Module Code: MATH5340M01

Module Title: Risk Management UNIVERSITY

c OF LEEDS

School of Mathematics Semester Two 202021

Academic integrity:

• The work that you submit must be your own work and must represent your own under-
standing.
• You must not get help from or discuss this assessment with anybody.
• This is an Open Book assessment. You may refer to lecture notes, coursework and other
module materials. You are advised not to consult other sources unless directed to do so
by the module leader. If you do consult other sources you must not copy or paraphrase
them; write your solution in your own words, with all sources closed and out of sight.
• You must read and sign an Academic Integrity form before starting. Attach this to your
solutions before submitting.

Instructions:

• There are 6 pages to this assessment.

• There will be 48 hours to complete this assessment, and an additional 2 hours to
upload your solutions. Late submissions will not be accepted.
• If you believe the assessment contains a mistake or is not clearly written, send an email
to the module leader. The module leader will normally respond within four hours of
receiving a query, but will not respond outside of normal working hours (09.00-17.00 UK
time).
• If you have trouble submitting your work, write to maths.taught.students@leeds.ac.uk.
• If a module leader issues a correction this will be posted on Minerva and you will also
be notified by email.
• Answer all questions.
• You must show all your calculations.
• Some of the formulae that you might need are written at the end.
• The numbers in brackets indicate the marks available for each question.

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Module Code: MATH5340M01

1. Answer the following questions as precisely as possible and use mathematical notation
where necessary.

(a) Give the definition of convex risk measure ρ and briefly explain the financial meaning
of each of the three properties. Provide two (different) examples of convex risk
measures, and also two different examples of risk measures which are not convex.
Give the mathematical expression for the risk measures in your examples and explain
the notation used. (5 marks)
(b) Let U be a random variable such that U follows U nif (0, 1) (the Uniform distribu-
tion on the interval (0, 1)). We define the random variables X1 and X2 by X1 = U
and X2 = 3 − 3U . Does the copula of the random vector (X1 , X2 )0 exist? Is the
copula unique? Provide justifications for your answers. Then, compute the copula,
by providing details of your computations. (5 marks)
(c) For each of the following statements, decide if it is true or false and briefly justify
your answer.
– Statement 1: If two random variables X1 and X2 are such that X2 = f (X1 )
with f a linear function, then the (usual) linear correlation coefficient (Pear-
son’s coefficient) ρ(X1 , X2 ) is equal to one.
– Statement 2: The graph of the quantile function of any random variable
necessarily has ”flat” (horizontal) parts.
– Statement 3: If X1 and X2 are two random variables such that both rank
correlation coefficients are equal to 0, then X1 and X2 are independent.
– Statement 4: Let X1 be a discrete random variable and X2 be a discrete
random variable. Then, there exists a unique copula for (X1 , X2 )0 .
– Statement 5: In the Merton model, the value of the firm is modelled by an
arithmetic Brownian motion.
– Statement 6: In the Merton model, the shareholders have an European put
option on the value of the firm. (6 marks)
(d) Let n be a positive integer such that n ≥ 2.
Let X1 , X2 , ..., Xn be n independent random variables with continuous CDFs.
Is the copula of the random vector (X1 , X2 , ..., Xn )0 unique? Justify briefly your
answer. Compute the copula of the random vector (X1 , X2 , ..., Xn )0 . Provide
details of your computations. (4 marks)
(e) Let α be a given number in [0, 1]. Let C1 and C2 be two different copulas in
dimension d = 2. We define the function C : [0, 1]×[0, 1] −→ [0, 1] by C(u1 , u2 ) =
αC1 (u1 , u2 ) + (1 − α)C2 (u1 , u2 ), for all (u1 , u2 ) ∈ [0, 1] × [0, 1].
Prove that the function C defined above is a copula. Provide details of your
arguments. (6 marks)

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Module Code: MATH5340M01

e−2u −1


(f) Let ψ be a function defined by ψ(u) = − ln e−2 −1
, for all u ∈ [0, 1]
(with the usual convention ln(0) = −∞).
– Compute ψ 0 and ψ 00 .
– Show that ψ is a generator.
– Is ψ a strict generator? Justify your answer.
– Compute the inverse function ψ −1 .
– Compute the copula associated with the generator ψ.
(9 marks)
[Total 35 marks]

2. Let A, B and C be three stocks. We place ourselves at time t (today). An investor

holds today (that is, at time t) a portfolio of 5 units of stock A and −3 units of stock
B and −6 units of stock C. (In other words, the investor holds 5 long positions of A,
3 short positions of B, and 6 short positions of C).
The price of stock A at time t is StA = 80, the price of stock B at time t is StB = 35
and the price of stock C at time t is StC = 50.
A B
We denote by St+1 the price at time t + 1 (tomorrow) of stock A, by St+1 the price at
C
time t + 1 (tomorrow) of stock B, and by St+1 the price at time t + 1 (tomorrow) of
stock C.
We denote by Xt+1  theArandom
 vector of risk factor changes from time t to time t + 1.
Xt+1
B A A
We have Xt+1 =  Xt+1 , where Xt+1 = ln St+1 − ln StA , Xt+1
B B
= ln St+1 − ln StB ,
C
Xt+1
C C
and Xt+1 = ln St+1 − ln StC .

