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principles of risk management

Questions and Answers of Principles Of Risk Management

4 If the spot AUD/USD exchange rate is quoted as 0.5413, what is the value of 1 ‘point’ on a deal of 1 million of the base currency?If the spot USD/JPY exchange rate is quoted as 107.13, what is
5 You buy USD 10 million against Canadian dollars at 1.3785 and sell USD 10 million at 1.3779. What is your profit or loss?
6 You are a dealer with a short position in US dollars against euros.A counterparty calls you for a price in EUR/USD. The market is currently 0.9503/08. Which of the following prices might you quote
7 You are a dealer. A customer asks you for a CHF/USD price. You quote him 0.6330/38 and he buys CHF 5 million from you. You want to cover this position in the market and therefore deal on a price of
8 You sell EUR 5 million against USD at 0.9320, you buy EUR 2 million at 0.9325, you buy EUR 4 million at 0.9330 and you sell EUR 3 million at 0.9327. The market closes at 0.9328 and the closing rate
9 The SEK/NOK exchange rate is 1.0523/28. What is the reciprocal rate?
10 Current spot rates are as follows:USD/CHF 1.5384/89 USD/SGD 2.3895/05 EUR/USD 0.9678/83 AUD/USD 0.5438/43(a) What is the two-way price for CHF/SGD? On which side of this price would the customer
1 Which of the following are true?(a) If the 6-month USD/CHF forward swap points change from 125/120 to 135/130, USD interest rates might have fallen.(b) If the 3-month forward swap points are
2 What should the mid-rate theoretically be for the USD/CHF 3-month outright, given the following? The 3-month period is 92 days.USD/CHF spot: 1.7120/26, USD 3-month interest rate: 5.10/5.20%CHF
3 What is the two-way 3-month swap price for USD/CHF, based on the following borrowing and lending rates? The 3-month period is 91 days.USD/CHF spot: 1.7120/26, USD 3-month interest rate:
4 You wish to take a particular speculative position and ask a bank for a 3-month USD/CHF swap price. It is quoted to you as 127/122 and you deal at 127. What is your expectation for market movements?
5 EUR/USD forward swaps are as follows. What can you say about the euro and dollar yield curves?6 months: 10/5 12 months: 5/10
6 You are a dealer and quote a customer 56/61 for a EUR/GBP 6-month swap (182 days). The customer buys and sells GBP 10 million and you base the spot on 0.6215.You immediately ask another bank for a
7 Given the following prices:USD/CAD spot: 1.5671/77 6-month swap 30/33 USD/SEK spot: 10.3458/68 6-month swap 70/67(a) What is the two-way 6-month forward outright price for CAD/SEK and at what price
8 You are a dealer and quote a 6-month GBP/JPY swap to a customer as 435/425. The customer buys and sells GBP 1,000,000, based on a spot of 178.10. You cover this position using two 6-month swaps
9 You are quoted all the following rates. What is the best rate at which you can sell sterling against yen 6 months forward outright, and how do you achieve it?GBP/JPY spot: 178.05/15 6-month swap:
10 Given the following rates for GBP/USD:Spot: 1.4253/58 O/N: 1.80/1.30 T/N: 2.10/1.60 S/N: 2.20/1.70 3 months: 183/178(a) At what rate can a customer buy sterling for outright value the day after
11 Today is Monday 27 October 2003. What are the spot and 1 month value dates?
12 Today is Wednesday 25 February 2004. What are the spot and 1-month value dates?
13 You need to sell and buy dollars against sterling forward-forward 2v5, given the following:GBP/USD spot: 1.4235/45 2-month swap: 15/11 3-month swap: 8/3 5-month swap: 12/18 (a) What two-way
14 What is the two-way time option outright price for delivery between 3 and 5 months, given the following prices?GBP/USD spot: 1.4235/45 3-month swap: 8/3 5-month swap: 12/18
15 You transact an NDF to buy HUF 1,000 million against USD at 301.55, for value 17 August. On 15 August, the spot rate for settlement of the NDF is 295.71. What is your profit or loss in US dollars?
