Master of Business Administration - Financial Risk Management Cohort: MBAFRM/14/PT Aug Examinations for 2014 2015 Semester I / 2014 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. 3. Answer any two questions from Section B. 4. Always start a new question on a fresh page. 5. Total Marks: 100. This Question Paper is printed on BOTH SIDES. This Question Paper Contains 4 questions and 12 pages. Page 1 of 12
SECTION A: COMPULSORY QUESTION 1: (50 MARKS) PART A: (3 MARKS X10 = 30 MARKS) ITEM 1 # Lara Fraser is the risk manager for Galaxy & Co., a large investment firm located in Scotland. She recently hired a new employee, Stuart Wallace, to assist her with enhancing the firm`s risk management process. Fraser asks Wallace to document the exposures to risk that have been identified through Galaxy &Co`s current risk management process. As Wallace begins the project, Fraser responds to client questions and requests. Client A states: I am a new client and received my first investment portfolio statement. The statement specifies, With a 95% confident, the VAR of the portfolio is USD1M for one month. My portfolio holds long stock positions along with some option positions on those stocks and I am concerned about the impact of low probability events may have on my portfolio performance. Can the VAR measure be adjusted to address this concern? In addition, please explain the primary limitation of VAR. Fraser responds with the following statements: Statement 1: VAR quantifies potential losses in simple terms. Statement 2: VAR often underestimates the magnitude and frequency of the worst returns. Statement: VAR is a forward-looking measure that cannot be back tested against historical data. Client B asks: I am preparing to make a VAR presentation to my Board of Directors. I am familiar with the analytical method of measuring VAR that Galaxy & Co uses. Please describe other methods for estimating VAR and indicate a disadvantage of each. Page 2 of 12
Galaxy &Co`s senior management wants to be confident that the firm is managing and measuring credit risk in an appropriate manner. They ask Fraser to provide a specific example of an investment instrument within the portfolio that may create credit risk. Fraser chooses to illustrate the concept of credit risk with a swap example. A portion of the firm`s portfolio is invested in floating rate notes. Galaxy uses interest rate swaps to manage the interest rate risk exposure of this investment. Specifically, the firm has entered into a one year pay variable receive fixed interest rate swap. The swap has a notional value of GBP1M. The current market value of the swap to Galaxy is GBP47,000 Required: 1. Fraser`s most appropriate response to Client A`s question regarding the possibility of adjusting the VAR measure is: A. An increase in the confidence interval will increase the magnitude of the VAR measure. B. The VAR measure will decrease if the time frame of measurement is increased. C. For your portfolio, any confidence interval will provide essentially identical VAR information. 2. Fraser correctly identifies a limitation of VAR in: A. Statement 1. B. Statement 2. C. Statement 3. 3. Fraser drafts a number of possible responses to client B. An appropriate response would included: A. The Monte Carlo simulation method requires an assumption of normally distributed returns. B. The historical method is nonparametric and does not allow the user to make assumptions about the probability distribution of returns. C. The historical method relies completely on events of the past, and the probability distribution of the past may not hold in the future. Page 3 of 12
4. With respect to the plain vanilla interest rate swap, which of the following most accurately describes Galaxy`s exposure to credit risk? A. No current credit risk. B. GBP47, 000 risk of loss. C. GBP953,000 at risk of loss 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. 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. Page 4 of 12
