Briefly analyse the effect of an increase in interest rates on the

investment portfolio of a profit maximising holding company.

Explain the purpose of a central counterparty (CCP) clearing over-the-counter (OTC) derivative trades. [2] Individual Clearing House (ICH), a CCP, allows its members to transact OTC swaps and options under a fixed schedule of initial margins by instrument. The margins are calculated separately for each OTC instrument based on 99% ten-day Value at Risk (VaR). For a portfolio of instruments, the margins are added together on a gross basis, i.e. without netting longs and shorts. Portfolio Clearing House (PCH), another CCP, similarly allows its members to transact OTC swaps and options but with a daily initial margin requirement based on 99% tenday VaR for the whole of a member's portfolio, i.e. all positions taken together. In other respects, including data sources and observation periods, the VaR methodologies for PCH and ICH are identical. Variation margin calculations are also identical. (ii) Estimate ICH's initial margin requirement for an equity index swap based on a price volatility of 24% per annum for the index. [2] (iii) Discuss: (a) the issues that a bank would consider when choosing between ICH and PCH as its clearing house for OTC derivatives. (b) the shortcomings of ICH's and PCH's initial margin calculations. (iv) Outline the problems that a CCP might encounter in clearing property derivatives.An up-and-in put is a European barrier put option that can only be exercised if the spot price of the underlying has at some point before expiry exceeded a specified barrier price H. Conversely, an up-and-out put is one that becomes worthless if the spot price of the underlying ever exceeds the barrier price H. Consider an up-and-in put, an up-and-out put and a vanilla put option, all with identical strike K which is lower than the barrier price H. The price of the underlying asset is S, and the barrier price has not yet been breached. (i) Sketch two graphs showing, for these options: (a) the value (b) the delta against S shortly after the options are issued. All three options should appear on each graph. [6] (ii) Explain the circumstances under which the vega of a barrier option could be negative. [2] A bank is reviewing its pricing calculations for barrier options. (iii) Outline the advantages and disadvantages of valuing the barrier options using: (a) algebraic formulae. (b) binomial or trinomial trees. (c) Monte Carlo techniques. You may assume that formulae exist for pricing up-and-in calls and puts based on continuous monitoring for barrier breaches.An investment bank is considering setting up a hedging service for companies to manage risk in their dened benefit pension funds. The service includes offering hedges for longevitv and inflation risks. {1} Describe the main derivativesbased products (Lg; swaps, options or structured bonds} that the bank could offer in these two areas of risk, explaining in each case whv the hedges would be important to a pension fund. {3] in considering how to price these products, there has been a debate within the bank about whether to use riskneutral or realworld valuation methods and parameters. [ii] Dutline the main points that should be considered in this debate