MID TERM EXAM

PAF KIET (Nazimabad Campus)

RISK MANAGEMENT
Prepared By Dr.Muhammad Imran Khan
SYED MUNAWAR ALI
61496

Part A

Multiple Choice Questions

1. Risk management can be defined as the art and science of ________ risk factors throughout the
life cycle of a project.
A. researching, reviewing, and acting on
B. identifying, analyzing, and responding to
C. reviewing, monitoring, and managing
D. identifying, reviewing, and avoiding
E. analyzing, changing, and suppressing

2. Risk Management includes all of the following processes except:

A. Risk Monitoring and Control
B. Risk Identification
C. Risk Avoidance
D. Risk Response Planning
E. Risk Management Planning

3. A risk response which involves eliminating a threat is called:

A. Mitigation
B. Deflection
C. Avoidance
D. Transfer
E. b and d

4. When should a risk be avoided?

A. When the risk event has a low probability of occurrence and low impact
B. When the risk event is unacceptable -- generally one with a very high probability of
occurrence and high impact
C. When it can be transferred by purchasing insurance
D. A risk event can never be avoided

5. An example of risk mitigation is:

A. Using proven technology in the development of a product to lessen the probability
that the product will not work
B. Purchasing insurance
C. Eliminating the cause of a risk
 D. Accepting a lower profit if costs overrun
E. a and b
6. Risk mitigation involves all but which of the following:
A. Developing system standards (policies, procedures, responsibility standards)
B. Obtaining insurance against loss
C. Identification of project risks
D. Performing contingent planning
E. Developing planning alternatives

7. Mitigating risk could involve.

A. identifying risks, obtaining insurance and developing alternatives
B. contracting and quality assurance
C. developing standards, buying insurance, and planning for contingencies and alternatives
D. re-scoping the project and reassessing requirements
E. C and D

8. Suppose a project has many hazards that could easily injure one or more persons and there is no
method of avoiding the potential for damages. The project manager should consider __________
as a means of deflecting the risk.
A. abandoning the project
B. buying insurance for personal bodily injury
C. establishing a contingency fund
D. establishing a management reserve
E. not acknowledging the potential for injury

Match each term with a statement

1. __ premium ___ A fee that is charged for insurance coverage.

2. __ risk ___ The possibility that a loss will occur.

3. __ insurance policy ___ A contract between two parties.

4. _ risk management ____The purpose is to minimize the costs of a loss or injury.

5. _ speculative risk ____A decision to market a new product is an example of this type of risk.

6. _ insurer ____The party that assumes financial responsibility for losses.

7. _ insurable risk ____Insurance companies are willing to assume this type of risk.

8. _. pure risk ____An example of this risk is the possibility of an automobile accident.

9. __ insurance ___It provides protection through a contract against loss.

10. _. self-insurance ____A monetary fund established to cover the cost of a loss.
 Part B
Question No 1
a)
Define the following
I) Interest Rate Swaps.
II) Currency Swaps.
III) Commodity Swaps.
IV) Credit Default Swaps

INTEREST RATE SWAPS

An interest rate swap is a forward contract in which one stream of future interest payments is
exchanged for another based on a specified principal amount. Interest rate swaps usually involve
the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase
exposure to fluctuations in interest rates or to obtain a marginally lower interest rate than would
have been possible without the swap.

CURRENCY SWAPS

A currency swap, sometimes referred to as a cross-currency swap, involves the exchange of

interest – and sometimes of principal – in one currency for the same in another currency. Interest
payments are exchanged at fixed dates through the life of the contract. It is considered to be a
foreign exchange transaction and is not required by law to be shown on a company's balance
sheet.

COMMODITY SWAPS

A commodity swap is a type of derivative contract where two parties agree to exchange cash
flows dependent on the price of an underlying commodity. A commodity swap is usually used to
hedge against price swings in the market for a commodity, such as oil and livestock.

CREDIT DEFAULT SWAPS

A credit default swap (CDS) is a financial derivative or contract that allows an investor to "swap"
or offset his or her credit risk with that of another investor. For example, if a lender is worried
that a borrower is going to default on a loan, the lender could use a CDS to offset or swap that
risk. To swap the risk of default, the lender buys a CDS from another investor who agrees to
reimburse the lender in the case the borrower defaults. Most CDS will require an ongoing
premium payment to maintain the contract, which is like an insurance policy.
 B)
A has A B Difference

$ 9.50% 8.25% 1.25%

¥ 7.00% 8.00% -1.00%

2.25% Max gain

comparative advantage in ¥ borrowing; B has comparative
advantage in $ borrowing.

