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principles of risk management

Questions and Answers of Principles Of Risk Management

1. From the S&P 500 prices, remove the prices that are simply repeats of the previous day’s price because they indicate a missing observation due to a holiday. Calculate daily log returns as RtC1 D
19. Suppose that a firm engages in a derivative transaction that qualifies for fair value hedging. The firm holds a security and hedges it by selling a derivative. During the course of the hedge, the
18. Identify and discuss five problems with regard to the application of FAS 133.
16. Briefly explain how speculative derivatives transactions are treated from an ac- counting perspective.
15. What is the most important component of an effective risk management system?
14. What responsibilities does senior management assume in a risk management system?
13. Explain the difference between the purposes of the G-30 Recommendations and the Risk Standard Working Group Recommendations.
12. Summarize in one sentence how each of the following organizations failed to prac- tice risk management:a. Metallgesellschaftb. Orange Countyc. Baringsd. Proctor and Gamble
10. Describe the primary differences between accounting for fair value hedges and accounting for cash flow hedges.
8. Why is hedge accounting used and how can it be misused?
5. Explain the difference between centralized and enterprise risk management.
4. Discuss the advantages and disadvantages of a centralized versus a decentralized risk management operation of an end user firm.
3. Identify the two primary types of derivatives specialists within a dealer organization.
2. Distinguish the typical objectives of a dealer engaging in a derivatives transaction from those of an end user.
1. Explain why end users, who conduct their risk management operations in the trea- sury department, should not require the treasury department to be a profit center.
22. (Concept Problem) A company has assets with a market value of $100. It has one outstanding bond issue, a zero coupon bond maturing in two years with a face value of $75. The risk-free rate is 5
21. (Concept Problem) Suppose you enter into a bet with someone in which you pay $5 up front and are allowed to throw a pair of dice. You receive a payoff equal to the total in dollars of the numbers
20. Company CPN and dealer SwapFin are engaged in three transactions with each other. From SwapFin's perspective, the market values are as follows: Swap 1 -$2,000,000 Forward 1 +$1,500,000 Option I
18. The following table lists three financial instruments and their deltas, gammas, and vegas for each $1 million notional principal under the assumption of a long posi- tion. (Long in a swap or FRA
17. Calculate the VAR for the following situations:a. Use the analytical method and determine the VAR at a probability of 0.05 for a portfolio in which the standard deviation of annual returns is
16. Consider a portfolio consisting of $10 million invested in the S&P 500, and $7.5 million invested in U.S. Treasury bonds. The S&P 500 has an expected return of 14 percent and a standard deviation
15. Suppose your firm is a derivatives dealer and has recently created a new product. In addition to market and credit risk, what additional risks does it face that are associated more with new
14. Identify the five types of credit derivatives and briefly describe how each works.
13. Explain how the stockholders of a company hold an implicit put option written by the creditors.
12. How is liquidity a source of risk?
10. How does the legal system impose risk on a derivatives dealer?
5. If a portfolio of derivatives is delta hedged by adding a position in Eurodollar futures, what other forms of market risk might remain? How can these risks be eliminated?
4. Identify the three parties involved in any credit derivatives transaction and de- scribe how they differ in their roles and responsibilities with regard to the transaction.
3. Explain the difference between market risk and credit risk. Are techniques for managing market risk appropriate for managing credit risk?
2. Identify why risk management can be beneficial to stockholders.
1. How is the practice of risk management similar to hedging and how is it different?
21. (Concept Problem) A convertible bond is a bond that permits the holder to turn in the bond and convert it into a certain number of shares of stock. Conversion would, thus, occur only when the
19. Suppose FRM, Inc. issued a zero-coupon, equity index-linked note with a five-year maturity. The par value is $1,000 and the coupon payment is stated as 75% of the equity index return or as zero.
17. Consider a 10-year, fixed-rate mortgage of $500,000 that has an interest rate of 12 percent. For simplification assume that payments are made annually.a. Determine the amortization schedule.b.
