Master of Business Administration - Financial Risk Management. Cohort: MBA(FRM)/15A/PT. RESIT/SPECIAL Examinations for

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1 Master of Business Administration - Financial Risk Management Cohort: MBA(FRM)/15A/PT RESIT/SPECIAL Examinations for Academic Year Semester I / Academic Year 2016 Semester II MODULE: FUNDAMENTALS OF RISK MANAGEMENT MODULE CODE: ACCF 5206 Duration: 3 Hours Instructions to Candidates: 1. This question paper consists of Section A and Section B. 2. Section A is compulsory and carries 50 marks. 3. Answer any two questions from Section B, each question carries 25 marks. 4. Always start a new question on a fresh page. 5. Total Marks: 100. This Question Paper isprinted on BOTH SIDES. This Question Paper Contains 4 questions and 11 pages. FUNDAMENTALS OF RISK MANAGEMENT-ACCF 5206 Page 1 of 11

2 SECTION A: COMPULSORY QUESTION 1: (50 MARKS) PART A ITEM 1 # Monika Kreuzer chairs the risk management committee for DGI Investors, a European money management firm. The agenda for the 1 June committee meeting includes three issues concerning client portfolios: 1. Estimating a new value at risk (VAR) for the Stimson Industries portfolio. 2. Revising the VAR for Muth Company given new capital market expectations. 1. VAR for Stimson Industries. DGI currently provides a 5 percent yearly VAR on the equity portfolio that it manages for Stimson. The 50 million portfolio has an expected annual return of 9.6 percent and an annual standard deviation of 18.0 percent. With a standard normal distribution, 5 percent of the possible outcomes are 1.65 standard deviations or more below the mean. Using the analytical (variance covariance) method for calculating VAR, DGI estimates the 5 percent yearly VAR to be million. Assuming that monthly returns are independent, committee member Eric Stulz wants to estimate a 5 percent monthly VAR for Stimson s portfolio. Stulz asks his fellow committee members for feedback on the following statements about VAR in a report he is preparing for Stimson Industries: Statement #1: Establishing a VAR involves several decisions, such as the probability and time period over which the VAR will be measured and the technique to be used. Statement #2: A portfolio s VAR will be larger when it is measured at a 5 percent probability than when it is measured at a 1 percent probability. Statement #3: A portfolio s VAR will be larger when it is measured over a month than when it is measured over a day. FUNDAMENTALS OF RISK MANAGEMENT-ACCF 5206 Page 2 of 11

3 2. Revising the VAR for Muth Company. Kreuzer provides a variety of statistics to Muth, for whom DGI manages a portfolio composed of 50 percent in Asia-Pacific equities and 50 percent in European equities. One of the statistics that Kreuzer supplies Muth is a 5 percent monthly VAR estimate based on the analytical (variance covariance) method. Kreuzer is concerned that changes in the market outlook will affect Muth s risk. DGI is updating its capital market expectations, which will include 1) an increase in the expected return on Asia-Pacific equities and 2) an increase in the correlation between Asia-Pacific equities and European equities. Kreuzer comments: Considered independently, and assuming that other variables are held constant, each of these changes in capital market expectations will increase the monthly VAR estimate for the Muth portfolio. Kreuzer also discusses the limitations and strengths of applying VAR to the Muth portfolio. She states that: One of the advantages of VAR is that the VAR of individual positions can be simply aggregated to find the portfolio VAR. Kreuzer also describes how VAR can be supplemented with performance evaluation measures, such as the Sharpe ratio. She states: The Sharpe ratio is widely used for calculating a risk-adjusted return, although it can be an inaccurate measure when applied to portfolios with significant options positions. Kreuzer is confident that the techniques she employs to mitigate credit risk are comprehensive and follow industry best practice standards. She drafts a description of the techniques used and includes the following statement: The best way to manage credit risk is to require collateral margin from opposite counterparty. Meanwhile, a member of the board committee drafts a memo with some of his initial thoughts: As an investment firm that manages international and domestic fixed income and equity portfolios, DGI Investors, are exposed to both financial and nonfinancial risks. Each of these broad topics will be addressed in turn. Kreuzer decides to initially add depth to the financial risks that the firm faces. FUNDAMENTALS OF RISK MANAGEMENT-ACCF 5206 Page 3 of 11