5. The duration of the Rojas University fixed-income portfolio in Exhibit 1 is closest to: A. 5.11. B. 5.21. C. 5.33. 6. Based on the data in Exhibit 1, the bond portfolio strategy used by the fired manager can best be described as: A. pure bond index matching. B. enhanced indexing/matching risk factors. C. active management/larger risk factor mismatches. 7. 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. ITEM 3 # The State Retirement Board (SRB) provides a defined benefit pension plan to state employees. The governors of the SRB are concerned that their current fixed-income investments may not be appropriate because the average age of the state employee workforce has been increasing. In addition, a surge in retirements is projected to occur over the next 10 years. Chow Wei Mei, the head of the SRB s investment committee, has suggested that some of the future pension payments can be covered by buying annuities from an insurance company. She proposes that the SRB invest a fixed sum to purchase annuities in seven years time, when the number of retirements is expected to peak. Chow argues that the SRB should fund the future purchase of the annuities by creating a dedicated fixed-income portfolio consisting of corporate bonds, mortgage-backed securities, and risk-free government bonds. Chow states: Page 5 of 12
Statement #1 To use a portfolio of bonds to immunize a single liability, and remove all risks, it is necessary only that 1) the market value of the assets be equal to the present value of the liability and 2) the duration of the portfolio be equal to the duration of the liability. Chow lists three alternative portfolios that she believes will immunize a single, seven-year liability. All bonds in Exhibit 1 are option-free government bonds. Chow then states: Statement #2 To immunize a single seven year liability, all the three bonds in Exhibit 1 have the same interest rate risks. Statement #3 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. The SRB governors would like to examine different investment horizons and alter- native strategies to immunize the single liability. The governors ask Chow to evaluate a contingent immunization strategy using the following assumptions: Page 6 of 12
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 (semi annual compounding). An immunized rate of return of 5.25 percent (semi annual compounding) is possible. 8. Is Chow s Statement #1 correct? A. Yes. B. No, because credit risk must also be considered. C. No, because the risk of parallel shifts in the yield curve must also be considered. 9. Is Chow s Statement #2 correct? A. No, Portfolio B is exposed to less reinvestment risk than Portfolio A. B. No, Portfolio B is exposed to more reinvestment risk than Portfolio C. C. No, Portfolio C is exposed to more reinvestment risk than Portfolio B. 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. (3 marks x10 = 30 marks) PART B: (8 MARKS) Manager A has been allocated $100M of capital and a weekly VAR of $5M. Manager B has been allocated $500M and a weekly VAR of $10M. Over a period, A earns a profit of $1M and B earns a profit of $3M. Manager A Manager B Capital $100M $500M VAR $5M $10M Profit $1M $3M Return on Capital?? Return on VAR?? Page 7 of 12
Required: Calculate the return on capital and the Return on VAR for the two managers and advise which manager has outperformed on a risk-adjusted basis. PART C: (12 MARKS) MCB has just issued a guaranteed investment contract (GIC). MCB needs to immunize this GIC, which guarantees a single paymentof USD160,000,000 in 4 years and provides a bond equivalent yield ofapproximately 3.50%. The investment team calculated the present value of the GIC to be USD 145,700,000. Thisis the amount they intend to invest today to immunize the GIC. WB is not permitted to use leverage and the current duration is 4. MCB is building a suitable portfolio and already holds the U.S. government bonds shown inexhibit 1. Existing Portfolio Bonds Bond Market Price (USD) Total Market Value (USD) Total Dollar Duration Bond A 102.32 49,113,600 954,278 Bond B 94.9 59,630,000 4,209,878 MCB must choose a U.S. government bond to complete the immunized portfolio. The investment team hasgathered the data shown in Exhibit 2. Bonds Available to Complete Immunized Portfolio Bond Market Price (USD) Yield to Maturity Modified Duration Bond X 99.97 3.52% 1.333 Bond Y 99.36 3.89% 2.154 Bond Z 99.35 3.85% 1.810 Required: Determine which bond (X, Y, or Z) is the most suitable for MCB to complete the immunized portfolio. Justify your response with one reason. Show your calculations. Page 8 of 12
