IMC Quantitative Methods and Risk — Questions and Answers
Question 1: An investment of £10,000 earns a compound annual return of 6% over 3 years. What is its approximate value at the end of the period?
- £11,800
- £11,910 (Correct answer)
- £12,000
- £11,600
Correct answer: £11,910
Using compound interest: FV = PV × (1 + r)^n = £10,000 × (1.06)^3 = £10,000 × 1.191016 = £11,910.16. Compound interest earns interest on interest, which is why the result exceeds simple interest (which would give £11,800).
Question 2: What does standard deviation measure in the context of investment returns?
- The average return of a portfolio
- The dispersion or volatility of returns around the mean (Correct answer)
- The maximum possible loss on an investment
- The minimum expected return
Correct answer: The dispersion or volatility of returns around the mean
Standard deviation measures the degree of variation of returns from the average (mean) return. A higher standard deviation indicates greater volatility and wider dispersion of returns. In finance, it is the most commonly used measure of total investment risk.
Question 3: What does Value at Risk (VaR) at a 95% confidence level over one day represent?
- The maximum profit expected in one day
- The maximum loss that is not expected to be exceeded on 95% of trading days (Correct answer)
- A guarantee that losses will not exceed the VaR figure
- The average daily return of the portfolio
Correct answer: The maximum loss that is not expected to be exceeded on 95% of trading days
VaR at 95% confidence over one day estimates the loss level that should not be exceeded on 95 out of 100 trading days (or equivalently, there is a 5% probability the loss will be greater). It does not indicate the size of losses in the worst 5% of cases — that is measured by Conditional VaR (CVaR).
Question 4: If two assets have a correlation coefficient of -0.8, what does this indicate?
- They tend to move in the same direction with high consistency
- They tend to move in opposite directions with high consistency (Correct answer)
- They have no relationship to each other
- One asset always rises when the other falls
Correct answer: They tend to move in opposite directions with high consistency
A correlation of -0.8 indicates a strong negative (inverse) relationship — when one asset's returns increase, the other's tend to decrease, and vice versa. Correlation ranges from -1 (perfect inverse) to +1 (perfect positive). A value of -0.8 is strongly negative but not perfectly inverse.
Question 5: What is the time value of money principle?
- Money held in a bank always earns interest
- A pound today is worth more than a pound in the future because of its potential earning capacity (Correct answer)
- Inflation always reduces the value of money over time
- Exchange rates determine the value of money
Correct answer: A pound today is worth more than a pound in the future because of its potential earning capacity
The time value of money principle states that money available today is worth more than the same amount in the future because it can be invested to earn a return. This is the foundation of discounting (calculating present values) and compounding (calculating future values) in finance.
Question 6: What is the net present value (NPV) rule for investment decisions?
- Accept all projects with a positive internal rate of return
- Accept a project if its NPV is positive, as it adds value; reject if NPV is negative (Correct answer)
- Accept projects only if the payback period is less than 3 years
- Accept all projects regardless of their NPV
Correct answer: Accept a project if its NPV is positive, as it adds value; reject if NPV is negative
The NPV rule states that an investment should be accepted if its NPV is positive (the present value of cash inflows exceeds the present value of cash outflows), meaning it creates value. A negative NPV would destroy value and should be rejected. NPV is considered the most theoretically sound capital budgeting method.
IMC Quantitative Methods and Risk
An investment of £10,000 earns a compound annual return of 6% over 3 years.
What is its approximate value at the end of the period?