16. A stock is priced at 125.37, the continuously compounded risk-free rate is 4.4 per- cent, and the volatility is 21 percent. There are no dividends. Answer the following questions.a. Determine a
13. Determine the prices of the following barrier options.a. A down-and-out call with the barrier at 90 and the exercise price at 95b. An up-and-out put with the barrier at 110 and the exercise price
11. Determine the price of an average price Asian call option. Use an exercise price of 95. Count the current price in determining the average. Comment on whether you would expect a standard European
6. Give an example of a situation in which someone might wish to use a barrier option.
5. Explain the difference between path-dependent options and path-independent options and give examples of each.
4. Explain why an interest-only (IO) mortgage strip has a value that is extremely volatile with respect to interest rates. What two factors determine its value? 10
2. Explain how a portfolio manager might justify the purchase of an inverse floating- rate note.
1. Explain the advantages and disadvantages of implementing portfolio insurance using stock and puts in comparison to using stock and futures in a dynamic hedge strategy.
25. (Concept Problem) Consider a call option with an exercise rate of x on an interest rate, which we shall denote as simply L. The underlying rate is an m-day rate and pays off based on 360 days in
24. (Concept Problem) Use the Black model to determine a fair price for an interest rate put that expires in 74 days. The forward rate is 9.79 percent, and the exercise rate is 10 percent. The
22. Suppose your firm had issued a 12 percent annual coupon, 15-year bond, callable at par at the 8th year. It is now two years later, so the bonds are not callable for an- other 6 years. At this
21. A company wants to enter into a commitment to initiate a swap in 90 days. The swap would consist of four payments 90 days apart with the underlying being LIBOR. Use the term structure of LIBOR as
20. Consider a three-year receiver swaption with an exercise rate of 11.75 percent, in which the underlying swap is a $20 million notional principal four-year swap. The underlying rate is LIBOR. At
19. A firm is interested in purchasing an interest rate cap from a bank. It has received an offer price from the bank but would like to determine if the price is fair. The cap will consist of two
18. A bank is offering an interest rate call with an expiration of 45 days. The call pays off based on 180-day LIBOR. The volatility of forward rates is 17 percent. The 45-day forward rate for
12. The following term structure of LIBOR is given Rate 90 days 6.00% 180 days 6.20% 270 days 6.30% 360 days 6.35%a. Find the rate on a new 6 9 FRA. Xb. Consider an FRA that was established
10. Explain how a forward swap is like a swaption and how it is different.
5. What are the advantages and disadvantages of an interest rate collar over an inter- est rate cap?
4. Show how a combination of interest rate caps and floors can be equivalent to an interest rate swap.
3. Compare the use of interest rate options with forward rate agreements. Explain why a financial manager might prefer one type of contract over another.
2. Explain how FRAS are like swaps and how they are different.
1. How are the payment terms of an FRA different from those of most other interest rate derivatives?
21. (Concept Problem) Consider a currency swap with but two payment dates, which are one year apart, and no exchange of notional principals. On the first date, the party pays U.S. dollars at a rate
20. Explain how an interest rate swap is a special case of a currency swap.
19. Suppose that a party engages in a swap, but before the expiration date of the swap, the party decides that it would like to terminate the position. Explain how it can do so.
18. Explain how swaps are similar to but different from forward contracts.
15. Explain how the following types of swaps are analogous to transactions in bonds.a. Interest rate swapsb. Currency swaps
14. Consider a $30 million notional principal interest rate swap with a fixed rate of 7 percent, paid quarterly on the basis of 90 days in the quarter and 360 days in the year. The first floating
13. Why is notional principal often exchanged in a currency swap but not in an inter- est rate or equity swap? Why would the parties to a currency swap choose not to exchange the notional principal?
12. (Concept Problem) An asset management firm has a $300 million portfolio consist- ing of all stock. It would like to divest 10 percent of its stock and invest in bonds. It considers the
10. You are a pension fund manager who anticipates having to pay out 8 percent (paid semi-annually) on $100 million for the next seven years. You currently hold $100 million of a floating-rate note
9. A pension fund wants to enter into a six-month equity swap with a notional princi- pal of $60 million. Payments will occur in 90 and 180 days. The swap will allow the fund to receive the return on
8. A U.S. corporation is considering entering into a currency swap that will call for the firm to pay dollars and receive British pounds. The dollar notional principal will be $35 million. The swap
7. Explain why interest rate swaps are more widely used than currency and equity swaps.
4. A corporation enters into a $35 million notional principal interest rate swap. The swap calls for the corporation to pay a fixed rate and receive a floating rate of LIBOR. The payments will be
22. (Concept Problem) You plan to buy 1,000 shares of Swiss International Airlines stock. The current price is SF950. The current exchange rate is $0.7254/SF. You are interested in speculating on the
21.a. What is the basis?b. How is the basis expected to change over the life of a futures contract? C. Explain why a strengthening basis benefits a short hedge and hurts a long hedge.
