BE631-6-SP /1
THIRD YEAR EXAMINATION 2022
RISK MANAGEMENT AND FINANCIAL INSTITUTIONS
Time allowed: 24 hours
Time to spend on your assessment: 2 hours
Maximum word count for assessment: 2000 words
Please see your exam timetable or check on FASER for the deadline to upload your answer.
The times shown on your timetable are in UK Time. Please check online for a conversion to your local time if you will be undertaking your assessment outside the United Kingdom
Candidates are permitted to use: Calculator – Casio FX-83GT PLUS/X or Casio FX-85GT PLUS/X only
The paper consists of FOUR questions.
Candidates must answer TWO questions: ONE from Section A and ONE from Section B.
All questions carry equal weight.
You can add hand written answers for equations/mathematical questions (take a photo/scan and add to your document).
SECTION A –
You must answer ONE question from Section A. Show all your work clearly in all cases for full credit.
QUESTION ONE
a) Determine the rate on the 6-month to 12-month Forward Rate Agreement (FRA(6x12m) contract) if the 6-month and 12-month US interest rates are 2% per annum (p.a.) and 4% p.a., respectively. Assume yearly compounding for all interest rates. (10 marks)
b) Suppose that the Duration of Assets (DA) is 5 years and the duration of liabilities (DL) is 3 years. The current market value of assets is 100 million pounds and the market value of liabilities is 80 million pounds. What would be the effect (loss or gain) on the market value of equity (dE) if interest rates increase from 5% p.a. to 7% p.a. ? (20 marks)
c) Calculate the Present Value of a zero-coupon bond with nominal value 1
million pounds and yield to maturity 6% pa and time to maturity equal to 10 years. Find the duration of the zero-coupon bond. (20 marks)
[TOTAL 50 MARKS]
QUESTION TWO
a) In an essay of 200 words or less, describe the approach that the Merton model takes in producing credit ratings. What is the most crucial parameter in the determination of corporate default probability in the Merton model? (20 marks)
b) The current market prices of a non-dividend paying stock is 50 pounds. The annual risk-free interest rate is 10%, and the current price of the 3-month forward contract written on the stock is 55 pounds. Is there an arbitrage opportunity in the market, or not? Assume continuous compounding. (20 marks)
c) What are the two basic ways for a risk manager to hedge against interest rate risk? Briefly justify your claims. (10 marks)
[TOTAL 50 MARKS]
SECTION B
You must answer ONE question from Section B.
QUESTION THREE
Discuss the importance of time horizon and confidence level in estimating VaR? (20 marks)
a) Explain how VaR was mis-used in LTCM and why? (10 marks)
b) Suppose that an investment has 0.5% chance of a loss of $10 million and a 99.5% chance of a loss of $1 million. What is the Value-at-Risk (VaR) for this investment when the confidence level is 99%? (10 marks)
c) A portfolio has daily expected return of 2% and daily standard deviation of
3.5%. The current value of the portfolio is $100 million. Assume that the 99% confidence level is 2.33.
i. What is the one day VaR at 99% confidence level? (5 marks)
ii. What is the 10-day VaR at 99% confidence level? (5 marks)
[TOTAL 50 MARKS]
QUESTION FOUR
a) Explain how credit risk is transferred through securitization. (10 marks)
b) Critically discuss the following: “All tranches in an ABS have the same risk exposure.” Discuss critically if this statement is true or false. (10 marks)
c) Discuss the main differences between hedge funds and mutual funds (10 marks)
d) Explain how Value-at-Risk (VaR) models are back tested. (10 marks)
e) Why the increase in house prices during 2000-2007 period is referred to as a bubble? (10 marks)
[TOTAL 50 MARKS]