CPM Risk Management 1 — Questions and Answers
Question 1: Which risk measure quantifies the maximum expected loss over a given time period at a specified confidence level?
- Standard deviation
- Value at Risk (VaR) (Correct answer)
- Beta
- Sharpe ratio
Correct answer: Value at Risk (VaR)
Value at Risk (VaR) estimates the maximum loss expected over a defined time horizon at a given confidence level (e.g., 95% or 99%).
Question 2: A portfolio manager notices that a fund's returns correlate strongly with a broad market index during downturns but diverge during upturns. This best describes which type of risk?
- Liquidity risk
- Downside correlation risk (Correct answer)
- Currency risk
- Concentration risk
Correct answer: Downside correlation risk
Downside correlation risk refers to the tendency of assets to become more correlated during market downturns, reducing diversification benefits precisely when they are most needed.
Question 3: Which of the following is a limitation of using historical standard deviation as a standalone risk measure for a portfolio?
- It is difficult to calculate
- It ignores market beta
- It assumes returns are normally distributed and stationary (Correct answer)
- It only applies to equity portfolios
Correct answer: It assumes returns are normally distributed and stationary
Standard deviation assumes normally distributed returns, but portfolio returns often exhibit fat tails and skewness, making historical standard deviation alone insufficient.
Question 4: Conditional Value at Risk (CVaR) is considered superior to VaR because it:
- Is easier to compute
- Captures the average loss beyond the VaR threshold (Correct answer)
- Ignores tail events
- Uses only historical data
Correct answer: Captures the average loss beyond the VaR threshold
CVaR (also called Expected Shortfall) measures the average loss in the worst-case scenarios beyond the VaR cutoff, providing better insight into tail risk.
Question 5: A portfolio manager wants to hedge interest rate risk in a bond portfolio. The most direct hedging instrument would be:
- Equity index futures
- Interest rate swaps or Treasury futures (Correct answer)
- Currency forwards
- Commodity options
Correct answer: Interest rate swaps or Treasury futures
Interest rate swaps and Treasury futures directly offset changes in bond prices caused by interest rate movements, making them the most appropriate hedges.
Question 6: Which risk management approach involves setting maximum allowable loss thresholds and automatically reducing exposure when they are breached?
- Passive indexing
- Stop-loss rules (Correct answer)
- Duration matching
- Factor tilting
Correct answer: Stop-loss rules
Stop-loss rules are pre-defined thresholds that trigger automatic portfolio de-risking when losses reach a specified level, limiting further downside exposure.
CPM Risk Management 1
Which risk measure quantifies the maximum expected loss over a given time period at a specified confidence level?