Deli is a risk-analyst at Nkumbu Bank (NB), a commercial bank with operations in Zambia. NB is currently expanding its operations to include proprietary trading and is reviewing its risk management policies. NB uses Value at Risk (VaR) models to monitor its risk exposures.

NB`s current portfolio of currencies contains only long positions. The volatility of the currencies in its portfolio has recently increased, and Deli expects volatility to remain high over the next several quarters. As a result, she has hedged the portfolio using currency options.

Required:

A. Explain Value at Risk as a measure of market risk and the key elements involved when interpreting VaR. (5 marks)

B. Outline the three methods used to calculate VaR. (5 marks)

C. For hedging purpose, the client is of the opinion that the delta normal method is the most appropriate. Advise the client on the appropriateness of this method. (3 marks)

D. The client has collected the daily prices for the last month of Bata stock and has computed the mean daily return to be 0.00085 and daily standard deviation to be 0.00111. Assuming the investment under consideration is K1M, provide an estimation of the following using the variance-covariance method:

I. The daily VaR at 5% level of significance. (4 marks)

II. The monthly VaR at 5% level of significance. (4 marks)

III. The annual VaR at 5% level of significance. (4 marks)

[Total= 25 marks]