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Question: Silo Bank begins its risk measurement process by calculating VaR for market, credit, and operational risk individually, and then aggregates the three measures to produce a firm-wide VaR. Correlation between risk types is a key input for calculating firm-wide VaR. Which of the following statements about correlation are valid?
i. When market and credit risks involve securities issued by firms such as bonds, warrants, and stocks, correlation estimates for market and credit risk can be derived using equity returns if Merton’s model for the pricing of debt holds.
ii. If correlations between highly adverse market, credit, and operational outcomes are high, there is diversification across risk categories and therefore the firm-wide VaR is substantially less than the sum of the market, credit, and operational risk VaRs.
iii. With non-normal distributions, the use of correlations estimated using historical data from a stable period may not adequately capture how extreme returns for one type of risk are related to extreme returns of another type of risk.
a. i, ii and iii
b. i only
c. ii and iii only
d. None of the statements are valid.
Answers:
30.1. b
Explanation:
i. is true.
ii. is false - if correlations are low, there is diversification benefit.
iii. is false - asset correlations tend to be higher in times of stress.
Hi David,
Is the answer wrong? I think the statement iii above should be correct? since it says "NOT adequately capture" which I think is true?
Thanks!
i. When market and credit risks involve securities issued by firms such as bonds, warrants, and stocks, correlation estimates for market and credit risk can be derived using equity returns if Merton’s model for the pricing of debt holds.
ii. If correlations between highly adverse market, credit, and operational outcomes are high, there is diversification across risk categories and therefore the firm-wide VaR is substantially less than the sum of the market, credit, and operational risk VaRs.
iii. With non-normal distributions, the use of correlations estimated using historical data from a stable period may not adequately capture how extreme returns for one type of risk are related to extreme returns of another type of risk.
a. i, ii and iii
b. i only
c. ii and iii only
d. None of the statements are valid.
Answers:
30.1. b
Explanation:
i. is true.
ii. is false - if correlations are low, there is diversification benefit.
iii. is false - asset correlations tend to be higher in times of stress.
Hi David,
Is the answer wrong? I think the statement iii above should be correct? since it says "NOT adequately capture" which I think is true?
Thanks!