4 Kreuzer responds with the following statements for VAR: Statement 1: VAR quantifies potential losses in simple terms. Statement 2: VAR often underestimates the magnitude and frequency of the worst returns. Statement 3: VAR is a forward-looking measure that cannot be back tested against historical data. Required: 1. The monthly VAR that Stulz wants to estimate for the Stimson portfolio is closest to: A. 0.8 million. B. 2.9 million. C. 3.9 million. 2. Regarding the three statements in the report thatstulz is preparing for Stimson Industries, the statement that is incorrect is: A. Statement #1. B. Statement #2. C. Statement #3. 3. Is Kreuzer correct in predicting the independent effects of the increase in the expected return and the increase in the correlation, respectively, on the calculated VAR of the Muth portfolio? Effect of Increase in the Effect of Increase in the Expected Return Correlation A. No No B. No Yes C. Yes No FUNDAMENTALS OF RISK MANAGEMENT-ACCF 5206 Page 4 of 11

5 4. Kreuzer`s statement regarding the management of credit risk is most likely: A. Correct. B. Incorrect, because the primary means of managing credit risk is periodic marking to market. C. Incorrect, because the primary means of managing credit risk is limiting the total exposure to a given counterparty. 5. As Kreuzer begins to add depth to the description of the initial source of risks present at DGI Investors, which of the following will he least likely include: A. Taxes. B. Liquidity. C. Interest rates. 6. Kreuzercorrectly identifies a limitation of VAR in: A. Statement 1. B. Statement 2. C. Statement 3. ITEM 2 # The investment committee of Rojas University is unhappy with the recent performance of the fixed-income portion of their endowment and has fired the current fixed- income manager. The current portfolio, benchmarked against the Lehman Brothers U.S. Aggregate Index, is shown in Exhibit 1. The investment committee hires Alfredo Alonso, a consultant from MHC Consulting, to assess the portfolio s risks, submit ideas to the committee, and manage the portfolio on an interim basis. FUNDAMENTALS OF RISK MANAGEMENT-ACCF 5206 Page 5 of 11

6 Alonso notices that the fired manager s portfolio did not own securities outside of the index universe. The committee asks Alonso to consider an indexing strategy, including related benefits and logistical problems. Alonso identifies three factors that limit a manager s ability to replicate a bond index: Factor #1: a lack of availability of certain bond issues Factor #2: a lack of available index data to position the portfolio. Factor #3: differences between the bond prices used by the manager and the index provider. Alonso also states: Statement #1 When managing the risks of a schedule of liabilities, multiple liability immunization and cash flow matching approaches do not have the same risks and costs. Whereas cash flow matching generally has less risk of not satisfying future liabilities, multiple liability immunization generally costs less. Statement #2 Assuming that there is a parallel shift in the yield curve, to immunize multiple liabilities, there are three necessary conditions: i) the present value of the assets be equal to the present value of the liabilities; ii) the composite portfolio duration be equal to the composite liabilities duration; and iii) I cannot remember the third condition. FUNDAMENTALS OF RISK MANAGEMENT-ACCF 5206 Page 6 of 11

7 The investment Committee would like to examine different investment horizons and alter- native strategies to immunize the single liability. The investment committee ask Alonso to evaluate a contingent immunization strategy using the following assumptions: The SRB will commit a $100 million investment to this strategy. The horizon of the investment is 10 years. The SRB will accept a 4.50 percent return (semiannual compounding). An immunized rate of return of 5.25 percent (semiannual compounding) is possible. 7. The duration of the Rojas University fixed-income portfolio in Exhibit 1 is closest to: A B C Regarding the three factors identified by Alonso, the factor least likely to actually limit a manager s ability to replicate a bond index is: A. #1. B. #2. C. #3 9. The condition that Haley cannot remember in his Statement #2 is that the: A. Cash flows in the portfolio must be dispersed around the horizon date. B. Cash flows in the portfolio must be concentrated around the horizon date. C. Distribution of duration of individual assets in the portfolio must have a wider range than the distribution of the liabilities. FUNDAMENTALS OF RISK MANAGEMENT-ACCF 5206 Page 7 of 11

8 10. Which of the following is closest to the required terminal value for the contingent immunization strategy? A. $100 million. B. $156 million. C. $168 million. [2 marks x10] PART B Klaus Bergen manages a portfolio of government bonds for a reinsurance company. The portfolio funds long-term liabilities that originated from the company s book of reinsurance. The required return for the portfolio and the discount rate for the liabilities are each 2.75%. The duration of the liabilities is currently 9.7, although this figure is revised frequently because of significant and unexpected variations in the amount and timing of claims. Bergen manages the portfolio using a classical immunization strategy, allocating to government bonds across a broad range of maturities. The market value of the portfolio is EUR 400 million, which is equal to the present value of the liabilities. The portfolio s immunized rate of return is 3.80%. a) Determine whether a cash flow matching strategy would be more effective than Bergen s current strategy. Justify your response with two reasons. [10 marks] b) Determine the required initial safety margin (in EUR) assuming a three-year investment horizon. [10 marks] Show your calculations. Note: Assume semi-annual compounding. FUNDAMENTALS OF RISK MANAGEMENT-ACCF 5206 Page 8 of 11

