Problem 1 Answer by “True”,“False”, or “Uncertain” and provide a short explanation for your

answer.

1. Credit risk is easy to quantify with historical corporate bond data. (3 minutes/points)

False, this market-based method is difficult to use for risk management.Since the implied default
probability from bond prices is risk-neutral and verydifferent from (usually larger than) physical
probabilities.

2. To compute monthly Value-at-Risk (VaR), we need daily log returns and the market value of
the position at risk. (3 minutes/points)

True, use the historical data method, estimate realized volatility with ascale.

3. Explain what is "immunization" when refering to interest rate risk. (3 minutes/points)

Immunization is basically matching duration of your asset and liabilityto get rid of interest rate
risk. This method is mainly used by pension funds,who get lots of long-term asset and liabilities.

4. We discussed three methods of computing Value-at-Risk (VaR), namely, making assumptions

about the distribution of returns, resampling from the historical distribution of returns, and using
simulations. Briefly explain all three methods, emphasizing their differences (6 minutes/points)

•Making assumptions on returns distribution. Linking the quantile and dataobserved by a simple
distribution, usually normal. ThenV aR=−W∗R∗=−2.33∗W∗σ.•Resample from historical data.
Use a bootstrap method to construct manysamples and then get the quantile by ranking. The
main difference is, this is anon parameter method, does not depends on assumptions and not
required forestimation of volatility.•Simulation. This is also a non parameter method while it
requires a dis-tribution assumption to generate random samples instead of bootstrap samplesfrom
historical data.
5. Explain why the concept of no arbitrage is crucial in pricing financial assets. (4
minutes/points)

No arbitrage is crucial for asset pricing to make sure assets with differentpayoffs cannot have the
same price. Only with it we can use replication methodto price contingent claims. This is also
reasonable in terms of risk-return trade-off and an equilibrium background.

6. Is it true that we can increase the value of a company by hedging systematic risks with
financial instruments? Explain (5 minutes/points)

Yes, roughly, hedging systematic risks would leads to lower discount ratefor valuation based on
the DCF method.

7. Explain what is a hedge ratio.(3 minutes/points)

Hedge ratio is the optimal amount of derivative to offset one unit of it’sunderlying asset’s
risk.h=dS/dF

8. We can hedge currency risk using futures, options, and swaps. Explain the difference between
these three contracts (4 minutes/points)

Option. Basically option provides the right to exchange currencies in afixed rate. One
would only exercise the option when it’s in the money at thematurity. Thus it’s payoff is
asymmetric and only eliminating one side of risk(while usually downside). Enter in a option
contract is sometimes expensive.•Futures. Futures provide obligation to buy or sell at a fix
rate. Thuseliminate the two sides of risks with a symmetric payoff. Enter in a future1
contract is not expensive, the only requirement is margin for default controlling.•Swaps.
Different with the two above, a swap is usually traded OTC betweentwo counterparties with
different contingent cash flows. For risk hedging, mainlythere is a party with fluctuating cash
flows and a party with fixed cash flows,they gonna swap the payoff to satisfy each other.

9. Oil is at a historic low and many investors expect it to go up in the future. Therefore, a good
hedging strategy would involve locking-in “cheap” oil by buying as many futures contracts as we
can afford. (4 minutes/points)
False, buying derivative itself without underlying is not hedging butspeculation. Here you
are betting high oil price with high leverage, would crashif oil price keep going down. This
is the scenario in case 4 which the MGcompany over hedged and thus crash when oil price
goes down.

10. Idiosyncratic risk can be reduced only using hedging strategies, such as buying put options or
futures contracts.(4 minutes/points)

False, besides derivatives, natural hedging is used to diversify idiosyn-cratic risks with no extra
cost.

11. The important point from Aspen Technologies (Homework: Case 3) is that we should mostly
focus on hedging expenditures rather than revenues. (3 minutes/points)

False, the main takeaway is you should hedge net exposure.

12. Define rollover risk and discuss whether fluctuations in interest rates will increase or
decrease rollover risk.(4 minutes/points)

Rollover risk for interest rate is a risk associated with Refinancing ofdebt. Basically, a
firm need to close their previous debt based on the old yieldand issue new debt with current
yield. With the same principal value of thebond, gain or loss depends on the present values
discounted by the old andcurrent rates. If rates rise, a firm would have to refinance it’s debt
by payinga higher interest. Same thing for investors lend money out, they would sufferfrom
decrease of interest rate.

13. Define liquidity risk and provide a few measures of liquidity. Can investors hedge against
liquidity risk? How? (4 minutes/points)

Liquidity risk can be defined as limit of long or short a required position.People measure
liquidity risk by bid-ask spread, volume, volatility etc. Notethat the liquidity risk is
correlated with credit risk and cash position, thus tohedge against liquidity risk, you need
properly manage the cash receiving andallocating to keep cash in hand for potential acquisitions.
For short position,strategy like boxing may also works.
14. A standard view in finance is that we cannot forecast returns, variances and correlations, and
therefore measuring risk (with VaRs) and hedging risk is pointless. (4 minutes/points)

The variance and correlation are easy to forecast, which providesconvenience to risk
management.

