Understanding VaR as a method for measuring market risk

Nominal measures are also referred to as notional measures. It bases its risk position on the nominal value of holdings and transactions.

Measures of factor sensitivity

It measures a higher level of sophisticated risk than a nominal measure to some extent. It assesses the portfolio or instrument's susceptibility to changes in a basic risk factor.

Make a four-by-three table with column titles for the four key market risks and row labels for three of the major asset classes: stocks, bonds, and options. Summarise the sensitivity measures used to assess the market risks relevant to each asset class.

Interest Rate Risk

Equity price risk Foreign exchange risk Commodity risk

Stocks Positively affected

Bonds Positively affected Positively affected

Options Positively affected Positively affected Positively affected Positively affected

Given that your table from the above exercise will have empty cells, do you think that other market risk sensitivity measures may be needed/logical if you are to form a true picture of risk? What would additional types of sensitivity measure you choose? Indicate these in your table.

Standard deviation-It measures data dispersion from the expected value. It used to make an investment decision that measures the amount of historical volatility that is associated with the annual investment rate of return relativity.

Beta- It measures the systematic risk a security has about the general market.

Conditional VaR-It is used to ascertain the tail risk of investment. It indicates the likelihood with a degree of confidence that there will be a break of VaR.

Produce a four-column table that outlines each of the major alternatives for the calculation of portfolio VaR. Is there anyone method of calculation-which you should summaries in one column of your table-that is to be preferred over the others? Be sure that you succinctly summarise the pros and cons of each approach in separate columns of your table.

Methods of measuring marker risk Pros Cons preference

Standard deviation Shows how much data is clustered around a mean value

It gives a more accurate idea of how the data is distributed

Not as affected by extreme values

The Past is Not the Future

Asymmetric Payoffs

Unable to quantify behavioral aspects of investing risk

Cannot be considered on their own

Beta Capture various anomalies

Based on extremely sound finance theory

Allows the investor to understand if the price of that Security has been more or less volatile than the market itself Higher costs,

Puts more risk into their portfolios for the opportunity for higher returns.

Calculated based on historical price movements It is preferred over beta is it rectify all the anomalies.

For what timeframes is VaR being estimated? What does this imply about its usefulness for forwarding planning in risk management?

It indicates the normal distribution of past losses in the investment portfolio. Therefore it is a probability-based estimation on the minimum loss in dollars that is expected over a period. It is used in making decisions as well as to set strategies.

Activity 7-3: the gap model and gap analysis

What is the gap model and how is it implemented in a bank? What difficulties are there in implementing this model?

Gap model is a process that allows a company to compare its actual performance to its expected performance and determine whether it is effective to the company.Gap model enables banks to offer loans to business owners across different industries by evaluating the performance of the business with the peers in the same industry. Gap only work well if assets and liabilities are comprised of fixed cash flows hence cannot be used to analyze options.

Explain what a positive gap, a negative gap, and a cumulative gap indicate.

Negative Gap is a circumstance in which bank's interest-sensitivity liabilities exceed its interest-sensitivity assets. The cumulative gap shows an imbalance that arises between the total volume of sensitive assets as well as liabilities of the bank over the time that is overvalued. The positive gap shows that there are more assets compared to liabilities in a given bucket.

Describe the shortcomings of the gap model, and provide insights into why these shortcomings may lead to false messages on risk positions and changes in risks. What role may time buckets play in creating some shortcomings in the model?

Its major shortcoming is based on the fact that Gap analysis looks into what the current performance of the business as opposed to what the market wants the business. Some of the shortcomings are caused by lack of efficient steps like technology needed, competitors gap, governmental influence and seasonal fluctuations.

What does EaR represent?

Earning at Risk

Outline how gap analysis can be applied to multi-currency exposures.

Interest rate Gap

Breakaway Gap

Dynamic Gap

Strategic Gap

Activity 7-4: the duration model, duration gap, and duration of equity

What is the basis for the duration model? Outline the two uses to which it may be applied when considering the impact on a bank of changes in interest rates. Are there difficulties in implementing this model?

Duration model is an estimated measure of price sensitivity of bond to a change in interest rate

It can be applied :

Influence the earnings as well as the profitability of the bank through their spread business policy.

It creates a parallel upward shift in short as well as long-term rates hence making banks assets more liquid.

The reason why implementing the duration model is difficult:

Despite duration being effective in calculating small changes, it does not have a provision for large changes hence the need to rely on the concept of convexity for accurate estimates.

Explain why equity is likely to be highly sensitive to changes in interest rates.

Equity and interest rate are inversely correlated hence when interest rates rise the prices of equity tend to fall

Outline the limitations of the duration approach as applied to the impact of interest rates on NII. Do these limitations also apply to applications of the model to the interest-rate sensitivity of equity? Explain.

Limitation of duration approach include:

Instantaneous and significant rate changes

Substantial rate changes over time,

Changes in the relationships between key market rates,

Changes in the shape or slope of the yield curve.

Yes, the limitation also applies to the applications of duration model on the IRR sensitivity of equity since equity and interest rate are inversely related.


Bali, T. G., Atilgan, Y., & Demirtas, O. 2013. Investing in hedge funds: A guide to measuring risk and return characteristics. Oxford: Academic.

Chen, F., Diebold, F. X., & Schorfheide, F. 2012. A Markov-switching multi-fractal inter-trade duration model, with application to US equities. Cambridge, Mass.

Dowd, K. 2005. Measuring market risk. Chichester, England: John Wiley & Sons.

Juric, M. B., Chandrasekaran, S., & Fiammante, M. 2010. WS-BPEL 2.0 for SOA composite applications with IBM WebSphere 7: Define, model, implement, and monitor real-world BPEL 2.0 business processes with SOA-powered BPM. Birmingham: Packt Pub.

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