20.a. Define the minimum variance hedge ratio and the measure of hedging effec- tiveness? What do these two values tell us?b. What is the price sensitivity hedge ratio? How are the price sensitivity
19. State and explain two reasons why firms hedge.
18. What factors must one consider when deciding on the appropriate underlying asset for a hedge?
17. (Concept Problem) As we discussed in the chapter, futures can be used to elimi- nate systematic risk in a stock portfolio, leaving it essentially a risk-free portfolio. A portfolio manager can
Determine the original basis. Then calculate the profit from a hedge if it is held to expiration and the basis converges to zero. Show how the profit is explained by movements in the basis alone.b.
15. Suppose you are a dealer in sugar. It is September 26, and you hold 112,000 pounds of sugar worth $0.0479 per pound. The price of a futures contract expir- ing in January is $0.0550 per pound.
14. On January 2 of a particular year, an American firm decided to close out its account at a Canadian bank on February 28. The firm is expected to have 5 mil- lion Canadian dollars in the account at
13. You are the manager of a stock portfolio worth $10,500,000. It has a beta of 1.15. During the next three months, you expect a correction in the market that will take the market down about 5
12. On November 1, an analyst who has been studying a firm called Computer Sci- ences believes the company will make a major new announcement before the end of the year. Computer Sciences currently
7. You are the manager of a stock portfolio. On October 1, your holdings consist of the eight stocks listed in the following table, which you intend to sell on December 31. You are concerned about a
6. Explain the difference between a short hedge and a long hedge.
3. For each of the following hedge termination dates, identify the appropriate contract expiration. Assume the available expiration months are March, June, September, and December.a. August 10b.
2. On January 31, a firm learns that it will have $5 million available on May 31. It will use the funds to purchase the APCO 9 1/2 percent bonds maturing in about 21 years. Interest is paid
20. On August 20 a stock index futures, which expires on September 20, was priced at 429.70. The index was at 428.51. The dividend yield was 2.7 percent. Discuss the concept of the implied repo rate
19. Explain the relationship between carry arbitrage and the implied repo rate.
18. What is program trading? Why is it so controversial?
17. Identify and explain some factors that make the execution of stock index futures arbitrage difficult in practice.
16. Define the conversion factor. Why are U.S. Treasury bond futures contracts de- signed with conversion factors?
15. Identify and discuss four non-traded delivery options related to U.S. Treasury bond futures contracts.
14. Explain the implied repo rate on a U.S. Treasury bond futures spread position.
13. Explain how the repurchase agreement plays a role in the pricing of futures con- tracts. What is the implied repo rate?
12. Assume that on March 16, the cheapest bond to deliver on the June T-bond futures contract is the 14s, callable in about 19 years and maturing in about 24 years. Coupons are paid on November 15
11. (Concept Problem) In this chapter, there are two equations presented for the implied repo rate related to bond futures contracts shown below. Explain these equations and discuss the differences
9. On March 16, the June T-bond futures contract was priced at 100 17/32 and the September contract was at 99 17/32. Determine the implied repo rate on the spread. Assume the cheapest bond to deliver
8. On March 16, the March T-bond futures settlement price was 101 21/32. Assume the 12 1/2 percent bond maturing in about 22 years is the cheapest bond to deliver. The CF is 1.4639. Assume that the
4. Rework problem 3 assuming that the index was at 388.14 at expiration. Determine the profit from the arbitrage trade, and express it in terms of the profit from the spot and futures sides of the
3. On July 5, a stock index futures contract was at 394.85. The index was at 392.54, the risk-free rate was 2.83 percent, the dividend yield was 2.08 percent, and the contract expired on September
2. Repeat problem 1, but now assume the one-month LIBOR rate on December 1 was 5.5 percent.
1. On November 1, the one-month LIBOR rate is 4.0 percent and the two-month LIBOR rate is 5.0 percent. Assume that Fed funds futures contracts trades at a 25 basis point rate under one-month LIBOR at

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