(a) Compute the expression for the portfolio loss Lt+1 from t to t+1 as a deterministic
A B C
function g of the risk factor changes Xt+1 , Xt+1 and Xt+1 . You need to provide
the explicit expression for the function g in your final answer. Provide details of
your computations. (5 marks)
(b) Compute the expression of the linearized loss Llin t+1 in this example. You need to
provide the expression of the linearized loss as a deterministic function h of the risk
A B C
factor changes Xt+1 , Xt+1 and Xt+1 . Provide details of your computations. (5
marks)

In all of the following subquestions  ofAthisexercise, we suppose that the random

Xt+1
B
vector of risk factor changes Xt+1 =  Xt+1  follows the tri-variate Normal distribu-
C
  Xt+1
m1
tion with mean vector m =  m2  and covariance matrix Σ given by
 m
3
2 −0.86 −0.15
Σ =  −0.86 3.4 0.48  .
−0.15 0.48 0.82

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Module Code: MATH5340M01

Here, you should take m1 equal to the date of your birthday, m2 equal to the month of
your birthday, and m3 equal to the year of your birthday.
For instance, if you were born on the 3rd of December 1999, then m1 = 3, m2 = 12,
and m3 = 1999; if you were born on the 23rd of January 2001, then m1 = 23, m2 = 1,
and m3 = 2001, etc.
A B
(c) Compute the (usual) linear correlation coefficient between Xt+1 and Xt+1 . Com-
B C
pute also the (usual) linear correlation coefficient between Xt+1 and Xt+1 . What
B
is the probability distribution of Xt+1 ? (4 marks)
(d) Compute the expectation and the variance of the linearized loss Llin t+1 . What is the
probability distribution of the linearized loss? Justify your answer.
Hint: The linearized loss is of the form Llin A B C
t+1 = αXt+1 + βXt+1 + γXt+1 , where α,
β, and γ are the numbers that you have determined in subquestion (b).
(6 marks)
(e) Compute V aRα (Llin
t+1 ). Take α = 0.99 for the numerical application.

(4 marks)
(f) Compute ESα (Llin
t+1 ). Take α = 0.99 for the numerical application. (4 marks)

[Total 28 marks]

3. Suppose that the loss on your portfolio has the following probability distribution:

Loss 0.1 0.3 0.6 0.8 1.1

Probability 0.05 0.10 0.15 0.6 0.1

Let us denote by L the random variable (r.v.) corresponding to the loss.

(a) Write down the cumulative distribution function FL of the r.v. L. (3 marks)

(b) Draw the graph (picture) of the cumulative distribution function FL from the pre-
vious question. (2 marks)

(c) Compute the probability that the loss L is (strictly) higher than 0.5. (1 mark)

(d) Compute the probability that the loss L is less than or equal to 0.5 and greater than
0.2. (2 marks)

(e) Compute V aRα (L) for the following two cases: α = 0.85 and α = 0.95. (4 marks)

(f) Write down the definition of ESα (L) (where α is the confidence level).
Compute ESα (L) for the following two cases: α = 0.85 and α = 0.95. (4 marks)
[Total 16 marks]

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Module Code: MATH5340M01

4. There are m firms issuing bonds. Each defaultable bond has face value N = 1000
pounds and maturity of 1 year.
An investor holds a portfolio consisting of five defaultable bonds of each of the m firms.
(Overall, the investor holds 5 × m bonds in the portfolio). For i ∈ {1, 2, . . . , m}, let Y i
be the default indicator of firm i, that is, Y i = 1 if firm i defaults, and Y i = 0 if firm i
does not default. The interest rate R is a risk factor for the defaultable bonds. Assume
that R has the following probability distribution:

 0.05 with probability 0.2
R= 0.02 with probability 0.4
0.03 with probability 0.4


Conditionally on the values of R, the random variables Y 1 , Y 2 , . . . , Y m are independent

and identically distributed with the following distribution

P(Y i = 1|R = 0.05) = 0.09, P(Y i = 1|R = 0.02) = 0.05, P(Y i = 1|R = 0.03) = 0.12

For the numerical application, you should take the number m (that is, the number of
firms) equal to the sum of your date of birth, your month of birth, and your year of
birth.
For instance, if you were born on the 4th of February 1999, then m = 4 + 2 + 1999 =
2005; if you were born on the 13th of November 1997, then m = 13+11+1997 = 2021.

(a) Compute first the probability that firm number m does not default, that is, compute
P (Y m = 0). (3 marks)
(b) Compute the probability that all the m firms default. (5 marks)
(c) Write the expression for the portfolio value at maturity and compute its expectation.
(5 marks)
(d) For i ∈ {1, . . . , m}, we denote by Ti the time to default of firm i. We now assume
that the times to default T1 , . . . , Tm are exponentially distributed with parameter

0.15 if R = 0.02
λ=
0.05 if R = 0.01

We assume moreover that the dependence structure of the random vector (T1 , . . . , Tm )0
is given by the Clayton copula with parameter θ = 3.
– Compute the probability that firm 1 defaults within 1 year, that is, compute
P (T1 ≤ 1).
– Compute the probability that all firms default within 1 year, that is,
compute P (T1 ≤ 1, T2 ≤ 1, . . . , Tm ≤ 1).
(8 marks)
Hint: We recall that the m-dimensional Clayton copula with parameter θ is defined
by
CθCl (u1 , u2 , . . . , um ) = [(u1 )−θ + (u2 )−θ + · · · + (um )−θ − (m − 1)]−1/θ .

[Total 21 marks]

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Module Code: MATH5340M01

END
You may need the following elements for some of the numerical applications.
1 2
• The standard normal density function φ is: φ(x) = Φ0 (x) = √1 e− 2 x .
2π

• The CDF F of the Exponential distribution with parameter λ > 0 is given by:

F (x) = (1 − e−λx )I[0,∞) (x).

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