What was the transparency problem in the subprime crisis of 2007?AppendixLO1
An asset is quoted bid 50, offer 55. What does this mean? What is the proportional bid–offer spread?AppendixLO1
Suppose that an investor has shorted shares worth $5,000 of Company A and bought shares worth $3,000 of Company B. The proportional bid–offer spread for Company A is 0.01 and the proportional
Suppose that in Problem 21.3 the bid–offer spreads for the two companies are normally distributed. For Company A the bid–offer spread has a mean of 0.01 and a standard deviation of 0.01. For
A trader wishes to unwind a position of 60 million units in an asset over 10 days. The dollar bid–offer spread as a function of daily trading volume q, is a + becq where a = 0.2, b = 0.1, and c =
Why does a bank need to keep track of the assets it has pledged as collateral as part of its procedures for managing liquidity funding risk?AppendixLO1
Why is it risky to rely on borrowings in the wholesale market for funding?AppendixLO1
What were the nature of the funding risk problems of Ashanti Goldfields and Metallgesellschaft?AppendixLO1
What is meant by (a) positive feedback trading and (b) negative feedback trading? Which is liable to lead to liquidity problems?AppendixLO1
What is meant by liquidity-adjusted VaR?AppendixLO1
Explain how liquidity black holes occur. How can regulation lead to liquidity black holes?AppendixLO1
Why is it beneficial to the liquidity of markets for traders to follow diverse trading strategies?AppendixLO1
Discuss whether hedge funds are good or bad for the liquidity of markets.Liquidity Risk 471 AppendixLO1
Suppose that a trader has bought some illiquid shares. In particular, the trader has 100 shares of A, which is bid $50 and offer $60, and 200 shares of B, which is bid $25 offer $35. What are the
A trader wishes to unwind a position of 200,000 units in an asset over eight days. The dollar bid–offer spread, as a function of daily trading volume q, is a + becq where a = 0.2, b = 0.15, and c =
Suppose that a bank’s sole business is to lend in two regions of the world.The lending in each region has the same characteristics as in Example 23.5 of Section 23.8. Lending to Region A is three
Suppose that the economic capital estimates for two business units are Business Units 1 2 Market Risk 10 50 Credit Risk 30 30 Operational Risk 50 10 The correlation between market risk and credit
Suppose that daily gains (losses) are normally distributed with a standard deviation of $5 million.(a) Estimate the minimum regulatory capital the bank is required to hold.(Assume a multiplicative
RAROC can be used in two different ways. What are they?Economic Capital and RAROC 507 AppendixLO1
A bank is considering expanding its asset management operations. The main risk is operational risk. It estimates the expected operational risk loss from the new venture in one year to be $2 million
In Problem 23.6, what is the incremental effect of each business unit on the total economic capital? Use this to allocate economic capital to business units.What is the impact on the economic capital
Suppose that the economic capital estimates for two business units are as follows:Business Units 1 2 Market Risk 20 40 Credit Risk 40 30 Operational Risk 70 10 The correlations are as in Table 23.3.
Suppose that the credit loss in a year has a lognormal distribution. The logarithm of the loss is normal with mean 0.5 and standard deviation 4. What is the economic capital requirement if a
In what respects are the models used to calculate economic capital for market risk, credit risk, and operational risk likely to be different from those used to calculate regulatory capital?AppendixLO1
What types of risk are included in business risk?AppendixLO1
What determines the confidence level used by a financial institution in its economic capital calculations?AppendixLO1
What is the difference between economic capital and regulatory capital?AppendixLO1
A futures price is currently at $40. The risk-free interest rate is 5%. Some news is expected tomorrow that will cause the volatility over the next three months to be either 10% or 30%. There is a
Suppose that a financial institution uses an imprecise model for pricing and hedging a particular type of structured product. Discuss how, if at all, it is likely to realize its mistake.AppendixLO1
Using Table 22.1, calculate the volatility a trader would use for an 11-month option with a strike price of 0.98.AppendixLO1
Suppose that all options traders decide to switch from the Black–Scholes–Merton model to another model that makes different assumptions about the behavior of asset prices. What effect do you
“For structured products, traders mark to model. They do not mark to market.”Explain this remark.AppendixLO1
Suppose that a central bank’s policy is to allow an exchange rate to fluctuate between 0.97 and 1.03. What pattern of implied volatilities for options on the exchange rate would you expect to
What is meant by “fair-value” accounting? What changes were made to fairvalue accounting in 2008 and 2009?AppendixLO1
The price of a certain stock is currently $20. Tomorrow, news is expected to be announced that will either increase it by $5 or decrease it by $5. What is the problem in using the
Distinguish between within-model and outside-model hedging.AppendixLO1
How is a financial institution likely to find that it is using a model different from its competitors for a particular type of derivatives product?AppendixLO1
What is the key difference between the models of physics and the models of finance?AppendixLO1
Using Table 22.1, calculate the volatility a trader would use for an eightmonth option with a strike price of 1.04.AppendixLO1
“The Black–Scholes–Merton model is nothing more than a sophisticated interpolation tool.” Discuss this viewpoint.AppendixLO1
Give two explanations for the volatility smile observed for options on a foreign currency.AppendixLO1
Give two explanations for the volatility skew observed for options on equities.AppendixLO1
Explain what is meant by (a) marking to market and (b) marking to model.AppendixLO1
What is the difference between a long forward position and a short forward position?AppendixLO1
Explain carefully the difference between hedging, speculation, and arbitrage.AppendixLO1
What is the difference between entering into a long forward contract when the forward price is $50 and taking a long position in a call option with a strike price of $50?AppendixLO1
Explain carefully the difference between selling a call option and buying a put option.AppendixLO1
An investor enters into a short forward contract to sell 100,000 British pounds for U.S. dollars at an exchange rate of 1.7000 U.S. dollars per pound. How much does the investor gain or lose if the
A trader enters into a short cotton futures contract when the futures price is 50 cents per pound. The contract is for the delivery of 50,000 pounds. How much does the trader gain or lose if the
Suppose you write a put contract with a strike price of $40 and an expiration date in three months. The current stock price is $41 and the contract is on 100 shares. What have you committed yourself
What is the difference between the over-the-counter market and the exchangetraded market? Which of the two markets do the following trade in: (a) a forward contract, (b) a futures contract, (c) an
You would like to speculate on a rise in the price of a certain stock. The current stock price is $29, and a three-month call with a strike of $30 costs $2.90. You have $5,800 to invest. Identify two
Suppose that you own 5,000 shares worth $25 each. How can put options be used to provide you with insurance against a decline in the value of your holding over the next four months?AppendixLO1
When first issued, a stock provides funds for a company. Is the same true of a stock option? Discuss.AppendixLO1
Suppose that aMarch call option to buy a share for $50 costs $2.50 and is held until March. Under what circumstances will the holder of the option make a profit? Under what circumstances will the
Suppose that a June put option to sell a share for $60 costs $4 and is held until June. Under what circumstances will the seller of the option (i.e., the party with the short position) make a profit?
