IMC Quantitative Methods and Risk 2 — Questions and Answers
Question 1: What is the difference between systematic and unsystematic risk?
- Systematic risk affects a single company; unsystematic risk affects the whole market
- Systematic risk affects the entire market and cannot be diversified away; unsystematic risk is company-specific and can be reduced through diversification (Correct answer)
- Both types of risk can be completely eliminated through diversification
- There is no practical difference between them
Correct answer: Systematic risk affects the entire market and cannot be diversified away; unsystematic risk is company-specific and can be reduced through diversification
Systematic risk (market risk) arises from macroeconomic factors like interest rates, recessions, and geopolitical events that affect all securities. Unsystematic risk (specific risk) relates to individual companies or sectors, such as a product recall or management failure. Only unsystematic risk can be reduced through diversification.
Question 2: An investor holds a bond portfolio and is concerned about rising interest rates. Which hedging strategy would be most appropriate?
- Buy call options on bonds
- Sell interest rate futures (go short) (Correct answer)
- Buy more bonds with longer duration
- Increase the allocation to equities
Correct answer: Sell interest rate futures (go short)
Selling (shorting) interest rate futures would profit when interest rates rise and bond prices fall, offsetting losses on the bond portfolio. Buying call options would profit if bond prices rose. Buying longer-duration bonds would increase interest rate sensitivity, and equities may also be negatively affected by rate rises.
Question 3: What is the holding period return (HPR) for a share purchased at £50, sold at £58, with £2 in dividends received?
- 16%
- 20% (Correct answer)
- 10%
- 4%
Correct answer: 20%
HPR = (Ending Value - Beginning Value + Income) / Beginning Value = (£58 - £50 + £2) / £50 = £10 / £50 = 20%. The holding period return captures both the capital gain (£8) and the income received (£2 dividend) relative to the initial investment.
Question 4: What does a normal distribution assumption imply about investment returns?
- All returns will be positive
- Returns are symmetrically distributed around the mean, with most observations clustered near the average (Correct answer)
- Extreme events are more likely than a normal distribution would predict
- Returns follow a predictable upward trend
Correct answer: Returns are symmetrically distributed around the mean, with most observations clustered near the average
A normal distribution is bell-shaped and symmetric around the mean. Approximately 68% of observations fall within one standard deviation, 95% within two, and 99.7% within three. While convenient for modelling, real financial returns often exhibit 'fat tails' (more extreme events than a normal distribution predicts).
Question 5: What is the Sharpe ratio of a portfolio with a return of 12%, a risk-free rate of 3%, and a standard deviation of 15%?
- 0.80
- 0.60 (Correct answer)
- 1.25
- 0.20
Correct answer: 0.60
Sharpe ratio = (Portfolio Return - Risk-Free Rate) / Standard Deviation = (12% - 3%) / 15% = 9% / 15% = 0.60. This means the portfolio earned 0.60 units of excess return per unit of total risk. A higher ratio indicates better risk-adjusted performance.
Question 6: What is 'operational risk' in the context of investment management?
- The risk that a counterparty defaults on a transaction
- The risk of loss resulting from inadequate or failed internal processes, people, systems, or external events (Correct answer)
- The risk that market prices move against a position
- The risk that an investor cannot sell a security quickly enough
Correct answer: The risk of loss resulting from inadequate or failed internal processes, people, systems, or external events
Operational risk encompasses losses arising from failures in internal processes (trade errors, settlement failures), people (fraud, human error), systems (IT failures, cyber attacks), or external events (natural disasters, regulatory changes). It is distinct from market risk, credit risk, and liquidity risk.
IMC Quantitative Methods and Risk 2
What is the difference between systematic and unsystematic risk?