9 PART C Aspen Fund has a portfolio worth USD 12,428,000 that consists of 38% of fixed income investments and 62% of equity investments. The 95% annual VaR for the entire portfolio is USD 1,367,000 and the 95% annual VaR for the equity portion of the portfolio is USD 1,153,000. Assume that there are 250 trading days in a year and that the correlation between stocks and bonds is zero. Required: What is the 95% weeklyvar for the fixed income portion of the portfolio? [12 marks] SECTION B: ANSWER ANY TWO QUESTIONS QUESTION 2: (25 MARKS) a) Outline the five steps involved in financial risk management. [5 marks] b) What is market risk and how does a company measure market risk? [5 marks] You have a portfolio consisting of two asset classes: long-term government bonds issued in the United States and equities issued in the United Kingdom. The expected monthly return on U.S. bonds is 0.85 percent, and the standard deviation is 3.20 percent. The expected monthly return on UK equities, in U.S. dollars, is 0.95 percent, and the standard deviation is 5.26 percent. The correlation between the U.S. dollar returns of U.K. equities and U.S. bonds is The portfolio market value is $100 million and is equally weighted between the two asset classes. Using the analytical or variance covariance method, compute the following: (i) 5 percent monthly VAR. [5 marks] (ii) 5 percent weekly VAR. [5 marks] (iii) What are the limitations of using analytical method to estimate VAR.? [5 marks] FUNDAMENTALS OF RISK MANAGEMENT-ACCF 5206 Page 9 of 11

10 QUESTION 3: (25 MARKS) PART A Roxy is a new trainee to the credit team of Wealth Bank Ltd. You have been tasked to answer some of the queries of the trainee in relation to credit risk. a) Briefly define credit risk. [5 marks] b) What are the difficulties faced in estimating the credit risk of a corporate customer? [5 marks] c) Briefly outline the methods of managing credit risk. [5 marks] PART B Assume that in six monts a manager will borrow USD1M at LIBOR for one year and LIBOR is currently at 5%. The manager enters an FRA with a reference rate of 5% and a notional principal of USD1,000,000. At inception, the value of the contract is zero. Three months into the contract, however, LIBOR has climbed to 6%. Assuming the risk-free rate is 4% d) Assuming the risk-free rate is 4%, determine the amount of credit risk and who bears it. [10 marks] QUESTION 4: (25 MARKS) Rob Diamond is the Treasurer at Emirates Bank, which has just raised deposit in the form of a guaranteed investment contract (GIC) to its corporate customers. He needs to immunize this GIC, which guarantees a single payment of 480,000,000 U.S. dollars (USD) in 4 years and provides a bond equivalent yield of approximately 3.50% and modified duration of 4%. Frost calculates the present value of the GIC to be USD 369,640,000. This is the amount he intends to invest today to immunize the GIC. He is not permitted to use leverage. (Cont) FUNDAMENTALS OF RISK MANAGEMENT-ACCF 5206 Page 10 of 11

11 Rob is building a suitable portfolio and already holds the U.S. government bonds shown in Exhibit 1. Exhibit 1 Existing Portfolio of Bonds Market Total Total Bond Price (USD) Market Value (USD) Dollar Duration (USD) Bond A ,556,800 2,420,141 Bond B ,815,000 9,164,939 Frost must choose a U.S. government bond to complete the immunized portfolio. He has gathered the data shown in Exhibit 2. Exhibit 2 Bonds available to Complete Immunized Portfolio Market Price Bond (USD) Yield to Maturity Modified Duration Bond X % Bond Y % Bond Z % Required: a) For classical immunization strategy, what are the two conditions to be satisfied? [5 marks] b) Determine which bond (X, Y, or Z) is the most suitable for Frost to complete the immunized portfolio. Justify your response with one reason. Show your calculations. [20 marks] ***END OF QUESTION PAPER*** FUNDAMENTALS OF RISK MANAGEMENT-ACCF 5206 Page 11 of 11