UBFF3293 Risk Management (MAY 2016)

UNIVERSITI TUNKU ABDUL RAHMAN

FACULTY OF BUSINESS AND FINANCE
ACADEMIC YEAR 2016/2017
BACHELOR OF FINANCE (HONS)
BACHELOR OF ECONOMICS (HONS) FINANCIAL ECONOMICS
BACHELOR OF BUSINESS ADMINISTRATION (HONS) BANKING AND FINANCE
BACHELOR OF SCIENCE (HONS) STATISTICAL COMPUTING AND
OPERATIONS RESEARCH
UBFF 3293 RISK MANAGEMENT
TUTORIAL QUESTIONS
Tutorial 1
1.
Objective
The focus is on risk management issues and therefore focuses on the essential
concepts underlying the risk analytics of existing models. It provides knowledge of
causes of increased volatility of financial risks, fundamentals of pricing principles,
risk management techniques and derivative markets. It details analytics without
attempting to provide a comprehensive coverage of each existing model
2.
Learning Outcome
On completion of this unit, a student shall be able to:
Explain the role and scope of risk management in organization and justify the
need for a holistic approach to risk management
Recognize and apply the principles which underpin the identification,
measurement and management of financial risks in large organizations
Identify and apply various risk quantification measures and risk management
tools that are available in the market
Undertake a critical analysis of risks from the viewpoint of the individual
transaction, the business module and the organization
Describe and evaluate the effectiveness of a variety of approaches to risk
financing, risk transfer and risk control and the factors that the corporate should
take into account in respect of such approaches and be able to make appropriate
conclusions and recommendations thereon
3.

Reading List
Main Text:
a. Chance, D. & Brooks, R. (2010) Introduction to Derivatives and Risk
Management (8th ed.). Cengage Learning South-Western Main Text
Additional Text:
b. McDonald, R.L. (2006) Derivatives Markets, (2nd ed.). Pearson Education
Addison Wesley
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UBFF3293 Risk Management (MAY 2016)

c. Horcher, K.A. (2005) Essentials of Financial Risk Management. John Wiley &
Sons
d. Sundaresan, S (2002) Fixed Income Markets and Their Derivatives (2nd ed.).
Thomson Learning South-Western
e. Crouchy, M., Galai, D. & Mark, R. (2002). Risk Management. New York: McGraw-Hill.
f. Hull, J. (2006). Options, Futures and Other Derivatives (6th ed.). New Jersey:
Pearson Prentice Hall.

g. Gitman, L.J. (2009). Principles of Managerial Finance (12th ed.). Boston: Pearson
Addison Wesley.

4.
No
.
1.

Method of Assessment
Method of Assessment
Coursework
a) Mid-term Test
b) Group Assignment
Total

2.
Final Examination
GRAND TOTAL

Total
40%
20%
20%
40%

(50 marks)
(50 marks)
100 marks
60%
100%

5.
Assignment
Refer to Assignment instructions
6.
Reminder on Deadlines
Mid-term Test
Week 8 (23 July 2016, 10am & Venue to be informed)
Submission of Assignment
Week 7 Friday (15 July 2016, 12:30pm)

UBFF3293 Risk Management (MAY 2016)

Tutorial 2 (Topic 1)
Introduction to Risk Management
Question 1
What do you understand by the word risk?
Question 2
Give an example of a situation that entails uncertainty but not exposure, and hence
no risk.
Question 3
Give an example of a situation that entails exposure but not uncertainty, and hence
no risk.
Question 4
Risk management is sometimes described as the process of identifying and
evaluating the trade-off between risk and expected return, and choosing the
appropriate course of action. Describe the risk management process.
Question 5
Explain four aspects that determine whether financial risk management is successful
in an organization.
Question 6
Explain the advantages for senior management having detailed written policies on
financial risk management.

UBFF3293 Risk Management (MAY 2016)

Tutorial 3 (Topic 2)
Risk and Return
Question 1
Consider the following assets:Market
Asset 1
Asset 2
Condition
Probability Return
Return
Good
0.25
16%
4%
Average
0.50
12%
6%
Poor
0.25
8%
8%
i)
Solve for the expected return and the standard deviation of return for each
investment.
ii)
Solve for the covariance and the correlation coefficient between Asset 1
and Asset 2.
iii)
If your investment is divided equally between Asset 1 and Asset 2, what is
your portfolio expected return and standard deviation?
iv)
How should you divide your portfolio among Asset 1 and Asset 2 if you
wish to minimize the standard deviation of your investment portfolio?

