PART 2

Question Three : Liquidity and market Risk

1. The liquidity problems in managed funds are different from those faced by commercial banks and insurance companies?

1. Discuss the above statement briefly and explain how does the liquidity risk of an open-end managed fund compare with that of a closed-end fund?

2. Discuss briefly why deposit insurance can decrease bank run and how can this scheme lead to a moral hazard problem.

(4 marks)

2. 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?

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

(3 marks)