UESTION ONE (COMPULSORY) A derivative is a financial instrument whose value is derived from the value of another asset, which is known as the underlying. When the price of the underlying changes, the value of the derivative also changes. A Derivative is not a product. It is a contract that derives its value from changes in the price of the underlying. Required: a) Explain carefully the difference between Hedging, Speculation, and Arbitrage. [6 Marks] b) What is the difference between entering into a long forward contract when the forward price is K1000 and taking a long position in a call option with a strike price of K1000? [2 Marks] c) Contrast between a forward contract and futures contract. [3 Marks] d) A US firm buys goods from a British supplier and needs 1 million in 3 months time. He decides to enter into a forward contract with a 3months spot rate of 1.614. What would happen, for example, if the spot exchange rate in 3months time was: (i) 1.6300 (ii) 1.5900 [4 Marks] e) Suppose that a March call option to buy a share for K500 costs K25 and is held until March. I) Under what circumstance (s) will the holder of the option make a profit? [2 Marks] II) Under what circumstance (s) will the option be exercised? [2 Marks] III) Draw a diagram showing how the profit on a long position in the option depends on the stock price at the maturity of the option. [2 Marks] f) Suppose that you enter into a six month forward contract on a non-dividend-paying stock when the stock price is K600 and the risk-free interest rate (with continuous compounding) is 12% per annum. What is the forward price? [4 Marks] [Total 25 Marks] 3 QUESTION TWO Consider a K1000 bond, issued at 10 interest which is paid semi-annually for 5 years maturity. Its YTM is 12 percent. Required: a) Define interest rate risk [2 Marks] b) Calculate the market value of the bond. [5 Marks] b) Compute the macaurys duration of the bond and explain what the figure means in relation to interest rate risk management. [10 Marks] c) Options and futures are zero-sum games. What do you think is meant by this statement? [3 Marks] d) Briefly critique securitization and explain its role in the 2007/2009 global financial crisis. [5 Marks] [Total 25 Marks] QUESTION THREE a) Define the central component of market risk management. [3 Marks] b) Explain the difference between VaR and Expected shortfall. [5 Marks] c) Suppose that it is determined that a $100 million portfolio could potentially lose $20 million once every 20 trading days What is the Var at 95% and 99% Confidence intervals? [4 Marks] d) Consider a portfolio of equities worth K1Million with an expected daily return of 4% and a daily standard deviation of returns of 0.10%. Assume that all returns are normally distributed. I. What is the daily VaR on this portfolio at a tolerance threshold of 95%? [5 Marks] 4 II. What is the value at risk over a 27-day period? [3 Marks] e) Explain the historical simulation approach as a measure of VaR. [5 Marks] [Total 25 Marks] QUESTION FOUR a) Explain credit risk [5 Marks] b) XYZ Banking Corporation holds a portfolio of K600m credit card receivables (outstanding loan balances on credit cards). The average annual default rate over the past 10 years for similar exposures has been 2%. When defaults have taken place the bank has taken these individuals to court and obtained recoveries, net of legal costs, of 10%. Calculate the expected loss for XYZ bank on this investment. [6 Marks] c) Consider a company for which working capital is K170,000, total assets are K670,000, earnings before interest and taxes is K60,000, sales are K2,200,000, the market value of equity is K380,000, total liabilities is K240,000, and retained earnings is K300,000. I. Compute these ratios using the Altman Z-score: X1, X2, X3, X4, and X5. [5 Marks] II. Assess the credit risk (z-score) of a potential borrowing firm and interpret the score. [5 Marks] d) What is meant by a Haircut in collateralization agreement? [4 Marks] [Total 25 Marks] 5 QUESTION FIVE Consider the following information for a particular investor. The investor has invested 35 percent each in A and C, and 30 percent in B. Rate of Return if State Occurs Economic condition Probability (P) Stock A Stock B Stock C Boom 0.20 30% 45% 33% Good 0.20 12% 10% 15% Poor 0.50 1% -15% -5% Bust 0.10 -20% -30% -9% Required: Calculate: a) Expected return of investing in each of the three stocks. [3 marks] c) The expected rate of return for the portfolio [3 Marks] b) The volatility (standard deviation for each of the stocks). [6 Marks] c) The coefficient of variation for each of the stocks? [3 Marks] d) The co-variance between project A and B, A and C, and B and C. [6 Marks] e) The total portfolio risk [4 Marks] [Total 25 Marks] 6 QUESTION SIX It is tempting to argue: Bank regulation is unnecessary. Even if there were no regulations, banks would manage their risks prudently and would strive to keep a level of capital that is commensurate with the risks they are taking. Unfortunately, history does not support this view. There is little doubt that regulation has played an important role in increasing bank capital and making banks more aware of the risks they are taking. Required: a) Explain the FIVE Pillars under Basel III [10 Marks] b) Define trading liquidity risk [2 Marks] c) An institution holds 10million shares of one company and 50million ounces of a commodity. The shares are bid K89.5, offer K90.5. The commodity is bid K15 offer K15.1. I. What is the liquidation cost in normal markets? [6 Marks] II. Given the mean and standard dev. of the bid-offer spread for the shares is 1 and 2 and for the commodity is 0.1 for both. What is the stressed liquidation cost at 99% confidence? [7 Marks