Question 2
Below is price and dividend data for two companies for each of five months.
Security A
Security B
Time
Price
Dividend
Price
Dividend
1
5.7
3.3
2
5.9
3.6
3
5.8
0.7
3.7
1.3
4
5.5
3.8
5
5.6
3.9
i)
Compute the rate of return for each company for each month.
ii)
Compute the average rate of return for each company.
iii)
Compute the standard deviation of the rate of return for each company.
iv)
Compute the covariance and correlation coefficient between security A and
security B.
v)
Assuming you invest 30,000 in security A and 40,000 in security B, compute
the average return and standard deviation for your portfolio.

Question 3
To what extent can the overall risk of a portfolio be reduced? Explain with the help of
correlation coefficient.

UBFF3293 Risk Management (MAY 2016)

Question 4
An investor holds a portfolio consists of 10,000 shares of Kerzhakov Berhad and
12,000 shares of Lazovic Berhad. Details for each of the two companies are as
follows:
Kerzhakov Berhad Lazovic Berhad
Expected Return
15%
20%
Dividend end of this year
RM0.45
RM0.30
Dividend growth rate
6%
8%
Book value per share
RM3.60
RM2.40
Beta
2.88
0.83
Calculate the portfolios systematic risk.
Question 5
Given that a stock has daily volatility of 0.257, calculate its annual volatility using
square root of time rule. (Assuming 250 trading days per year) What is your
assumption about the stocks volatility?
Question 6
The volatility of a stock price is 25% per annum. What is the standard deviation of
the percentage price change in one trading day? In eight trading days? In thirty
trading days? Assume 252 trading days

UBFF3293 Risk Management (MAY 2016)

Tutorial 4 (Topic 3)
Fixed Income Securities
Question 1
Paul has recently inherited RM1, 000 and is considering purchasing 10 bonds of the
Octopus Corporation. The bond has a par value of RM100 with 10 percent coupon
rate and will mature in 10 years. Does Paul have enough money to buy 10 bonds if
the required rate of return is 12 percent? (Note: calculation of bonds intrinsic value is
not needed).
Question 2
a)
IPM Company has an issue of $1,000 par value bonds with a 14 percent
coupon interest rate outstanding. The issue pays interest semiannually and
has 10 years remaining to its maturity date. Bonds of similar risk are currently
selling to yield a 12 percent rate of return. What is the value of these IPM
Company bonds? What is the bonds current yield?
b)
The Coffee Plantation Company issued a 30-year bond 15 years ago with a
face value of $1,000 and a coupon rate of 6%. The bond is currently selling
for $850. What is the yield-to-maturity to an investor who buys it today at that
price? (Assume semiannual coupon).
Question 3
Describe the relationship between bonds prices and interest rates using your own
example.
Question 4
Calculate the yield-to-maturity (YTM) and current yield for each of the bonds below:
Par Value Market Price Coupon rate (%) per period Years to maturity
Bond
X
RM1,000
RM820
9% annually
8
Y
RM100
RM118
3% semiannually
5
Z
RM500
RM560
12% annually
12
Question 5
Suppose you observe the following effective annual zero-coupon bond yields:
0.030 (1-year), 0.035 (2-year), 0.040 (3-year), 0.045 (4-year) and 0.050 (5-year)
For each of the maturity year, compute the zero-coupon bond prices, continuously
compounded zero-coupon bond yields, the par coupon rate and the 1-year implied
forward rate.
Question 6
Suppose you observe the following par coupon bond yields:
3.30% (1-year), 3.55% (2-year), 3.87% (3-year)
For each maturity year, compute zero-coupon bond prices, effective annual and
continuously compounded zero-coupon bond yields and one-year implied forward
rate. Assume the bond has a par value of RM 100.

