Answer Question Three (b) ( Use as much as you need )

3 marks

(b) Fifth Star Bank has $2 million position in a 7-year, zero-coupon bond with a face value of $1 427 648.The bond is trading at a yield to maturity of 8 per cent. The historical mean change in daily yields is 0.0 per cent, and the standard deviation is 10 basis points. Assume the bank desires no more than a 5 per cent chance that yield changes will be greater than this maximum?

1. What is the daily earnings at risk for this bond?

2. What would be the VAR for the bond for a 5-day period?

3. What is meant by value at risk (VAR)? How is VAR related to DEAR in the RiskMetrics Model?

iv. What is the statistical assumption behind the calculation of the VAR? Could you comment on this assumption in light of any criticism?