Problem 2 Answer the following questions:

1. The 1-month forward price of oil is  = $34 The current spot price is 0 = $27 The 1-month

risk free rate is  = 1% Storage cost is  = 2% per month. Can you imply the monthly
convenience yield?(5 minutes/points)

Considering the pricing formula:F0=S0[(1 +rf)(1 +rstorage)(1 +y)]T−ty=S0(1 +rf)(1

+rstorage)F0−1 =−0.1819You can apply log return formula and get similar results.

2. Explain the challenges that BlackRock faces when offering index ETFs. Be as specific as
possible.(3 minutes/points)

The main challenge is that when index turbulent a lot, it’s difficult tokeep the Net Asset Value
of fund consistent with the index movement. Moreadjustment means more transaction cost.

3. Securitized products, such as mortgage backed securities (MBS), provide an effective way of
selling off credit risk but they have been systematically mispriced during the financial crisis of
2007-2008.(3 minutes/points)

True, the idea behind is banks packaging their loan and sell to investorto transfer default risk.
However, there are potential problems like adverseselection and monitoring issues. The
subprime mortgage crisis is an example,without enough transparency, investors did not know
what’s in their loan bundleand thus cannot fairly evaluate the default risk.

4. Credit Generale (Homework: Case 2) was exposed to currency risk. There were a few
elements to its exchange rate exposure, namely:

(a) There was lack of liquidity in the GBP/DM exchange rate market. Explain.(3 minutes/points)
The situation is, because of a sudden jump in British Pound depreciation,2
the GBP/DM exchange rate surge down, a company like CG with a high GBPposition required to
be exchange back cannot find a trade.

(b) The company should have hedged all risk before entering into the initial GBP position.
Explain.(3 minutes/points)

The company can do so by entering a future contract to fix their rate whentrading GBP for DM.
However, in the short run, this might be difficult sincethe magnitude of this transaction is large.
It’s possible to settle several dealswith different maturity to split this whole 1 bn.

(c) Credit Generale decided to hedge their risk by using the more liq- uid USD/DM market.
What currency did they decide to go long (and which ones short) in order to hedge their position.
Explain.(3 minutes/points)

They should short S/DM rate, which means short selling dollars to buy DM since Dollar is
positive correlated with GBP. What would happen is when GBP keep going down, the original
position keep bleeding. While dollar also goes down, they could close the short position in a
cheaper rate to generate some profit as a offset for the original position.

(d) To minimize risk, Credit Generale had to compute the optimal hedge ratio. Carefully explain
how to derive the optimal hedge ratio in this case. (5 minutes/points)

V AR=σ2s+ ∆2σ2h+ 2∆ρσsσhBy F.O.C:∆ =−ρσsσh=−COV(Rs,Rh)V AR(Rh)To estimate your

hedge ratio, you need historical data of underlying and the hedging tool, here respectively,
GBP/DM, S/DM.

(e) To implement the optimal hedge ratio, what statistics does the com- pany need to forecast?
Carefully explain how you would go about forecasting the statistics and whether your forecasts
are likely to be accurate?(5 minutes/points)
By the formula in d., you need to forecast covariance and variance of thehedging tool.
Basically this can be done with volatility models like GARCH andDynamic Conditional
Correlation. The accuracy of your forecast depends onthe persistence of the correlation and
variance you are trying to model. As youguys did last quarter, the persistence for currency
data,macro variables,equityreturns are not exactly the same.

5. Interest rate risk is closely associated with the notion of duration.

(a) Bond A has a duration of 3 years and bond B has a duration of 7 years. By how much would
the price of both bonds change if the short- term interest rate increases by 10 basis points. (4
minutes/points)

DUR=−∆P/P∆YTake the short rate as a 30 day interest rate, 10 basis increase means
1.2%increase for annual rate. Thus Bond A price will decrease 3.6%, Bond B willdecrease
8.4%.

(b) Suppose that you are managing a pension plan. The plan has $15B in assets with duration of
9 years and liabilities of $12B with duration of 15 years. Is this plan exposed to interest rate risk.
Explain and provide calculations. (4 minutes/points)

They are exposed to interest rate. To reach a perfect hedge by matchingduration you
need:DURA∗A=DURL∗LHere the liability part dominate the total position, as interest rate goes
up, thepension fund will pay less in future and thus is better off.

(c) Provide an immunization strategy that involves investing in 30-year Treasurys (with duration
of 10 years) and 3-year Treasuries (with duration of 2 years). Be specific what assets you will go
long, which ones you will short, and how much.(7 minutes/points)

Construct a long-short portfolio to increase duration of asset. Suppose theamount is x:DURA= 9

+x15∗10−x15∗2WhereDURA=DURL∗LA= 12(1)3
Thus x = 45/8 = 5.625 billion. The strategy is long 5.625 B of 30 year bondfinancing by the
short position of same amount of 3 year bond.