UBFF3293 Risk Management (MAY 2016)

Tutorial 5 (Topic 4)
Derivatives Markets
Question 1
The key function of derivatives is in risk management. There are different types of
risks found in todays markets. Some of the commonly found risks are Market/Price
Risk, Inflation Risk, Interest Rate Risk, Default/Credit Risk, Liquidity Risk,
Currency/Exchange Rate Risk, and Operational Risk. Explain each type of risks.
Question 2
What are the major functions of derivative markets in an economy?
Question 3
Explain the difference between (a) forwards, (b) futures, and (c) options.
Question 4
a. What are the three ways in which derivatives can be misused?
b. Why is speculation controversial? How does it differ from gambling
Question 5
What are the three limitations of forwards that led to the creation of futures?
Question 6
What are the advantages of options over forwards and futures?

UBFF3293 Risk Management (MAY 2016)

Tutorial 6 (Topic 5 Part I)

Options
Question 1
Why short puts and long calls are grouped together when considering position limits?
Question 2
Discuss the three possible ways in which an open option position can be terminated.
Is your answer different if the option is created in the over-the-counter market?
Question 3
Consider an option that expires in 68 days. The bid and ask discounts on Treasury
bill maturing in 68 days are 8.20% and 8.24%. Find the approximate risk-free rate.
Question 4
The following option prices were observed for a stock on July 6, 2010. The stock is
currently priced at RM165.13. The options expirations are July 17, August 21 and
October 16. The risk-free rates are 0.0516, 0.0550 and 0.0588 respectively.
Strike
CALLS
PUTS
Jul
Aug
Oct
Jul
Aug
Oct
155
10.50
11.80
14.00
0.20
1.25
2.75
160
6.00
8.10
11.10
0.75
2.75
4.50
165
2.70
5.20
8.10
2.35
4.70
6.70
170
0.80
3.20
6.00
5.80
7.50
9.00
Compute the intrinsic values and time values for the following American calls:
a)
July 160
b)
October 155
c)
August 170
Question 5
The following option prices were observed for a stock on July 6, 2010. The stock is
currently priced at RM165.13. The options expirations are July 17, August 21 and
October 16. The risk-free rates are 0.0516, 0.0550 and 0.0588 respectively.
Strike
CALLS
PUTS
Jul
Aug
Oct
Jul
Aug
Oct
155
10.50
11.80
14.00
0.20
1.25
2.75
160
6.00
8.10
11.10
0.75
2.75
4.50
165
2.70
5.20
8.10
2.35
4.70
6.70
170
0.80
3.20
6.00
5.80
7.50
9.00
Compute the intrinsic values and time values for the following American puts:
a)
July 165
b)
August 160
c)
October 170

UBFF3293 Risk Management (MAY 2016)

Question 6
The following option prices were observed for a stock on July 6, 2010. The stock is
currently priced at RM165.13. The options expirations are July 17, August 21 and
October 16. The risk-free rates are 0.0516, 0.0550 and 0.0588 respectively.
Strike
CALLS
PUTS
Jul
Aug
Oct
Jul
Aug
Oct
155
10.50
11.80
14.00
0.20
1.25
2.75
160
6.00
8.10
11.10
0.75
2.75
4.50
165
2.70
5.20
8.10
2.35
4.70
6.70
170
0.80
3.20
6.00
5.80
7.50
9.00
Check the following combinations of European calls and puts to determine whether
they are conform to the put-call parity rule. If you see any violations to the rule,
suggest a strategy.
a)
July 155
b)
August 160
c)
October 170

UBFF3293 Risk Management (MAY 2016)

Tutorial 7 (Topic 5 Part II)

Options
Question 1
List and discuss the six factors affecting stock option prices based on American calls
and puts.
Question 2
Calculate the price of a three month European call option on a non-dividend paying
stock with a strike price of $50 when the current stock price is $52, the risk free
interest rate is 10% per annum, and the volatility is 30% per annum.
Question 3
What is the price of a European call option on a non-dividend paying stock when the
stock price is $65, the strike price is $60, the risk-free interest rate is 12% per
annum, the volatility is 20% per annum, and the time to maturity is six months?
Question 4
PYQ October 2007 Section B Q3(a)
(a)
What is the price of a European call option on a dividend paying stock when
the stock price is $105, the strike price is $90, the risk-free interest rate is
12% per annum, the dividend yield is 8% per annum, the volatility is 20% per
annum, and the time to maturity is nine months?
You are given the following formulae:
T
N d1 Ke rT N d 2
C = Se

ln S K r 2 T
2

d1
T
Where
d 2 d1 T

(b)

