Financial Risk Analytics and management

Comprehensive Examination 9th December 2020 time : 2hours

Make your own assumptions to answer and explain each question. Clearly mention the assumptions.
Each question carries 5 marks.

1. A zero coupon bond with face value of $100 has one year to expiry. The probability of default is
10%. In the event of default, assume that the recovery rate is 40%. The continuously
compounded discount rate is 5%. What price you will be willing to pay for this bond?

2. An analyst develops a model for forecasting bond defaults. The model is 90% accurate.
In other words, of the bonds that actually default, the model identifies 90% of them;
likewise, of the bonds that do not default, the model correctly predicts that 90% will
not default. You have a portfolio of bonds, each with a 5% probability of defaulting.
Given that the model predicts that a bond will default, what is the probability that
it actually defaults?

3. You are invested in two hedge funds. The probability that hedge fund Alpha generates
positive returns in any given year is 60%. The probability that hedge fund Omega
generates positive returns in any given year is 70%. Assume the returns are
independent. What is the probability that both funds generate positive returns in a
given year? What is the probability that both funds lose money?