Summer 2019 Exam

FM402
Financial Risk Analysis

Suitable for all candidates

Instructions to candidates

There are two sections: Section A and Section B.

There are two questions in each section.

Answer a total of three questions. All questions have equal weight.

Questions with parts have marks allocated as shown.

Time Allowed Reading Time: None

Writing Time: 2 hours

You are supplied with: No additional materials

You may also use: No additional materials

Calculators: Calculators are allowed in this examination

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 SECTION A

Question 1. [33 marks] Give a definition and an intuitive interpretation of Value at Risk (VaR). Discuss
the properties of VaR risk measures when returns are normally distributed. Discuss to what extent
normality of financial returns is an appropriate assumption. As an alternative risk measure, is tail loss
more robust to underlying distributional assumptions? Discuss how you would use tail loss.

Question 2. [33 marks] It has been argued that the average credit quality of new US corporate loans
has been declining over recent years while at the same time securitisation of US corporate loans has
been growing significantly. This has led some commentators to draw a parallel with the situation in
US subprime mortgages before the 2007-08 crisis. Discuss what you would consider the main
weaknesses of the global financial system before the 2007-08 crisis. Building on this, discuss how
you would assess current risks coming from the US corporate debt market.

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 SECTION B

Question 3

Assume that the spot curve is flat at 1% and that there is no default risk.

i) [5 marks] Consider a 4-year zero-coupon bond with face value of £100. Calculate the price,
Macaulay duration, modified duration and convexity of this bond.

ii) [15 marks] Now consider a 6-year coupon bond with a face value of £100 and an annual coupon
of £3. Calculate the price, Macaulay duration, modified duration and convexity of this bond.

How would you hedge the interest rate exposure on a long position with a market value of £200 million
in this 6-year coupon bond using the 4-year zero-coupon bond described in part i)? Give a quantitative
answer and explain all the steps in your calculations.

For what types of movements in the spot curve will this hedge work well? For what types of
movements in the spot curve will it work less well? Explain your answers.

iii) [13 marks] Now suppose that in addition you have an 8-year zero-coupon bond available to hedge
the interest rate exposure on the 6-year coupon bond. Using both zero-coupon bonds, derive a more
robust hedge than in part ii). Give a quantitative answer and explain all the steps in your calculations.
What type of movement in the spot curve would this type of strategy leave you exposed to?

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Question 4

Consider a European put option on an underlying stock. The current price of the underlying stock is
90 and the strike price of the option is 100. You may assume that riskless interest rates are equal to
zero.

The Black-Scholes-Merton delta of the option is equal to -0.7264. Its gamma is equal to 0.0239.

i) [3 marks] What are the assumptions underlying the Black-Scholes-Merton model?

ii) [4 marks] Suppose a market-maker has just sold 1000 of these put options. How could he/she
hedge the delta of the position at the initial market price by entering a position in the underlying asset
and the riskless asset? Explain your answer.

iii) [16 marks] Now suppose that the price of the underlying jumps to 89. Based on the information
you have, what adjustment would the market-maker have to make to his/her hedge in order to keep
it approximately delta neutral? Explain your answer.

After the market-maker has rebalanced the hedge, suppose the price of the underlying jumps to 91.
What adjustment would the market-maker have to make now to his/her hedge in order to keep it
approximately delta neutral?

In the particular scenario you have just looked at, would this discrete rebalancing have led to a profit
or a loss relative to the theoretical scenario of continuous rebalancing? Explain.

iv) [5 marks] Does the kind of rebalancing described in the previous part work well when there are
large jumps in asset prices? Explain why or why not, with reference to historical examples where
appropriate.

v) [5 marks] Without deriving explicit formulae, explain how you would use the Black-Scholes-Merton
framework to price a corporate bond.

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