(10 marks)
What are the assumptions that are required that make the Black-Scholes
formula for stock options valid
(8 marks)

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UBFF3293 Risk Management (MAY 2016)

Tutorial 8 (Topic 6)
Value at Risk (VaR)
Question 1
A company has a portfolio consisting of $20 million invested in Microsoft and $10
million invested in AT&T. The daily volatility of Microsoft is 3%, the daily volatility of
AT&T is 2%, and the coefficient of correlation between the returns from Microsoft and
AT&T is 0.3. Calculate the one-day and 10-day VaR of the investment in Microsoftonly, AT&T only and the portfolio of Microsoft and AT&T at the 99% confidence level.
Question 2
Suppose a portfolio manager holds two distinct classes of stocks. The first class,
worth $20 million, is identical to the S&P 500. It has an expected return of 12% and a
standard deviation of 15%. The second class is identical to the Nikkei 300, an index
of Japanese stocks, and is valued at $12 million. Assume that the currency risk is
hedged. The expected return is 10.5% and the standard deviation is 18%. The
correlation between the Nikkei 300 and the S&P 500 is 0.55. All figures are
annualized. (Assume 250 days)
With this information, calculate one-day VaR and VaR at the 95% confidence level
for S&P 500, Nikkei 300 and the portfolio.
Question 3
Consider a position consisting of a $300,000 investment in asset A and a $500,000
investment in asset B. Assume that the daily volatilities of the assets are 1.8% and
1.2% respectively, and that the coefficient of correlation between their returns is 0.3.
What is the five-day 95% value at risk for the portfolio?
Question 4
PYQ October 2007 Section A Q1(b)
You are given the following additional information:
Asset A:
Value of investment: RM30 million
Expected return: 15% p.a.
Standard deviation: 10% p.a.
Asset B:
Value of investment: RM20 million
Expected return: 12% p.a.
Standard deviation: 8% p.a.
Correlation coefficient between returns on asset A and B is 0.3
Required:
You have been asked by your boss to compute the one-day and ten-day VaR and
VaR for the portfolio, and to interpret the results to him. You are to assume a 252days trading year.

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UBFF3293 Risk Management (MAY 2016)

Tutorial 9 (Topic 7)
Bond Risk
a)

Question 1
Consider a $100,000 bond with 10% coupon payments made semiannually.
Calculate the value of the bond for combinations of the following maturities and
zero-coupon yields for all maturities:
Maturities: 5, 10, 15 and 20 years
Interest rates: 8%, 10%, 12% and 14%
b) Consider the results in part (a) above. Describe how maturity and yield (discount
rate) affect the value of a coupon-bearing bond. Explain these effects in as much
detail and with as much intuition as you can
Question 2
Compute the duration of the following bonds. All bonds have a face value of
$100,000. They differ by their coupon and maturity. Assume coupon rates of 8%,
10%, 12% and 14%. Consider maturities of 5, 10, 15 and 20 years, and assume the
yield curve is flat at 9%.
Question 3
Suppose your company is in the US and has foreign portfolio investment with bonds
worth 50 million. Assume that the current exchange rate is S = $1.2/. You predict
that risk factors affecting the bond portfolio are the daily price returns and
movements in the exchange rate between $ and . You are given the following
information:
Standard deviation of returns on the bonds is 0.5% per day
Standard deviation of the exchange rate is 1% per day
Correlation between the two risk factors is 0.25
Compute the 1-day VaR with 99% confidence levels for each risk factor and for the
whole position.
Question 4
Suppose a 10-year zero coupon bond with a face value of $100 trades at $69.20205.
a. What is the yield to maturity and modified duration of the zero-coupon bond?
b. Calculate the approximate bond price change for a 50 basis point increase in
the yield, based on the modified duration you calculated in part a). Also
calculate the exact new bond price based on the new yield to maturity.
c. Calculate the convexity of the 10-year zero-coupon bond.
d. Now use the formula (equation 7.15) that takes into account both duration and
convexity to approximate the new bond price. Compare your result to that in
part b)

