
Therefore, US dollar equivalent in FX positon in Yen = 𝑆𝑤𝑓10,000,000 x $0.7072135
= $7,072,135 or 𝑆𝑤𝑓10,000,000 ÷ 𝑆𝑤𝑓 1.4140 = $7,072,135

B. Assume that the volatility in daily changes in exchange rate for both currencies is 25
basis points (0.0025) and the chance of bad rate occurrence is 2.5% (95% confidence
interval). What is the value of each currency that is exposed to daily risk?
1st step find the total dollar value of the FX position = total the above two dollar equivalent foreign
currency positions ($2,675,465.98 + $7,072,135 = $9,747,601.7).
2nd step find the FX volatility using z-score x the change in foreign exchange rate
= 1.96 x 0.0025 = 0.0049
The confidence interval for the distribution of the FX rates is 95% and there is 2.5% chance that
the FX rates will decline. Therefore, the Z-score is 1.96.
3rd step is to find the Daily earnings at risk (DEAR). DEAR = Market value of the FX position x
FX volatility
= $ 9,747,601.7 x 0.0049= $ 47,763.25
If the foreign exchange rates decline by 25 basis point, the bank will lose $47,763.25.

6. Suppose the FI holds a $1 million trading position in stocks that reflect a US stock market
index (e.g. the Wilshire 5000). What is the DEAR of the stock portfolio if the returns are
normally distributed with 95% confidence interval? If over the last year, the standard deviation

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 of the daily returns on the stock market index was 200 basis point. Determine the DEAR of the
stock portfolio?
1st step find the stock market return volatility using z-score x the standard deviation of market
volatility
= 1.96 x 0.02 = 0.0392
The confidence interval for the distribution of the FX rates is 95% and there is 2.5% chance that
the stock volatility will increase. Therefore, the Z-score is 1.96.
2nd step is to find the Daily earnings at risk (DEAR). DEAR = Market value of the stock or equity
position x Stock return volatility
= $ 1 million x 0.0392 = $ 39,200
If the stock return volatility increased by 200 basis point or 2%, the bank will lose $39,200 of its
stock or equity investment.
7. Suppose that AIG insurance company holds a $10 million trading position in stocks that reflect
a US stock market index (e.g. DOW JONES). What is the DEAR of the stock portfolio if the
returns are normally distributed with 90% confidence interval? If over the last year, the
standard deviation of the daily returns on the stock market index was 50 basis point. Determine
the DEAR of the stock portfolio?

1st step find the stock market return volatility using z-score x the standard deviation of market
volatility
= 1.65 x 0.005 = 0.00825
The confidence interval for the distribution of the FX rates is 90% and there is 5% chance that the
stock volatility will increase. Therefore, the Z-score is 1.65.
2nd step is to find the Daily earnings at risk (DEAR). DEAR = Market value of the stock or equity
position x Stock return volatility
= $ 10 million x 0.00825 = $ 82,500
If the stock return volatility increased by 200 basis point or 2%, the bank will lose $82,500 of its
stock or equity investment.