Financial Risk Management worksheet

1. What is the difference between the forward price and the value of a forward contract?
2. Suppose that you enter into a 6-month forward contract on a non-dividend-paying
stock when the stock price is $30 and the risk-free interest rate (with continuous
compounding) is 12% per annum. What is the forward price?
3. A stock index currently stands at 350. The risk-free interest rate is 8% per annum
(with continuous compounding) and the dividend yield on the index is 4% per annum.
What should the futures price for a 4-month contract be?
4. Explain carefully why the futures price of gold can be calculated from its spot price
and other observable variables whereas the futures price of copper cannot.
5. Explain carefully the meaning of the terms convenience yield and cost of carry. What
is the relationship between futures price, spot price, convenience yield, and cost of
carry?
6. Explain why a foreign currency can be treated as an asset providing a known yield.
7. Is the futures price of a stock index greater than or less than the expected future value
of the index? Explain your answer.
8. A 1-year long forward contract on a non-dividend-paying stock is entered into when
the stock price is $40 and the risk-free rate of interest is 10% per annum with
continuous compounding.
a) What are the forward price and the initial value of the forward contract?
b) Six months later, the price of the stock is $45 and the risk-free interest rate is
still 10%. What are the forward price and the value of the forward contract?
9. The risk-free rate of interest is 7% per annum with continuous compounding, and the
dividend yield on a stock index is 3.2% per annum. The current value of the index is
150. What is the 6-month futures price?
10. Assume that the risk-free interest rate is 9% per annum with continuous
compounding and that the dividend yield on a stock index varies throughout the year.
In February, May, August, and November, dividends are paid at a rate of 5% per
annum. In other months, dividends are paid at a rate of 2%per annum. Suppose that
the value of the index on July 31 is 1,300. What is the futures price for a contract
deliverable in December 31 of the same year.
11. A company uses an EWMA model for forecasting volatility. It decides to change the
parameter λ from 0.95 to 0.85. Explain the likely impact on the forecasts.
12. Assume that an index at close of trading yesterday was 1,040 and the daily volatility
of the index was estimated as 1% per day at that time. The parameters in a
GARCH(1,1) model are ω=0.000002, a=0.06, and ß=0.92. If the level of the index at
close of trading today is 1,060, what is the new volatility estimate?
13. The most recent estimate of the daily volatility of the dollar–sterling exchange rate is
0.6% and the exchange rate at 4:00 p.m. yesterday was 1.5000. The parameter λ in the
EWMA model is 0.9. Suppose that the exchange rate at 4:00 p.m. today proves to be
1.4950. How would the estimate of the daily volatility be updated?
14. A company uses the GARCH(1,1) model for updating volatility. The three
parameters are ω, a,and ß. Describe the impact of making a small increase in each of
the parameters while keeping the others fixed.
15. The parameters of a GARCH(1,1) model are estimated as ω=0.000004, a= 0.05, and
ß=0.92. What is the long-run average volatility and what is the equation describing
the way that the variance rate reverts to its long-run average? If the current volatility
is 20% per year, what is the expected volatility in 20 days?
16. Suppose that the daily volatility of the FTSE 100 stock index (measured in pounds
sterling) is 1.8% and the daily volatility of the dollar–sterling exchange rate is 0.9%.
Suppose further that the correlation between the FTSE 100 and the dollar–sterling
exchange rate is 0.4. What is the volatility of the FTSE 100 when it is translated to
U.S. dollars? Assume that the dollar–sterling exchange rate is expressed as the
number of U.S. dollars per pound sterling. (Hint: When Z = XY, the percentage daily
change in Z is approximately equal to the percentage daily change in X plus the
percentage daily change in Y.)
17. Suppose that GARCH(1,1) parameters have been estimated as ω=0.000003,a= 0.04,
and ß=0.94. The current daily volatility is estimated to be 1%. Estimate the daily
volatility in 30 days.
18. Suppose that GARCH(1,1) parameters have been estimated as ω=0.000002,a= 0.04,
and ß=0.94. The current daily volatility is estimated to be 1.3%. Estimate the
volatility per annum that should be used to price a 20-day option.
19. What is the difference between expected shortfall and VaR? What is the theoretical
advantage of expected shortfall over VaR?
20. What conditions must be satisfied by the weights assigned to percentiles in a risk
measure for the subadditivity condition in Section 12.5 to be satisfied?
21. A fund manager announces that the fund’s one-month 95% VaR is 6% of the size of
the portfolio being managed. You have an investment of $100,000 in the fund. How
do you interpret the portfolio manager’s announcement? 12.4 A fund manager
announces that the fund’s one-month 95% expected shortfall is 6% of the size of the
portfolio being managed. You have an investment of $100,000 in the fund. How do
you interpret the portfolio manager’s announcement?
22. Suppose that each of two investments has a 0.9% chance of a loss of $10 million and
a 99.1% chance of a loss of $1 million. The investments are independent of each
other.
a) What is the VaR for one of the investments when the confidence level is 99%?
b) What is the expected shortfall for one of the investments when the confidence level is
99%?
c) What is the VaR for a portfolio consisting of the two investments when the
confidence level is 99%?
d) What is the expected shortfall for a portfolio consisting of the two investments when
the confidence level is 99%?
e) Show that in this example VaR does not satisfy the subadditivity condition,
whereas expected shortfall does.