STAT3320 Assignment 1 Suggested Solution

(5-10% of total assessment) 1) How do banks cater for and support the risk they take on? [8%]

They use internal risk management by quantifying and analyzing the risk and then take adequate actions to adjust their capital ratio, portfolio, etc. In doing so, they take reference on external regulatory bodies. When they are fully aware of, understand and willing to take on the risk, they will use their capital to support their risk.

2)

a)

How do the risk types grouped by HKMA differ from those of general market practice. [11%]

For general market practice, Interest rate risk and liquidity risk are grouped under market risk but they are separated in HKMAs grouping method. HKMA doesnt include compliance risk. b) Explain the reasons for the difference. [6%]

Liquidity and Interest Rate risks are large parts of the risks of most banks in HK, hence worth separating out for better control. For example, banks must have sufficient liquid assets so that they can meet the withdrawal demand from depositors. Also, for interest rate risk, since banks usually involve large deal of borrowing and lending, changes in interest rate may affect their cash flows to a great extent. From HKMA angle, banks are expected to fully comply with the relevant regulations; otherwise, license will be removed. 3) Central banks are used to be the regulatory and supervisory bodies for the banks in their countries. What is/are the regulatory and supervisory body/ies for the banks in China? Discuss briefly the development and evolution of the/se regulatory and supervisory body/ies. [20%]

People's Bank of China (PBC or PBoC) and China Banking Regulatory Commission

(CBRC) are the regulatory and supervisory bodies for banks in China. PBC was established on December 1, 1948 based on the consolidation of the former Hubei Bank, Beihai Bank and Xibei Farmer Bank. At that time, the headquarter was located in Shijiazhuang, Hebei. Later, it was relocated to Beijing in 1949. In particular, PBC was directly under the control of the Government Administration Council of the Central People's Government. PBC became the state-owned bank. Its responsibilities were to issue currency (RMB), manage the Nationals finance, manage the financial market, and support recovery of the economy. Under the leading of the Central Peoples Government, PBC established a unified national banking system and a unified currency system, with RMB as the currency in the Peoples Republic of China. Foreign currencies could no longer be used in China. Also, deposits and foreign exchange service were provided. In addition, inflation was finally stopped and capitals were allocated to enhance the economic recovery. PBC was the only bank which offered loans to industries and people. All capitals for investment were managed by the PBC. This built a stepping stone for economic recovery. From 1979 onwards, as part of economic reform, the commercial banking functions of the PBC were split off into four independent but state-owned banks in 1983. Agricultural Bank of China was founded in February 1979 to stimulate the economic development of rural area. Bank of China became a bank which specialized foreign exchange market. Financial services became more and more complex and diversified. In September 1983, the State Council decided to have the PBC function as a central bank. It formulated macro policies for the financial system of the country. Also, loans for industries and commercial sectors and deposits services were offered and provided by the Industrial and Commercial Bank of China, instead of the PBC. The PBC continued to strengthen, reform and develop the financial system. The Law of the People's Republic of China on the People's Bank of China passed by the Third Plenum of the Eighth National People's Congress on March 18, 1995 legally confirmed the PBC's central bank status. In 1998, the PBC underwent a major restructuring. All provincial and local branches were abolished, and the PBC opened nine regional branches, whose boundaries did

not correspond to local administrative boundaries. In March 2003, the First Plenum of the Tenth National People's Congress approved the Decision on Reform of the Organizational Structure of the State Council, separating the supervisory responsibilities of the PBC for the banking institutions, asset management companies, trust and investment companies and other depository financial institutions. Instead, the China Banking Regulatory Commission was established to supervise the financial industry. On December 27, 2003, the Standing Committee of the Tenth National People's Congress approved at its Sixth Meeting the amendment to the Law of the People's Republic of China on the People's Bank of China, which has strengthened the role of the PBC in the making and implementation of monetary policy, in safeguarding the overall financial stability and in the provision of financial services. Afterwards, the PBCs responsibilities are to formulate currency policies, mainly the stability of the financial system and provide financial service. It is stated that PBC is a part of the State Council. It is the central bank of the Peoples Republic of China. The history of CBRC is much shorter than that of PBC. CBRC was established on 28th April 2003. It was to take over the supervisory role of PBC. Its main function is formulating policies and rules according to the law, checking and authorizing the establishment, merger and closure of financial institutions and conducting supervision to assess, monitor and mitigate the overall risk of the financial system. Sources: (1) PBC: http://www.pbc.gov.cn/publish/main/531/index.html (2) CBRC: http://www.cbrc.gov.cn/chinese/info/yjhjj/index.jsp 4) Apart from individual exceptional cases, collaterals and/or guarantees are required for lending products or transactions. However they are sometimes not considered for financial contracts such as forwards, swaps and options. Explain the reason/s. [5%]

For lending products, the main component of credit risk faced is the lending risk and the amount at risk is the full principal amount borrowed plus interest, which is clearly stated in the contract and can be objectively calculated. So collaterals and guarantees can be used to protect the lender against credit exposures in lending products.