A desires $ funding;
B desires ¥ funding;

Effective costs and savings:

A: Pays to bank -8.39%

Pays to ¥ debt -7.00%
Receives from bank 7.12% ==> -8.27%

Direct borrowing cost 9.50%

Effective cost 8.27% ==> saving: 1.23%

B: Pays to bank -7.17%

Pays to $ debt -8.25%
Receives from bank 8.35% ==> -7.07%

Direct borrowing cost 8.00%

Effective cost 7.07% ==> Savings: 0.93%

The Bank benefits from swap:

$ Spread: 8.39% - 8.35% = .04%

¥ Spread: 7.17% - 7.12% = .05% ==> Total .09%

1.23% + .93% + .09% = 2.25% maximum gain for all partie

 C)
Suppose a life insurance company issued $100 million of five-year Guaranteed Investment Contracts
that commit it to pay a fixed rate of 9% semi-annually. Suppose the company is able to invest $100
million in a five-year semi-annual floating rate instrument yielding 6-month UBOR plus 100 b.p.

a. Describe the interest exposure by the insurance company. At what point would the
company not be able to earn enough on the floating rate instrument to pay for its fixed
obligations?
b. Suppose there is available in the market a 5-year fixed-floating interest rate swap with a
notional amount of $ 100-million with the following terms:
- receive fixed 8.5% every six months
- pay 6-month LIBOR
How can the insurance company use this swap to hedge its interest rate exposure?
c. Calculate the spread the company would lock in if it chooses to enter the swap agreement.

SOLUTION
a. The company is obligated to pay 9% fixed. Its cash-flow pattern is as follows:

LIBOR + 1% - 9%. Company is exposed to decreases in short-term interest rates. If its revenues
from its floating-rate investment is less than 9%, the firm will lose money on its positions. Its
investment is yielding LIBOR + 1%. Therefore, whenever LIBOR is less than 8%, the company’s
interest income will not cover its obligations and the firm will lose money.

b. If the firm enters into the available swap, it will hedge its asset/liability exposure. Money
received: From Original Investment LIBOR+ 1% from Swap Agreement 8.5% Net Received LIBOR
+9.5% Money Paid: To GIC 9% From Swap Agreement LIBOR Net Paid 9%+LIBOR

c. Spread Income: (LIBOR + 9.5%) - (LIBOR + 9%) = 0.5% Using a swap, the firm is able to lock in
a spread income and hedge itself
 Question No 2
a)
Explain types of derivatives (forwards, futures & options)

Derivatives
Derivatives are securities whose value is determined by an underlying asset on which it is
based. Therefore the underlying asset determines the price and if the price of the asset
changes, the derivative changes along with it. A few examples of derivatives are futures,
forwards, options and swaps. The purpose of these securities is to give producers and
manufacturers the possibility to hedge risks. By using derivatives both parties agree on a sale at
a specified price at a later date. In each derivative certain aspects are documented such as the
relation between the derivative, type of underlying asset and the market in which they are
traded. It is essential to understand the strengths and weaknesses of each derivative to employ
them to their fullest potential.

Futures
Futures are exchange organized contracts which determine the size, delivery time and price of a
commodity. Futures can easily be traded because they are standardized by an exchange. Per
commodity traded there are different aspects specified in a futures contract. First of all is the
quality of a commodity. For a commodity to be traded on the exchange, it must meet the set
requirements. Second is the size of a single contract. The size determines the units of a
commodity that is traded per contract. Thirdly is the delivery date, which determines on which
date or in which month the commodity must be delivered. Thanks to the standardization of
futures commodities can easily be traded and give manufacturers access to large amounts of
raw materials. They can buy their materials on the exchange and don’t need to worry about the
producer or take on contracts with multiple suppliers.

Forwards
Forwards and futures are very similar as they are contracts which give access to a commodity at
a determined price and time somewhere in the future. A forward distinguish itself from a future
that it is traded between two parties directly without using an exchange. The absence of the
exchange results in negotiable terms on delivery, size and price of the contract. In contrary to
futures, forwards are usually executed on maturity because they are mostly use as insurance
against adverse price movement and actual delivery of the commodity takes place. Whereas
futures are widely employed by speculators who hope to gain profit by selling the contracts at a
higher price and futures are therefore closed prior to maturity.

Options

Options are a form of derivatives, which gives holders the right, but not the obligation to buy or
sell an underlying asset at a pre-determined price, somewhere in the future. When you take an
option to buy an asset it is called a ‘call’ and when you obtain the right to sell an asset it is called
a ‘put’. To determine whether it is profitable to exercise an option, the current market price (spot
price) and the price in the option (strike price) need to be compared. By comparing both prices, a
choice can be made to either exercise the option or let it expire. When exercising an option there
are three positions on which the holder can find themselves. The first is in the money (ITM),
where the strike price is more favorable than the spot price and thus it will be advantageous to
exercise the option. The second is at the money (ATM) in which the strike and spot price are
equal and so no advantage can be gained. The third is out the money (OTM), where the strike
price is higher than the spot price. In this case it is better to let the option expire and buy the
commodity at the current market price. There are two ways of settling an option between two
parties. The first way is to physically deliver the underlying commodity. The other way is to cash
settle the option. In this way the difference between the spot and strike price is paid to the holder
of the option upon exercising of the option. An option has a few advantages over other
derivatives. The most important advantage is that an option is not binding, in the way is does not
obligate one to buy a commodity. It gives you the right to buy it and so when the price of the
option is higher than the current market price you can just let the option expire and buy at the
spot price. The only loss made, will be the premium which is the cost for maintaining the option.
Another advantage is the usefulness of options as a hedging tool. Options offer the tools to
successfully hedge price movements with a small investment risk.

