A00151

Non-Alpha Only

BIRMINGHAM BUSINESS SCHOOL

M.SC. INVESTMENTS

RISK MANAGEMENT

BANNER CODE: 07 02697

A00151

SUMMER EXAMINATION 2013

3 HOURS

ANSWER 3 QUESTIONS
ANSWER AT LEAST ONE QUESTION FROM EACH SECTION
ALL QUESTIONS CARRY EQUAL MARKS

CALCULATORS MAY BE USED IN THIS EXAMINATION PROVIDED THEY ARE NOT CAPABLE OF
BEING USED TO STORE ALPHABETICAL INFORMATION OTHER THAN HEXADECIMAL NUMBERS

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Non-Alpha Only

SECTION A

1.

(33.3%)
a. Hedging using derivatives can be difficult. Discuss reasons why [35
marks]
this is so.

b. Discuss the constant proportional and option based portfolio [35

insurance strategies. In each case use an equation and diagram marks]
to support your discussion. What problems would you face in
implementing these strategies?
c. Discuss the uses of the Greeks in the management of risks.

[30
marks]

Total 100 marks

2.

(33.3%)
a. Compare

and

contrast

the

Creditmetrics

approaches to modelling credit risk.

and

the

KMV [40
marks]

b. Stress testing and back testing of models are important elements [35
of risk management. Explain why this is the case and provide marks]
illustrative example(s) where their application is critically
important.

c. The normal distribution is a reasonable approximation of the [25

distribution of returns to a financial time series, however it has marks]
fallen into disrepute in its application to risk management.
Discuss.

Total 100 marks

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3.

(33.3%)
a. Discuss the characteristics of the sound risk management [45
system suggested by JP Morgan Investment Analytics. Give marks]
reasons for their importance.

b. Discuss the lessons for risk management that have been drawn [30
marks]
from the recent financial crisis.

c. What is endogenous risk and why is it important in risk [25

marks]
management?
Total 100 marks

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SECTION B
4.

(33.3%)
a. Suppose a US bank has a three-month forward contract with a
European bank to deliver 100 million Sterling for $150 million US
dollars. The current annualised three-month interest rate for the
US dollar is 2.00% and the corresponding rate for Sterling is
3.00%.
The daily standard deviations in per cent terms for the spot
exchange rate is 0.5, for the sterling interest rate is 0.06 and for
US dollar interest rate is 0.05. The following correlation matrix is
available.

Spot FX

Sterling

US$

Spot FX

0.10

0.15

Sterling

0.10

0.25

US $

0.15

0.25

i. Estimate the daily Value-at-Risk for the contract at the 99% [45
marks]
confidence level.

ii. The diversification benefits.

b. Discuss

the

strengths

and

[10
marks]
weakness

of

Value-at-Risk. [20
marks]

c. Discuss the strengths and weaknesses of the methods that might [25
marks]
be employed to estimate Value-at-Risk
Total 100 marks

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5.

(33.3%)
a. Assume a bank has assets of $1 billion and debt type liabilities of [25
$900 million. The duration of the assets is estimated to be 5 marks]
years and that of the liabilities to be 2 years. Assume the zero
coupon yield curve is flat at 3 per cent. What is your estimated
impact on the market value of the banks equity capital caused by
an upward shift in the yield curve of 1 per cent?

b. Illustrate how the change in market value of equity might be [40

marks]
hedged using:-

i.

Treasury bond futures contracts where the where the 20-year

T-bond underlying the futures contracts has a duration of 7.5
years and a contract price of $97,000.

c.

ii.

Three month Eurodollar futures contracts with a price of

$975,000.

iii.

A plain vanilla swap with a fixed leg duration of 7 and a

floating rate leg duration of 1 year
Forward rate agreements, caps, collars and swaps are [35
instruments that can be used to manage interest rate risk. marks]
Discuss the advantages and disadvantages of each.
Total 100 marks

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Non-Alpha Only

6.

(33.3%)
a. A US securities firm is planning to return Yen 2000mn to the US [40
in 3 months time. The firm is concerned that the Bank of Japan marks]
might intervene in the currency market to prevent the yen from
rising against the US dollar. The firm is considering hedging Yen
1500mn of its exposure with one of two option strategies.
The first strategy is a put spread, and the second, a range
forward. Under the put spread the firm will buy a put option at a
premium of 4 per cent and an exercise price of Yen 90/$ and sell
a put option at a premium of 2 per cent and an exercise price of
Yen 95/$.
The second strategy is a range forward and is a zero cost
strategy where the firm will buy a put option at an exercise price
of Yen95/$ and sell a call option, at an exercise price of yen85/$.
For illustrative purposes assume the current spot exchange rate
is yen 88/$ and that the exchange rate in three months time is
either Yen 84/$, yen90/$ or yen96$. Show all calculations and
plot the payoff diagrams for the hedged position. .

Which strategy would you recommend and why?

b. Discuss the roles that duration and convexity might play in bond [30
marks]
portfolio risk management.

c. Various degrees of currency hedging are used in fund

management. Critically discuss the reasons for such hedging.

[30
marks]

Total 100 marks

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7.

(33.3%)
a. You manage 50 million bonds that were issued by a UK retail [50
company some six years ago. The bonds now have a remaining marks]
life of 4 years. Due to government austerity measures you are
concerned that consumer confidence will fall further increasing
the likelihood that the bonds will default within the next four
years. As a result you are considering transferring the credit risk
associated with the bonds via a named credit default swap.
You estimate the recovery rates in the event of a default will be
60%, 55% 50% and 45% in years 1, 2, 3, and 4 respectively.
Further you estimate the probability of default in each year will be
2 per cent conditional on no prior year default.

Assume any

default will occur mid-year and that the risk-free zero curve is flat
at 5 % , and further that, for illustration the bonds have a zero
risk premium. What premium would you expect to pay for the
four year credit default swap?

b. Various institutions are active buyers and sellers of credit [20

protection. What types of institutions are active in the credit risk marks]
transfer market and what are their motivations dealing in credit
transfer instruments?

c. Briefly explain a total return swap and a credit linked note. [30
marks]
Total 100 marks

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End of exam