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UBFF3293 Risk Management (MAY 2016)

Tutorial 10 (Topic 8 Part I)

Forwards, Futures, Swaps and Management of Interest Rate Risk
Question 1
What are circuit breakers? What are their advantages and disadvantages?
Question 2
Explain how the clearinghouse operates to protect the futures market.
Question 3
Explain the differences among the three ways of terminating a futures contract:
offsetting trade, cash settlement, and delivery. How is a forward contract terminated?
Question 4
A major bread maker is planning to purchase wheat in the near future. Identify and
explain the appropriate hedging strategy.
Question 5
Explain the arguments against hedging.

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UBFF3293 Risk Management (MAY 2016)

Tutorial 11 (Topic 8 Part II)

Forwards, Futures, Swaps and Management of Interest Rate Risk
Question 1
Assume that in 5 months time, DEF Ltd will need to borrow $50 million for 8 months.
DEF Ltd wants to hedge using a FRA. The relevant FRA rate now is 8%. Required:
a)
State what FRA is required to quote the x by y type.
b)
What is the total amount of interest payment and the effective annual cost of
borrowing (assume 365-day calendar year) with the FRA arrangement to hedge
if in 5 months time, the interest rate is:
7%
11%
Question 2
Suppose a company has RM10,000,000 loan with 6-months rollover. The company
is worried that come next rollover in December, the interest rate would have
increased. Current interest rate is 4% and 3-month December interest rate futures
priced at 95.75. Show how the interest rate risk may be hedged using futures if in
December, the loan is rolled over at 5% and 94.88. Given: 1 tick = 0.01%. Size per
contract = RM1,000,000.
Compute hedge efficiency ratio and effective annual cost of borrowing.
Question 3
What are the differences between forward and futures contracts?
Question 4
Assume that there are 2 companies, A and B that plan to raise RM10 million debt
financing via issue of bonds. A and B have the following details
A is a highly rated company that prefers to borrow at a variable interest rate
B is a lowly rated company that prefers to borrow at a fixed interest rate
The rates that these companies would pay for issuing either floating (variable) rate or
fixed rate bonds are as follows:
Company
Fixed rate bond
Floating rate bond
A
9%
LIBOR + %
B
11%
LIBOR + 1%
Using the principle of comparative advantage, advise how a swap arrangement
would be beneficial to A and B. Assume A and B have equal bargaining power.
Question 5
Assume that it is now 1 December. Your company expects to receive $7 million from
a large order in four months time. This will then be invested in high quality
commercial paper for a period of six months, after which it will be used to pay part of
the companys dividend. The companys treasurer wishes to protect the short-term
investment from adverse movements in interest rates, by using interest rate futures
or forward rate agreements (FRAs).

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UBFF3293 Risk Management (MAY 2016)

The current yield on high quality commercial paper is Bank Base Rate + 0.60%.
CME $1,000,000 3 month $ futures. $25.00 tick size.
March 96.25
June 96.60
Futures contracts mature at the month end. Bank Base Rate is currently 4%.
FRA prices (%)
4v6
4.35 4.30
4 v 10
4.08 4.03
6 v 10
4.00 3.95
Required:
Devise a futures hedge to protect the interest yield of the short-term investment.
Explain how the futures hedge is expected to work
ii)
Ignoring transactions costs, explain how a FRA would be set up for the short-term
investment
iii)
If the Bank Base Rate fell by 0.5% points during the next four months and the
relevant futures price then is 96.65, show the expected outcomes of each hedge
in the cash market, futures market and FRA market as appropriate
i)

