2011 WINTER EXAMINATION

Module Code: RM Programme(s): MSc Finance/MBA

Student ID:

Module Title: Risk Management

Seat Number:

Exam Date: Exam Duration:

12 January 2011 15 minutes reading time 3 hours writing time

No. of Pages (including cover sheet): 4

ALLOWABLE MATERIALS
Open Book Examination Non-programmable calculator permitted

INSTRUCTIONS TO CANDIDATES 1. Answer THREE of the five questions presented. For each question selected answer ALL sections. 2. This exam is worth 50% of the final marks for this module. You are required to achieve a minimum of 40% in this examination to pass. 3. Possible marks for each question are given in brackets. 4. All answers must be written in the answer booklet provided. 5. SHOW ALL WORK. Partial credit may be awarded but only if work is shown. 6. For verbal questions please structure your answers appropriately; a good answer will provide an introduction, discussion and summary. Word counts are intentionally omitted; be as terse or as verbose as necessary to answer the question, but strive to be CLEAR AND CONCISE.

This paper MUST NOT BE REMOVED from the examination venue

QUESTION 1 You are a bank relationship manager considering the loan application for a middle sized corporate client. You are presented with the following information about the client (assume US$): Working capital Total assets EBIT Sales Market value of equity Total liabilities Retained earnings 10K 1,100,000 150K 1,200,000 300K 520K 80K

(a) How likely do you believe it that this company might default on its obligations? Your answer should reference the Altman Z-score for this company. (5 marks) (b) At the same time the company sells one million dollars of assets, one of your banks analysts forecasts sales for this company will decrease by 700K, at the same time liabilities will decrease by 300K. Recalculate the Z-score and comment on the significance of these changes; is the calculated score valid considering the changes observed? (8 marks) (c) Explain the Altman Z-score and its significance to credit risk. (d) Explain the Merton model, comparing it to the Altman Z-score. (10 marks) (10 marks)

QUESTION 2 You are presented with a portfolio that over a twenty day holding period exhibits a normal distribution of returns with mean = 0 and a standard deviation = $12M. Required a) Calculate VaR for the one day and five day holding periods at the 99% confidence intervals (5 marks) b) Assume the mean has been miscalculated, and actually is = 1.2M. In light of this revelation, calculate VaR for the one day and five day holding periods at the 97.5% confidence intervals (5 marks) c) Risk Managers often assume a normal distribution for financial time series; critically discuss this assumption, referencing specific markets. (12 marks) d) What is the single question that VaR answers? Why do we prefer VaR rather than delta, gamma or vega? (11 marks)

UoW/LSBF RM MBA/ MSc Finance/Level 7

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QUESTION 3 You are employed by a ratings agency, and forecast profits Bank Alpha will report. Your analysis assumes a normal distribution of possible outcomes, with a mean of $2.2M and standard deviation of $1.2M. SUMMARY BALANCE SHEET Bank Alpha 2010 ASSETS Cash Marketable Securities LIABILITIES 10 Deposits 10 Subordinated longterm debt with maturity > 5Y 75 Equity capital 5 100 Total

80 10

Loans Fixed Assets Total

10 100

Required (a) Consider carefully Bank Alphas equity capital; showing all work, is it adequate, with 95% confidence to insure the institution will not be rendered insolvent by possible losses? In percentage terms, how much additional capital would be necessary to protect against a similar loss scenario at the 99.9% confidence interval (5 marks) (b) Explain the importance of Equity capital, comparing and contrasting to Long-term debt; make sure your answer considers compliance under Basel II (5 marks) (c) Basel II allows banks to choose between the standardized, the IRB and the Advanced IRB approaches when calculating counterparty credit risk. From the banks perspective explain the pros and cons of each approach. (10 marks) (d) Bank Alphas loan book consists of $100M of unsecured, personal loans (i.e., not mortgages). The one year PD of the loan book is 1.5%. The recovery rate is 80%. Assume the loss correlation is 0.55; calculate the one year WCDR with a 99.9% confidence interval, as well as the maximum loss realized (per year) should this WCDR occur. (5 marks) (e) Under Basel II the following formula is used to calculate required capital: EAD * LGD * (WCDR PD) * MA Define these terms grounding your answer with a specific example. Explain the significance of each term to regulators and the regulatory capital calculation. (8 marks)

UoW/LSBF RM MBA/ MSc Finance/Level 7

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QUESTION 4 You are structuring a portfolio based on two available investments as follows: Asset ONE TWO 5% 25% 20%

The correlation of returns between the two assets, , is -0.8 Required (a) Produce a table showing the risk / return tradeoff by constructing portfolios weighted in 10% increments of either asset. Weights for each asset will range from 0% to 100%. Your table should have eleven rows and four columns, and will clearly present asset weights, as well as the portfolios mean and standard deviation. (7 marks) (b) Display your results in two dimensional risk / return space. (c) Describe the portfolios characteristics when either asset is 100% weighted. (3 marks) (3 marks)

(d) Which portfolio would a rational investor select and why? Identify this portfolio on the graph you previously created. (3 marks) (e) Describe in words, without using either a table or graphical results, what would happen to the portfolios mean and standard deviation should the correlation of returns between these two assets, , be positive and NOT negative and the assets weighted 50% each (assume these assets are perfectly positively correlated). (10 marks) (f) Consider a well-structured portfolio with mean and volatility ; why would an investor consider adding assets that are negatively correlated to this portfolio? (7 marks)

QUESTION 5 As a Risk Manager working for an investment bank, you have been asked to brief Senior Management on various approaches to calculating VaR. Required a) Explain the Historical Simulation Approach to calculating VaR. Identify the various steps involved, as well as the data required to accomplish this calculation. (5 marks) b) Explain the Variance-Covariance Approach to calculating VaR. Outline the various steps involved, as well as the data required to accomplish this calculation. (5 marks) c) Compare and contrast the two approaches, illustrating scenarios where one model would be favoured over the other. (10 marks) d) Explain Monte Carlo Simulation. Detail the steps involved, as well as the data required to accomplish this calculation. (5 marks) e) A technique sometimes used to augment Monte Carlo Simulation is called Partial Simulation. What is this technique and why is it employed? (8 marks)

END OF QUESTION PAPER

UoW/LSBF RM MBA/ MSc Finance/Level 7 Winter 2011 Exam Page 4 of 4