A company knows that it is due to receive a certain amount of a foreign currency in four months. What type of option contract is appropriate for hedging?AppendixLO1
A United States company expects to have to pay 1 million Canadian dollars in six months. Explain how the exchange rate risk can be hedged using (a) a forward contract and (b) an option.AppendixLO1
In the 1980s, Bankers Trust developed index currency option notes (ICONs).These are bonds in which the amount received by the holder at maturity varies with a foreign exchange rate. One example was
Suppose that USD-sterling spot and forward exchange rates are as follows:Spot 1.6080 90-day forward 1.6056 180-day forward 1.6018 What opportunities are open to an arbitrageur in the following
A company has money invested at 5% for five years. It wishes to use the swap quotes in Table 5.5 to convert its investment to a floating-rate investment.Explain how it can do this.AppendixLO1
A company has borrowed money for five years at 7%. Explain how it can use the quotes in Table 5.5 to convert this to a floating-rate liability.AppendixLO1
A company has a floating-rate liability that costs LIBOR plus 1%. Explain how it can use the quotes in Table 5.5 to convert this to a three-year fixed-rate liability.AppendixLO1
A corn farmer argues “I do not use futures contracts for hedging. My real risk is not the price of corn. It is that my whole crop gets wiped out by the weather.”Discuss this viewpoint. Should the
An airline executive has argued: “There is no point in our hedging the price of jet fuel. There is just as much chance that we will lose from doing this as that we will gain.” Discuss the
Why is the cost of an Asian basket put option to Microsoft considerably less that the cost of a portfolio of put options, one for each currency and each maturity (see Business Snapshot
A United States investor writes five call option contracts. The option price is$3.50, the strike price is $60, and the stock price is $57. What is the initial margin requirement?AppendixLO1
“Oil, gas, and electricity prices tend to exhibit mean reversion.” What do you think is meant by this statement? Which energy source is likely to have the highest rate of mean reversion? Which is
Does a knock-out barrier call option become more or less valuable as the frequency with which the barrier is observed is increased?AppendixLO1
Suppose that each day during July the minimum temperature is 68◦ Fahrenheit and the maximum temperature is 82◦ Fahrenheit. What is the payoff from a call option on the cumulative CDD during July
Explain how a 5 × 8 option contract on electricity for May 2013 with daily exercise works. Explain how a 5 × 8 option contract on electricity for May 2013 with monthly exercise works. Which is
A trader shorts 500 shares of a stock when the price is $50. The initial margin is 160% and the maintenance margin is 130%. How much margin is required from the investor initially? How high does the
A company enters into a short futures contract to sell 5,000 bushels of wheat for 25 cents per bushel. The initial margin is $3,000 and the maintenance margin is $2,000. What price change would lead
The current price of a stock is $94, and three-month European call options with a strike price of $95 currently sell for $4.70. An investor who feels that the price of the stock will increase is
A bond issued by Standard Oil worked as follows. The holder received no interest. At the bond’s maturity the company promised to pay $1,000 plus an additional amount based on the price of oil at
The price of gold is currently $1,500 per ounce. The forward price for delivery in one year is $1,700. An arbitrageur can borrow money at 10% per annum.Trading in Financial Markets 119 What should
A company’s investments earn LIBOR minus 0.5%. Explain how it can use the quotes in Table 5.5 to convert them to (a) three-, (b) five-, and (c) ten-year fixed-rate investments.AppendixLO1
What position is equivalent to a long forward contract to buy an asset at K on a certain date and a long position in a European put option to sell it for K on that date?AppendixLO1 Estimate the

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