Question 6
Your are the treasurer of a firm that will need to borrow $10 million at LIBOR plus 2.5
points in 45 days. The loan will have a maturity of 180 days, at which time all the
interest and principal will be repaid. The interest will be determined by LIBOR on the
day the loan is taken out. To hedge the uncertainty of this future rate, you purchase a
call on LIBOR with a strike of 9 percent for a premium of $ 32,000. Determine the
amount you will pay back and the annualized cost of borrowing for LIBORs of 6
percent and 12 percent. Assume the payoff is based on 180 days and a 360-day
year. The current LIBOR is 9 percent.
Question 7
A large, multinational bank has committed to lend a firm $25 million in 30days at
LIBOR plus 100 bps. The loan will have a maturity of 90 days,at which time the
principal and all interest will be repaid. The bank is concerned about falling interest
rates and decides to buy a put on LIBOR with a strike of 9.5 percent and a premium
of $ 60,000. Determine the annualized loan rate for LIBORs of 6.5 percent and 12.5
percent. Assume the payoff is based on 90 days and a 360-day year. The current
LIBOR is 9.5 percent.

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UBFF3293 Risk Management (MAY 2016)

Tutorial 12 (Topic 9)
Interest Rate Models
Question 1
Determine the zero-bond prices and generate the interest curve under the Vasicek
model for 5 years (semi-annual intervals), given the following parameters
Kappa = 0.1
Long-run r = 12%
Sigma = 2%
r = 10%
Question 2
Construct a 4-period, 3-step (8 terminal node) binomial interest rate tree where the
initial interest rate is 10% and rates can move up or down by 2% ; model your tree
after that in figure 24.3. Compute prices and yields for 1-, 2-, 3- and 4- year bonds.
Do yields decline with maturity? Why?
Question 3
What are the 1-, 2-, 3- and 4-, and 5-year zero-coupon bond prices implied by the
two trees? Given the following is the short rate.
Tree #1
0.08
0.07676
0.0817
0.07943
0.07552
0.10362
0.10635
0.09953
0.09084
0.13843
0.12473
0.10927
0.1563
0.13143
0.15809
Tree #2
0.08

0.08112
0.09908

0.08749
0.10689
0.1306

0.08261
0.10096
0.12338
0.15078

0.07284
0.08907
0.10891
0.13317
0.16283

Question 4
What volatilities were used to construct each tree? (You computed zero-coupon bond
prices in the previous problem; now you have to compute the year-1 yield volatility
for 1-, 2-, 3- and 4- year bonds.) Can you unambiguously say that rates in one tree
are more volatile than the other?

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UBFF3293 Risk Management (MAY 2016)

Tutorial 13 (Topic 10)

Management of Credit Risk
Question 1
Read the attached write-up (Appendix A13) and answer the following questions
a) Describe the 3 issues that an institution (say, a bank) will have consider when
assessing credit risk from a single counterparty
b) What do you understand by the credit quality of an obligation?
c) Is there a difference between credit ratings used by banks relative to those used
by others?
Question 2
a)
What are the limitations to the use of external ratings issued by companies like
Moodys, JP Morgan etc?
b)
What is the relationship between stock/bond prices and credit risk?
Question 3
Use of KMV model
Suppose you are given the following information regarding Monsanto in March 1998:
1.
Book value of all liabilities: $7.2 billion
2.
Estimated default point (D): $5.7 billion
3.
Market value of equity: $33.9 billion
4.
Estimated market value of firm (V): $41.3 billion
5.
Estimated volatility of firm value : 20%
Estimate the firms distance-to-default (DD)
Question 4
Rating To:
Rating
From
F
FF
FFF

F FF
FFF
0.0
0.0
0.9
7
3
0.1
0.0
5
0.8
5
0.1
0.3
0.6

Consider a firm with an F rating.

a. What is the probability that after 4 years it will still have an F rating?
b. What is the probability that after 4 years it will have an FF or FFF rating?
c. From examining the transition matrix, are firms tending over time to become
rated more or less highly? Why?
Question 5
Identify and explain the primary methods of managing credit risk for derivatives
dealers.

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UBFF3293 Risk Management (MAY 2016)

Question 6
Comment on the current credit risk assumed for each of the following positions. Treat
them separately; that is, not combined with any other instrument.
a. You are short an out-of-the-money interest rate call options.
b. You entered into a pay fixed-receive floating interest rate swap a year ago.
Since that time, interest rates have increased.
c. You are long an in-the-money currency put option.
d. You are long a forward contract. During the life of the contract the price of the
underlying asset has decreased below the contract price.

18