6. Suppose that you have $1 million invested in the US stock market.

(a) The annual volatility of the log stock market return is 16%. What would be the 1-month
Value-at-Risk at the 1% level?(2 minutes/points)

VaR=−2.33∗1m∗0.16/√12 =−0.1076m

(b) Suppose you want to hedge your exposure with respect to market risk. What financial
instruments should you use and why?(3 minutes/points)

One could hedge market risk by trading market index put options or futures.Alternatively, a short
exposure index ETF also works.

7. Is it true that, in a dynamic hedging situation, one should not change the hedge ratio unless the
volatility of the underlying asset changes? Provide an example or an explanation.(4
minutes/points)

No, by the formula:∆ =−ρσsσh=−COV(Rs,Rh)V AR(Rh)To dynamically hedge you need keep
updating both the covariance and varianceof hedging asset.

8. Consider a 5-year credit default swap (CDS) on a corporate bond with current spread of 90
bps.

(a) If you hold $100M of the reference bond on your balance sheet, how much do you have to
pay annually for credit insurance?(4 minutes/points)

The payment is 100M*90bps = 0.9M

(b) Suppose that the survival probability of this particular bond is 90% over 5 years and the
recovery rate, in case of default, is 40% per year. Is the CDS price a good deal for the buyer or
seller of insurance? Explain by providing calculations.(5 minutes/points)

The five year survival probability is 90%, approximately the default prob-ability per year is 2%.
This can be seen by survival probability of n years as:Probn= (1−q)n≈1−nq
As a buyer the expected loss per year is 2%*(1-0.4) = 120bps. The buyer pays90 bps annually to
insure a 120 bps loss, so that’s a good deal for buyer.
(c) Suppose that the recovery rate, in case of default, is 40% per year and that the CDS is priced
accurately. Then, what is be the implied average annual probability of default?(5 minutes/points)

If the CDS is correctly priced, the expected loss should equal the spread.P= 90bps/0.6 =
1.5%

9. A corporate bond that is rated AA by S&P has a spread of 30bps with respect to Treasurys of
the same maturity and has a recovery rate of 50%. Another corporate bond that is rated A by
S&P at the same time has a spread of 20bps with respect to Treasurys of the same maturity and
has a recovery rate of 50%. The A-rated and the AA-rate bonds have the same duration.

(a) Is the credit rating provided by the S&P in agreement with the credit spreads that are
observed in the market. Explain.(3 minutes/points)

Apply the formulaq(1−f) = ̃y−y, where q is the default probability, f isthe recovery rate, ̃y−yis
the spread. Then:qAA= 0.6%qA= 0.4%This is inconsistent with the credit rating, AA bond
should has lower spreadand imply lower default probability

(b) If you had to buy one of these fixed income instruments, which one would you buy and why?
(3 minutes/points)

You should buy the AA bond since it’s safer while are priced with a higherYTM, this means the
AA bond is underpriced.

(c) If you had to construct an arbitrage strategy, what would it be? Ex- plain?(4 minutes/points)

The arbitrage strategy is buy AA bond which is underpriced by shortingA bond which is
over priced. If the market is efficient, the mis-price will beeliminated and this strategy
would generate profit.
10. The value of a company, Truce Inc., at time  is $5 billion. It has debt that matures in 1 year
with face value of $4.5B. Suppose that the volatility of the company’s total return is 20% per
year.

(a) Is the company’s current market value of debt equal to its face value, $4.5B? Why? (2
minutes/points)

No, besides the discount factor, the value should be less because of defaultrisk.

(b) Use a binomial tree approach to find the market value of equity and the market value of debt
of the company. (6 minutes/points)

Measure the volatility in a binomial setting: u = 1.2, d = 0.8

The value of equity and debt is the discounted expected value shown above.

(c) What would the shareholders’ incentives be in this situation? Explain and provide an
example. (4 minutes/points)

The shareholder get the control right and thus would like to take more risky operations to drive
the volatility up, shift the risk to debt holder and get the benefit. For example say the volatility is
40%, then you can tell the benefit of shareholder as below:

(d) If the debtholders of Truce are aware, ex-ante, of the shareholders incentives, what can they
do? (4 minutes/points)

Problem 3 Consider a two-period option pricing problem. In each period the stock price of
Aliace Inc’s can increase by 25 percent from an initial value of $40 a share. Over the next year,
the stock will either increase or decrease by 25 percent. The 1-year interest rate is 5 percent. If
the strike price of an European Put option is $35, then:

1. (a) Draw a binomial tree, clearly marking the payoffs of the European put option.(4
minutes/points)

(b) Price the European put option using any method you choose. (8 minutes/points)

(c) Compute the hedge ratios (deltas) at every branch of the tree. Ex- plain why the deltas change
with the time-to-maturity and money- ness. (5 minutes/points)
(d) Using a familiar identity, find the value of a European Call option with the same strike price
and maturity. (5 minutes/points)