SECTION B: ANSWER ANY TWO QUESTIONS QUESTION 2: (25 MARKS) Lyle Watson is Chief Executive Officer of Capital Cubed, a U.K.-based investment bank that was recently formed by the merger of three investment banks. Each of the original trading teams, now known as Capital 10, Capital 20, and Capital 30, continues to operate independently. All three teams report trading profits and losses in British pounds (GBP). Their trading strategies are as follows: Capital 10 s strategy is to trade long-only large-capitalization U.S. equities with currency exposures unhedged. Capital 20 s strategy is to trade long-only European investment-grade bonds with currency exposures hedged. Capital 30 s strategy is to trade options on U.K. equities. Each team has its own director of business development. These directors all report to Capital Cubed s head of business development. The head trader on each team is in charge of monitoring the team s risk. Each head trader provides a calculation of value at risk (VAR) and Watson adds them together to calculate Capital Cubed s VAR. Because the teams trade different instruments, the back offices have not been combined and the manager of each back office reports to both his head trader and to Watson. Lastly, to save costs, all three data warehouses have been integrated into a central data warehouse. A. (i) Identify three weaknesses in Capital Cubed s enterprise risk management (ERM). (3 marks) (ii) Describe, for each weakness, one method to improve Capital Cubed s ERM. (3 marks) The following are excerpts from a recent internal Capital Cubed risk report: Page 9 of 12
1. The weekly 1% VAR calculation for Capital 10 is GBP 1.2 million, so there is a1% probability that it will lose at most GBP 1.2 million in a single week. 2. Capital 20 calculates VAR at a probability of 1% rather than 5% to get a more conservative measure of the magnitude of its potential losses. 3. The variance covariance method of calculating VAR is unreliable for capturing the risk exposure of Capital 30. 4. Capital 30 sends its largest client a weekly VAR estimate using a probability of5%. Currently this estimate is GBP 0.8 million, so Capital 30 has advised the client to be prepared for losses greater than this amount up to five weeks every three years. B. Identify two excerpts that contain errors. Justify each response with one reason. (7 marks) An analyst would like to know the VAR for a portfolio consisting of two asset classes: long-term government bonds issued in the United States and longterm government bonds 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 U.K. bonds, 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. and U.S. bonds is 0.35. The portfolio market value is $100 mil- lion and is equally weighted between the two asset classes. Using the analytical or variance covariance method, compute the following: (i) 5 percent monthly VAR. (3 marks) (ii) 1 percent monthly VAR. (3 marks) (iii) 5 percent weekly VAR. (3 marks) (iv) 1 percent weekly VAR. (3 marks) Page 10 of 12
QUESTION 3: (25 MARKS) PART A: (16 MARKS) (i) Brief define credit risk in financial transactions. (5 marks) (ii) What are the difficulties faced in estimating the credit VaR for a firmwide or portfolio? (5 marks) (iii) Briefly outline the methods of managing credit risk. (6 marks) PART B: (9 MARKS) Tony Smith believes that the price of a particular underlying, currently selling at $96, will increase substantially in the next six months, so he purchases a European call option expiring in six months on this underlying. The call option has an exercise price of $101 and sells for $6. (i) How much is the current credit risk, if any? (3 marks) (ii) How much is the current value of the potential credit risk, if any? (3 marks) (iii) Which party bears the credit risk(s), Tony Smith or the seller? (3 marks) QUESTION 4: (25 MARKS) You are the manager of a portfolio consisting of three bonds in equal par amounts of $1,000,000 each. The first table below shows the market value of the bonds and their durations. (The price includes accrued interest.) The second table contains the market value of the bonds and their durations one year later. Page 11 of 12
As manager, you would like to maintain the portfolio s dollar duration at the initial level by rebalancing the portfolio. You choose to rebalance using the existing security proportions of one-third each. Calculate: A. For classical immunization strategy, what are the two conditions to be satisfied? (5 marks) B. Calculate for the pension fund`s government bond portfolio: i. The dollar durations of each of the bonds. (5 marks) ii. The rebalancing ratio necessary for the rebalancing (10 marks) iii. The cash required for the rebalancing. (5 marks) Show your calculations. ***END OF QUESTION PAPER*** Page 12 of 12