AAA Bank is an Australian bank, the bank wants to measure its market risk exposure by calculating the daily earnings at risk (DEAR) on its trading portfolio.

The bank's trading portfolio consists of the following assets:

(a) Fixed-income securities (Bonds):

The bank holds a 10-year zero coupon bond with a face value of AUD$3,500,000. The bond is trading at yield to maturity of 3 percent. The potential adverse move in yields is 0.0035.

Calculate DEAR for Fixed Income if a 90% confidence limit is required. [2 marks]

(b) Equities:

The bank holds an AUD$6 million trading position in stocks that reflects the stock market index (the = 1). Over the last year, The historical mean change in the stock market index was 0.0 per cent and the standard deviation of the stock market index was 2.1%

Calculate DEAR for equities if a 90% confidence limit is required. . [2 marks]

(c) Foreign exchange:

The bank has a net long position of 7.5 million Euros (7.5M) at the close of business on a particular day. The exchange rate is AU$1.63/1 (i.e. 1.63 AUD = 1) at the daily close. Looking back at the daily changes in the exchange rate of the euro to AUD for the past year, the bank finds that the historical mean change in daily exchange rates was 0.0 per cent and the volatility or standard deviation () of the spot exchange rate was 0.66%.

Calculate DEAR for FX if a 90% confidence limit is required. [2 marks]

(d) Now assume correlations (_ij) among assets are as follows

________________________________________________________________________

Foreign Exchange Stocks

Bond -0.5 0.4

Foreign Exchange 0.3

Calculate 10 day Value at Risk (VAR) of FIM banks trading portfolio using a 90% confidence level and explain how the VAR position would be interpreted. [2 marks]

(e) Explain the weaknesses of the RiskMetrics model in measuring market risk. Further, explain the impact on the estimate of market risk due to the weaknesses in the model. [2 marks]