b)
Explain Black - Scholes Model, Binomial Model, Monte Carlo Simulation

Black-Scholes
The Black-Scholes model is the most popular method for valuing options and can be quite accurate.
It relies on fixed inputs (current stock price, strike price, time until expiration, volatility, risk free
rates, and dividend yield). The good thing is, you don’t have to be a math whiz, just find the right
inputs and use a good online calculator (here’s a decent one). For most regular options, using a
Black-Scholes model is good enough. The downside to the Black-Scholes model is that it’s a black
box calculator and it doesn’t offer the flexibility required to value options with non-standard features,
such as a price reset feature or a mandatory exercise requirement.

Binomial models
In contrast to the Black Scholes model, a binomial model breaks down the time to expiration into a
number of time intervals, or steps. At each step, the model predicts two possible moves for the stock
price, (one up and one down) by an amount calculated using volatility and time to expiration. This
produces a binomial distribution of underlying stock prices. The model produced is a theoretical
representation of all the possible paths that the stock price could take during the life of the option.
At the end of the model -- i.e. at expiration of the option -- all the terminal option prices for each of
the final possible stock prices are known as they simply equal their intrinsic values.
Next the option prices at each step of the model are calculated working back from expiration to the
present. The option prices at each step are used to derive the option prices at the next step of the
model. Any adjustments to stock prices (at an ex-dividend date) or option prices (as a result of early
exercise of American options) are worked into the calculations at the required point in time. As you
work your way back to the present, you are left with one option price.
It should be noted that if no alterations are made and the same inputs as a Black-Scholes model are
used, and when using a sufficient number of steps, the results of the binomial model and a Black
Scholes model will be identical. However, the binomial model also offers more flexibility because
the user can alter the inputs at each step in the process to account for differences in the ability to
exercise a particular option that shows non-standard features. The downside is that binomial models
are complex to construct and depending on the number of steps used in the model, can be incredibly
unwieldy in terms of size of the spreadsheet and computing power needed to run.

Monte Carlo Simulation

Monte Carlo simulation uses computerized modeling to predict outcomes. The model first generates
a random number based on a probability distribution. The random number then uses the additional
inputs of volatility and time to expiration to generate a stock price. The generated stock price at the
time of expiration is then used to calculate the value of the option. The model then calculates results
over and over, each time using a different set of random values from the probability functions.
Depending upon the model, the number of uncertainties and the probability distributions used, a
Monte Carlo simulation could involve thousands or tens of thousands of recalculations before it is
complete. For option models, Monte Carlo simulation typically relies on the average of all the
calculated results as the option price.
In some ways the Monte Carlo provides the best of both the Black-Scholes and binomial worlds.
With the right software, (here’s a good, inexpensive option) you can provide the inputs and let the
model do its thing, ultimately spitting out a result (although it takes a little longer than the Black-
Scholes calculation). And while it isn’t as unwieldy to use a binomial model, it still provides
flexibility in the inputs that can be used.
 C)
For a two-period binomial model, you are given:

(i) Each period is one year.

(ii) The current price for a non-dividend-paying stock is 20.
(iii) u = 1.2840, where u is one plus the rate of capital gain on the stock per period if the stock
price goes up.
(iv) d = 0.8607, where d is one plus the rate of capital loss on the stock per period if the stock
price goes down.
(v) The continuously compounded risk-free interest rate is 5%.

Calculate the price of an American call option on the stock with a strike price of 22.

1- call input
0= put 1
Assumption
Stock Price 20
Strike Price 22
Time(yrs)( 3 months) 90/360 days 2
Volatility 0.20
Risk free rate 0.05
Div Yield 0.00
Number of step 2.00
Time per Step(time/no. Of step) 0.50

  -0.59
Call  
Solved(find the variable down one)  
u(magnitude of up jump) 1.2840
d(magnitude of down jump) 0.8607
a 1.105
p (probability of up jump) 59.50%
1-p (probability of down jump) 40.50%
Discount Rate 0.9753
Discount rate for put 0.90
   

Stock 20.00
Call Value 3.69
PUT Value 3.60
Price goes UP 3 onths 25.68
Call Formula--> 6.37
  0.00
   
Price go DOWN 17.21
  0.00
Put Formula--> 6.27

Price go more Up 6 months 32.97

OPTION UP----> 10.97
(stock price *U) 0.00
   
  10.40
  0.00
(Stock price *D) 0.00
   
  14.82
  0.00
Option Down---> 5.18