On the other hand, the main component of credit risk involved in financial contracts such as forwards, swaps and options is the pre-settlement risk and the amount at risk is the replacement value of the contract, which is usually difficult to determine. So collaterals and guarantees may not be practical. Furthermore, the potential exposure is often limited by arrangement of netting of payments and/or settlement at maturity. However, as a matter of prudent risk management, collateral in the form of margin or otherwise may be posted under the terms of the relevant contracts, but usually in a separate credit support document. 5) Mr Hu would like to enter into an Interest Rate Swap (IRS) with another party. The details of the IRS are: Fixed rate receiver, floating rate payer: Mr Hu Tenor: 3 years Interest/Coupon payment: quarterly Fixed rate: 4% per annum, quarterly basis Notional principal: $100m Before transacting, Mr Hu would like to assess the pre-settlement risk of the IRS. Assuming: Percentage changes in interest rates/yields are normally distributed, with standard deviation of 15% p.a. 95% confidence level Ignoring the risk, if any, of the floating leg of the IRS, and of the payment settlement at each payment date, calculate the potential exposures of the IRS over the entire tenor at each payment date. Plot these twelve potential exposures on a graph to show the credit risk profile of the IRS. [25%] The pre-settlement risk to the swap comes from the fact that the fixed leg has a fixed swap rate c that could differ from the prevailing market rate. When the fixed rate receiver enters a new contract to replace the defaulted one, the new swap rate is the prevailing market rate. If the prevailing market rate declines, the fixed rate receiver will receive less for the remaining payments. The more the prevailing market rate declines, the larger is the loss. So we should consider the 5-percentile of the prevailing market rate for the potential exposures at 95% confidence level. For time t > s,

| (0, 2 ( ))

=>

| ( , 2 2 ( )).

Therefore, the 5-percentile of = ,5% = 1.645 . At each payment date t, just after the payment, the potential exposure of the IRS over the entire tenor is 1 1 1 ( ) ( + + + ) 4 1 + ,5% /4 (1 + ,5% /4)2 (1 + ,5% /4) + = ( c ,5% (1 + ,5% /4)

) (1 (1 +

,5% ) )+ 4 (1 + ,5% /4)

where F is the notional principal and N is the number of remaining payments. For example, at t = 0.25, just after the first payment, there are 11 remaining payments, 0.25,5% = 0 1.645 0 0.25 = 4% 1.645 4% 0.15 0.25 = 3.5065% Potential Exposue c ,5% = ( ) (1 (1 + ) )+ ,5% 4 ,5% (1 + 4 ) 100 3.5065% 11 (1 + ) 4

4% 3.5065% 11 = 100M ( ) (1 (1 + ) )+ 3.5065% 4 100 = 1.2883M

Therefore, the 5-percentile of the prevailing market rate and the potential exposure at each payment date are:

Time, t ,5% Exposure Time, t ,5% Exposure

0.25 3.5065% 1.2883 1.75 2.6944% 1.5995

0.5 3.3021% 1.6680 2 2.6043% 1.3733

0.75 3.1453% 1.8496 2.25 2.5196% 1.0964

1 3.0131% 1.9086 2.5 2.4396% 0.7731

1.25 2.8966% 1.8762 2.75 2.3634% 0.4067

1.5 2.7913% 1.7696 3 2.2906% 0

The credit risk profile of the IRS:

6) Calculate the daily Value-at-Risk of the following portfolio, as at close of 24Feb2012, using historical simulation with 99% confidence level and past 102 trading days (including 24Feb2012) historical data. [25%] 100 shares of Hong Kong Bank (code 00005) 100 shares of China Life (code 02628) 1,000 shares of Citic Pacific (code 00267) 1,000 shares of Johnson Electric (code 00179) 1,000 shares of MTR (code 00066)

Since we have 102 historical prices, we have 101 observations of daily log returns, 1 , 2 , , 101 for stock , = 1, ,5. Here the procedures for calculating the VaR using log-returns are demonstrated. The procedures for the case of simple returns are similar. Let the price on 24 Feb be 0 for stock . Assume that the return on each stock on

27 Feb will take value on each of the 101 observations of returns, then we have 101 possible prices or scenarios on 27 Feb for each stock , = 1, ,5 , say 1 , 2 , , 101 , where = 0 exp( ) , = 1, ,101, = 1, ,5. Then, the change in stock price between 27 Feb and 24 Feb under scenario for each stock is = 0 , = 1, ,101, = 1, 5. The change in portfolio value under the scenario is
5

= , = 1, ,101.
=1

where is the number of shares of stock . The 99% VaR is the second most negative multiplied by -1. The answer is $2318.6511.