001s! [Non Alpha Calculators Only Calculators may be used in this examination provided they are nat capable ‘of boing used to store alphabetical information other than hexadecimal numbers. ‘THE UNIVERSITY OF BIRMINGHAM Degree of MSc Investments Risk Management 07 02687, 800151 May 2012 ‘Hours: ‘Students are required to answer THREE questions. At least ONE question must be anewered from section A and one from section B. 0702607 1 (Tura over)‘s0o1si [Non Alpha Calculators Only Section A Question + (2) Hedging options, even simple options, can be difficult. Discuss Teasons why tis iss. (25marks) (©). Explain in deta how you would a carry out a delta-gamma-vega hedge on a large call option you have just sold on a stock of a major publicly quoted company. (30 marks) (c) Explain the alfference between conventional and synthetic repos. (20 marks) (@) What are equty swaps? Explain their uses. (15 marks) (Total 100 marks) Question 2 (@) Discuss the constant proportional and option based portfolio insurance strategies, In each case use a diagram to support your Giscussion. What problems would you face in implemeriing these strategies? (40 marks) (©) Stress testing and'back testing of models are Important Fisk management. Explain why this is Ue cave end provid ‘example(s} where their application is citically important (35 marks) (4) What is mapping? Why and wherein finance is it needed?” Use two fexamples of mapping to illustrate your discussion. (25 marks) (Total 109 marks) 702607 2 (Tarn over)Aoo1st Non Alpha Calculators Only Question 3 (2) What are the characteristics of a sound risk management system? {Give reasons for their importance, (60marks) (©) What are the majo’ lessons for risk management that you would draw fiom the recent financial crisis?” (60 marks) (Total 100 marks) Section B ‘Question 4 (a) Suppose a US bank has a ex month forward contract with a European bank to deliver 100 milion Euros for $130 milion US dollars. The current sicmonth interest rate for the US dollar is 2.00% per annum and the corresponding rate forthe Euro is 3.00% per annum. “The standard deviation in percent terms forthe spot exchange rate is 0.5, for the eure interest rate is 0.07 and for US dollar interest rae is 0.08. The following correlation matrix is available, SpotFX Euro USS ‘Spot FX q 007 0.13 Euro oo7 1 020 uss. OH (@ Estimate (the Value-at-Risk for the contract at the 99% confidence level, (45 marks) ana (The diversification benefits (10 marks) (0) Discuss the strengths and weakness of Value-at-Risk (20 marks) (©) Several methods might be employed to estimate Vahe-at-Risk (Choose one ofthe methods and discuss its strengths and weaknesses. (25 marks) (Total marks 100) Question 5 07 02697 3 (Tura over)Aoo1st ‘Non Alpha Calealators Only (a) In mid-March you expect to raise $10 milion in sic months time which you plan to invest for six months, The current US dollar spot rate of interest for sir monthe is 2.25% per annum and for 12 months is 2.5% per ‘annum. You are concered that inflation worries may mean that interes: rates wil rise by a greater extent than is anticipated by the market. You propose to hhedge your exposure by using elter a forward rate agreement or Eurodoliar futures contracts, The current price of the September Eurodoliar futures contract is 97.3 and the contract size is $1 milion 0 Jgnoring a bi-ask spread and other costs, what is likely to be the inferest rate quoted on the forward rate agreement? State any ‘assumptions you make. (18 marks) {i Assume, for lustration purposes, your view tums out tobe correct ‘and wen you came t0 borrow the money the six- month spot market rate is 3% per annum forthe six-month borrowng period, ‘What willbe the cash setlement between your company and the bank that sold you the forward rate agreement? (25 marks) (ii) How many Eurodollar futures contracts do you require to hedge the above exposure ifthe debt was six month commercial paper? Also what are the gains or losses on your futures hedge? State any assumptions you make (30 marks) (©). Forward rate agreements, caps, collars and swaps are instruments that can be used to manage interest rate risk. Discuss the edvantages and disadvantages of each. (20 marke) (Total marks 100) Question 6 ‘A.US secures fir is planning to return Yen 1,000 milion to fhe US In 3 ‘months time. The firm is concerned thatthe Bank of Japan might intervene in the curreny market to prevent the yen from rising against the US dollar. ‘The frm is considering hedging Yen 750 millon ofits exposure with one of {wo option strategies. ‘The first strategy Is a put spread, and the second, a range forward. Under the put spread the frm will Buy & put option at a premium of 4 per cent of the contract 0702607 4 (Turn over)‘Ago1si Non Alpha Caleulators Only size and an exercise price of Yen 78/$ and sell a put option at a remium of 2 per cent of the contact size and an exercise price of Yen 62/6 The range forward is a zero ooet strategy where the firm will buy a put option at an ‘exercise price of Yen82/$ and sella call option, at an exercise price of yen7a/8. The unhedged portion wil be exchanged in the maket. For iustrative purposes assume the current spot exchange rate is yen 80/$ and that the exchange rate In three months’ ime is eter Yen 76VS, yen80/S or yyen84V§. Show all calculations and plot the payoff diagrams for the hedged positon only. (@) Which strategy would you recommend and why? (40 marks) (Discuss the roles that duration, Key rate duration and convexity might play in bond portfolio risk management, (96 marks) (€) What are the ‘Greeks’? Explain their uses in risk management (36 marks) (Total 190 marks) ‘Question 7 (@) You hold £10 milion bonds that were issued by a UK retal company ‘some eight years ago. The bonds now have a remaining ilfe of 4 years. Due te government austerity measures you are concerned that consumer confidence wil fal further increasing te likelihood that the bond ssuers wil default within the next four years. As a result you are considering transferring the credit risk associated with the bonds via a named credit defauit swap. ‘You estimate the recovery rates in the event of a defauit wll be 60%, 55% ‘50% and 45% in years f, 2, 3, and 4 respectively, Further you estimate the probablity of deraut each year will be 4 per vei condiional on no prior year default, Assume anj default wil occur mid-year and thatthe risk-tree Zero curve is flat at 4 %. What premium would you expect to oay for the ‘our year credit default swap? (60 marks) (b) Various institutions are active buyers and sellers of credit protection ‘What types of institutions are active in the credit risk transfer market and what benefits do they derive from such activity? (20 marks) (@) Brit explain other methods that might be used to transfer credit risk. (30 marks) (Total 100 marks) 0702697 (End of Exam)