RISK MANAGEMENT MODULE C QUIZ 2

A market-risk cycle typically includes identifying exposures, measuring risk, setting and communicating limits, monitoring positions, reporting/escalating exceptions and mitigating exposures. It should be supported by governance, reliable data, independent review and periodic model validation.

The net open position reflects the net exposure to foreign-currency movements after eligible offsets. Monitoring it helps keep potential gains or losses from exchange-rate changes within approved and regulatory limits. Gross transaction volume alone may not show the bank’s net directional exposure.

Selling the expected US-dollar receipt forward locks in an exchange rate for the future conversion, subject to contract terms and counterparty risk. This reduces downside uncertainty from dollar depreciation, though it also limits the benefit if the dollar strengthens.

Basis risk arises when the hedging instrument and the exposure do not move in perfect offsetting relation. Differences in instrument, maturity, benchmark or market liquidity can cause the hedge to underperform even if the broad risk factor moves as expected.

Market liquidity risk is the risk that a position cannot be traded quickly at a reasonable price because of market depth or disruption. It is related to, but distinct from, funding liquidity risk, which concerns the ability to meet cash obligations when due.

Counterparty credit risk is the possibility that the other party to a transaction defaults before final settlement and the bank incurs a loss in replacing the contract. OTC derivatives can create exposure that changes with market values and should be managed through limits, collateral and netting arrangements where enforceable.

Model risk is the risk of loss or poor decisions due to errors in model design, assumptions, implementation, data or use. Fat-tailed market returns can produce more extreme outcomes than a normal-distribution assumption predicts, leading to understated tail risk.

For a small yield change, a bond or portfolio with higher modified duration generally has a larger percentage price change in absolute terms. The direction remains inverse for ordinary fixed-rate bonds: yields rising tends to reduce prices and yields falling tends to increase them.

Longer-duration bonds generally have greater price sensitivity to a given small yield change. Duration is affected by maturity, coupon and yield; therefore, maturity alone is not a perfect rule in every comparison, but the question directly compares duration.

Historical simulation is data-dependent. If the look-back window does not contain a relevant shock or regime, the method may fail to reflect the risk of that event. Scenario analysis and stress testing can address some of these blind spots, though they also require judgment and sound design.

When correlations rise, assets that usually offset each other may fall together, weakening diversification and increasing portfolio losses. Stress testing should examine changes in both risk-factor levels and dependence structures, rather than assuming correlations remain stable.

Expected Shortfall considers the severity of losses in the tail beyond the VaR quantile by measuring the average loss in that tail under the selected convention. VaR alone identifies the threshold loss at a confidence level but does not quantify how bad losses beyond it may be.

Options have nonlinear payoffs and their sensitivities change as market factors move. A simple linear approximation may fail to capture gamma effects and changes in volatility or other option sensitivities. Full revaluation or suitable nonlinear methods may be required for reliable risk estimation.

A long call or long put generally has positive vega: all else equal, its value tends to increase when implied volatility rises because greater expected variability increases the option’s potential payoff value. Exact effects depend on the instrument and terms.

Beta measures the sensitivity of an asset’s or portfolio’s returns to movements in a chosen market benchmark. A beta above one typically indicates greater sensitivity than the benchmark, while beta below one indicates lower sensitivity, subject to estimation and market conditions.

A short futures position benefits when the futures price falls and loses when it rises, all else equal. Futures are marked to market, so adverse price movement can lead to margin calls under the contract’s clearing arrangements.

Useful reporting typically includes exposures by risk factor and business unit, limit utilisation and breaches, VaR or other risk measures, stress-test results, valuation issues, significant concentrations and emerging trends. Reports should be timely, accurate and actionable.

Independent price verification checks whether front-office valuations are reasonable using sources independent of traders, helping detect stale, inaccurate or biased marks. It supports reliable profit-and-loss reporting, risk measurement and controls over hard-to-value instruments.

Aggregate risk measures can conceal concentrated exposures or model limitations. Concentration monitoring identifies vulnerability to a specific currency, tenor, issuer or market segment and supports more targeted limits and stress tests. Being within an aggregate VaR limit does not automatically make every concentration acceptable.

The bank should promptly escalate the breach, assess the exposure and execute authorised mitigation—such as reducing positions, hedging or obtaining a formally approved exception where policy allows. The response should be documented and consistent with limits and governance; simply concealing the breach is inappropriate.