BE631-6-SP/1
THIRD YEAR UNDERGRADUATE EXAMINATION 2023
RISK MANAGEMENT AND FINANCIAL INSITUTIONS
Time allowed: 24 hours
Time to spend on your assessment: 2 hours
Maximum word count for assessment: 2000 words
Please seeyour exam timetable or check on FASER for the deadline to upload your answer.
The times shown on your timetable are in UK Time. Please check online for a conversion to your local time ifyou will be undertaking your assessment outside the United Kingdom.
Candidates are permitted to use: Calculator – Casio FX-83GT PLUS/X or Casio FX-85GT PLUS/X only
The paper consists of FOUR questions. All questions carry equal weight.
Candidates must answer TWO questions:
ONE from Section A and ONE from Section B.
You can add hand written answers for equations/mathematical questions (take a photo/scan and add to your document).
SECTION A
You must answer ONE question from Section A. Show all your work clearly in all cases for full credit.
QUESTION ONE
a)
Suppose that you are bank’s AAA manager. The bank has two bonds on its asset side: one bond is a coupon bond with a duration of 5 years and the other one is a zero-coupon bond with a maturity of 5 years. Both bonds have the same yield to maturity, which is 4%. In the liabilities side, there is one zero-coupon bond with maturity of 2 years and yield to maturity of 2%. The value of the bank’s assets is £100million and the value of its liabilities is £80 million.
i. Calculate the bank’s duration gap. (10 Marks)
ii. Estimate the change in the banks’ net worth if yields increase by 1%. What was the net worth before the increase in the interest rates? Comment on your answer. (5 Marks)
iii. How could you use a Forward Rate Agreement (FRA) to reduce your exposure to an increase in interest rates? (5 Marks)
b)
In 200 words or less, explain how you can hedge a spot position in bonds using bond futures. What is the position you will take in the bond futures, if you expect interest rates to rise? Furthermore, explain how the formula below helps you to apply duration-based hedging and what are the limitations of this approach? (10 Marks)
c)
In 200 words or less, explain how investors swap price risk for basis risk when they hedge using futures. (10 Marks)
d)
Determine the rate on the 12-month to 24-month Forward Rate Agreement (FRA(12x24m) contract) if the 12-month and 24-month US interest rates are 3% per annum (p.a.) and 5% p.a., respectively. Assume yearly compounding for all interest rates. (10 Marks)
[TOTAL: 50 MARKS]
QUESTION 2
a)
The price of a European put option is 1.20 euros. The underlying asset has a spot price of 20, and the exercise price of this option is 18. The option expires in three months. The risk-free rate is 1%.
i. What is the price of the call option using the put-call parity? (5 Marks)
ii. Which option is in the money, and which is out of the money? (5 Marks)
iii. In 200 words or less, explain the factors that determine the price of a call option (using the Black-Scholes formula). (10 Marks)
b)
The price of a non-dividend paying stock is £10 pounds today. The risk free-rate is 2%. The price of a 6-month future on this stock is 12. Are there any arbitrage opportunities, and if yes, which strategy you would follow to realize riskless profit? (10 Marks)
c)
In 200 words or less, describe the approach that the Merton model takes in producing credit ratings. What is the most crucial parameter in the determination of corporate default probability in the Merton model? (10 Marks)
d)
In 200 words or less, describe how banks use the Receiver Operating Characteristic (ROC) curves to gauge the credibility of potential borrowers. (10 Marks)
[TOTAL: 50 MARKS]
SECTION B
You must answer ONE question from Section B.
QUESTION THREE
a)
Boston Bank is an investment bank. The chief risk officer (CRO) has simulated the profits and losses of his portfolio using the past 500 realizations of the risk factor prices. After sorting them, he obtained the value of the 10 largest losses, which are listed below.
-700,000
|
-680,000
|
-650,000
|
-630,000
|
-620,000
|
-580,000
|
-500,000
|
-480,000
|
-450,000
|
-400,000
|
i. What is the 1-day 99% VaR of Boston Bank? (5 Marks)
ii. Describe the simple historical simulation approach when measuring Value-at-Risk (VaR). Describe the key assumptions of this approach. (10 Marks)
iii. Discuss the advantages and disadvantages of the historical simulation approach. (5 Marks)
b)
A bank has a position worth $15 million in Google shares. The annual standard deviation of Google stock is about 25%. The daily change in the value of the portfolio is normal distributed with a mean of zero. Assume that the 99% confidence level is 2.33 and there are 250 trading days in a year.
i. What is the one-day VaR at the 99% confidence level? (5 Marks)
ii. What is the 9-day VaR at the 99% confidence level? (5 Marks)
iii. Discuss the key assumptions of the Parametric Approach when evaluating Value- at-Risk (VaR). (10 Marks)
c)
The table below reports information about the Value-at-Risk (VaR) of two banks. Column (I) shows the expected number of times the VaR was supposed to be exceeded according to the VaR methodology. The other two columns report the actual number of times the VaR was indeed exceeded in 2006 (column II) and in 2007 (column III).
Bank
|
Expected
VaR’s
violations
(I)
|
Actual VaR’s violations
2006
(II)
|
Actual VaR’s violations
2007
(III)
|
Green Bank (95%)
|
13
|
3
|
10
|
Blue Bank (95%)
|
13
|
0
|
28
|
For which one of the two banks listed above, the VaR methodology was a good instrument to evaluate the losses due to market risk in 2007? Why? (10 Marks)
[TOTAL: 50 MARKS]
QUESTION FOUR
a)
“All tranches in an ABS have the same risk exposure.” Discuss critically if this statement is true or false. (10 Marks)
b)
Discuss the main differences between hedge funds and mutual funds. (10 Marks)
c)
Explain the term ‘short selling’ and provide an example. (10 Marks)
d)
How do you (Chief Risk Officer) choose the “appropriate” confidence interval when calculating Value-at-Risk (VaR)? What happens to your VaR if you increase the “confidence”? (10 Marks)
e)
Briefly explain the importance of backtesting in Value-at-Risk (VaR) and briefly explain how Value-at-Risk (VaR) models are back tested. (10 Marks)
[TOTAL: 50 MARKS]