00151 Non-alpha only UNIVERSITY°F BIRMINGHAM BIRMINGHAM BUSINESS SCHOOL ‘M.Sc. InvesrmeNTs Risk MANAGEMENT Banner Cove: 07 02697 00151 ‘SUMMER EXAMINATION 2011 3 HouRS ‘Arrener3 questions. EMT AT LEAST ONE QUESTION FROM SECTION A AND ONE FROM SECTION B CALCULATORS MAY BE USED IN THIS EXAMINATION PROVIDED THEY ARE NOT CAPABLE OF ‘BEING USED TO STORE ALPHABETICAL INFORMATION OTHER THAN HEXADECMAL NUIABERS 1 Tum over00151 Non-alpha only SECTIONA “Risk has become @ growing concern for most financial institutions today, respective of whether this concem stems from an increasingly competitive marketplace or from more stringent regulations, financial institutions must have a robust risk management in place if they wish to survive in a more interconnected and complex world.” (JP Morgan ‘Setting up @ sound risk management framework’, June 2008) Discuss the characteristics ofa 'sound’ risk management process and framework, 1, Digcuse portfolio insurance strategies. b. Discuss stress testing and back testing of Value-at-Risk models fc. What is mapping and why is it needed? Illustrate your ‘explanation using two types of securities as examples of mapping @. Compare and contrast the Creditmetrics and the KMV approaches to modelling credit risk . Market risk models have been accepted for regulatory purposes but not credit risk models, Discuss the reasons why this is the case, Total mas: 100, “otal mark: 100 (35 marks) (0marks) (95 mats) “ota mas: 100 (75 maris) (25 maria) Tum over00151 ‘Non-alpha only SECTIONB Total mars: 190 ‘8, Suppose a US bank's balance sheet has an asset duration of 7 years and a labilty duration of Tyear, The balance sheet assets are $10 millon and the liablities is $9 milion. The bank anticipates a significant rise in interest rate from 3 per cent to 4 per cent in the near future and is planning to hedge its interest rate risk exposure using elther Treasury bond futures or a swap contract. iL T+bond futures ate priced at $97 per $100 of face value for the (40 marks) 20-year bond underiying the futures, the minimum contract sizes $100,000 and the duration ofthe deliverable bond is 9 years OR, OR li, Aseume the duration of @ curent 10 year bond paying the (40marks) same interest as the fixed rate payments on the swap is 6.5 years, and the duration of floating rate bond, which is ‘equivalent to the floating rate payments and re-prices annually, is 1 year. Swaps are avalable in multiples of a rion dollars. Iustrate both hedges and discuss the assumptions underlying both hedges. 3 Tum overAgo1st Non-alipha only . Suppose you have sold 10 calls for a premium of $2.45 per share (40 mars) ‘on a stock with an exercise price of 80 and a maturity of 60 days. Each call is based on 100 shares. The underling share price is, $50, The sold option’s delta, gamma and vega are 0.55, 0.075 and 8.20 respectively. A second option on the same underlying asset has an exercise price of 55, a maturity of 100 days and its premium is $4.147 per underlying share. It has a delta, gamma and vega values of 0.30, 0.05 and 9.05 respectively. i, You ate required to construct a self-financing portfolio that is. [25mars] delta and gamma neutral, | What isthe portfolo's vega? Is mmars} 6. Briefly explain how you would extend the above construction to (20 marks) make t vega eutral 4 Turn overA00tst Non-alpha only Total marks: 100 1 In mid-March you expect fo raise $10 milion in six months time (70 marks) wien you plan to invest for six months, The current US dollar spot rate of interest for si months is 2.25% and for 12 months is 25%, ‘You are concerned that inflation worries may mean that interest rates wil rise by @ greater extent than is anticipated by the market. You propose to hedge your exposure by using either & forward rate agreement or Eurodoliar futures contracts. The curent price of the September Eurodoliar futures contract Is 98.36 |. Ignoring @ bid-ask spread and other costs what is likely to be [16mars] the interest rate quoted on the Forward rate agreement? State any assumptions. © you. «= make li, Assume, for ilustraion purposes, your view turns out to be [26marks) comect and when you come to borrow the money the six- month spot market rate is 3% for the six-month borrowing period. What will be the cash settlement between your ‘company and the bank that sold you the forward arte agreement? ii, How many Eurodolar futures contracts do you require to [20maris) hedge the above exposure if the debt was six month commercial paper? Also what willbe the gains or losses on ‘your futures hedge? State any assumptions you make. b. Forward rate agreements, Caps, collars and corridors are (20 marks) instruments that can be used to manage interest rate risk Discuss the advantages and disadvantages of each, 5 Tun overAoo1s1 1. A German securties firm is planning to return $10,000,000 to Germany in 3 months time, The firm is concerned that hedge funds and other big funds are rumoured to be betting that the dollar will no longer be seen as a safe haven in times of crisis. The frm is considering fully hedging its exposure with one of two stratogies, The fist is a put spread, and the second, a participating forward. Under the put spread the firm will uy @ put option at @ premium of 4 per cent at an exercise price of USS1.42/€ and sella put option at a premium of 2 per cent and fan exercise price of USS1.46I6, The participating forward is a zero cost strategy where the firm will buy a put option on {$10,000,000 and sell a call option on $6,000,000 both at an exercise price of US$1.43/E Assume the spot exchange rate is uss1.39€ Iustrate the possible receipts the firm might obtain under the proposed hedges over an exchange rate range from $1.35/€ to 31.5016. Which strategy would you recommend and _ why? No Caleulator “otal mas: 100| (35 mars) Tun overAgotst Nomalpha only b. Assume you ate a fund manager holding @ £10 millon porfoio of (86 marks) large company stocks that are listed on the London stock marke. ‘Assume futher your portfolio has a beta value of 1.15. You are concerned that the stock market might suffer a temporary, but significant, fall over the next three months as a result of developments in the Middle East and the UK govemment's austerity measures so you decide to fully hedge your portolio using FTSE 100 stock index futures contracts. ‘The FTSE 100 index is currently at 6000, Its annualised dividend yield Is 2 per cent and the annualised 3 month interest rate is 4 per cont, ‘Assume at the end ofthe three months the FTSE 100 index has {allen to 5400 on the day the futures contracts expire, i. What isthe price of the FTSE 100 stock futures contract? [Sma] li, What ig the resutt of your hedge? State all assumptions. 80 marks) you make, (Each index point is worth £10). ©, Discuss the advantages and disadvantages. of international (90 marts) portfolio diversification under normal and crisis conditions. 7 Tum overAggts1 Non-aipha only ‘. You hold £10 milion bonds that were issued by a company some ten years ago. The bonds now have a remaining life of 4 years. You believe the default probability of the bonds is likely to inerease and further that the recovery rate in the event of defautt, will iso fall, As a result you are considering transferring the credit isk via a named credit dofault swap. You estimate the recovery rate will be 40 per cent and that the ‘faut probabilties each year willbe 4 per cent conditional on no prior year default. Assume any default will ocour mid-year and thatthe risk-free zero curve is flat at § per cent. What premium would you expect to pay forthe swap? b. Who are the buyers and sellers of credit risk protection? Discuss, the benefits each expects to receive from credit risk transfer. . Briefly explain what other methods might be used to transfer credit isk? “otal mare: 100 (6omais) (25 mars) (25mars) End of Paper