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THE UNIVERSITY OF WARWICK
UNIVERSITY OF WARWICK

PaQer Details

Paper Code: 1895R0

Paper Title: Financial Risk Management

Exam Period: April 2024

Exam Rubric

Time Allowed: 2 hours

Exam Type: Unrestricted Open Book Examination - Permitted Texts: Any

Approved Calculators: Permitted

Instructions

You should answer ALL THREE questions

(Continued.../)
Question 1. [120 marks]

Suppose that you are a risk manager of a small bank that is financed by a mixture of equity
and deposits. The bank has invested all the raised money in long-maturity bonds. Deposits are
modelled as nearly-zero-maturity bonds that their owners can withdraw any time, and have
a market value of £3.3 million; and assume that the assets are four zero-coupon bonds, each
with face value £Im, and maturities of 10, 11, 12 and 13 years.
The current interest rate for all horizons (which is also your discount rate) with annual
compounding is r = 1%.

Balance Sheet

Assets Deposits
--
£Im in years 10, 11, 12, 13 £3.3m
Equity
 (a) [15 marks] Calculate the current market value of the bank's assets and the market value
of the equity.

(b) [15 marks] What would be the change in the market value of assets if the whole yield
curve increased by 1%? Explain why this would be a problem. Note that since deposits
have almost-zero maturity, their value remains the same after interest-rate changes.

For deposits

Macaulay Duration: since this calculates the weighted average amount of time until cash flows from a
bond are received. When it comes to deposits, there is only one cash flow at time zero and no more
cash flows to take into account. The Macaulay Duration is therefore practically negligible.

Modified Duration: Since this gauges how responsive the price of a bond is to fluctuations in interest
rates. Given that deposits have a nearly zero maturity, their present value would be hardly affected by
changes in interest rates. As a result, the deposits' Modified Duration is also practically negligible.
Thus,
Macaulay Duration =0

Modified Duration =0

You are concerned that interest rates may go up, and would like to duration-hedge your interest
rate exposure by issuing some long-term debt in the form of 10-year zero coupon bonds. Assume
that issuing bonds for £X million is used to pay back deposits in the value of £X million.

(c) [10 marks] Calculate the Macaulay and modified duration of the assets and of the deposits.

(d) [20 marks] Calculate how much debt in 10-year bonds, by replacing some of the deposits,
would make sure the bank is immunized against (small) interest rate movements.

(e) [20 marks] After putting on the hedge, interest rates indeed increase to 2%. Compute
the equity value for the hedged versus the unhedged portfolio. Discuss the benefits of
hedging.

Benefits of hedging
1. The bank has been able shielded itself against unfavorable changes in interest rates by

hedging. The duration matching method makes sure that interest rate fluctuations have as

little of an effect as possible on the portfolio's total value.

2. The bank has hedged its exposure to unfavorable changes in interest rates. The duration
 matching method makes sure that interest rate fluctuations have as little of an effect as

possible on the portfolio's total value.

3. Hedging have contributed to portfolio equity value stabilization, particularly in times of

interest rate volatility. Thus, the Investors and stakeholders can feel secure because of this

steadiness.

4. Hedging have lowered the possibility of losses brought on by changes in interest rates by

helping the bank better manage its interest rate risk. Hedging can help to increase long-term

financial performance and profitability by reducing the effect of interest rate fluctuations on

the equity value.

(Question 1 continues over page... /)

(f) [20 marks] Suppose now that interest rates increase to 4% as a result of a rapid succession
of interest rate raises by the central bank. Compute the equity value for the hedged
versus the unhedged portfolio, and compare the equity value in case of hedging to the
one obtained in part (e). Explain why we see a difference and how one could fix this
issue (but do not make any extra calculations for this).
comparison

1. In section (e), the duration matching technique kept the equity value of the hedged portfolio

steady even when interest rates rose to 2%.

2. In this case, the greater influence on the market value of assets could cause the equity value

of the hedged portfolio to decline more dramatically if interest rates rise quickly to 4%.

Reason for the Difference

The level of the interest rate increase accounts for the difference in equity value between the

two scenarios. In this scenario, the interest rate increase was rapid (to 4%), in contrast to section (e),

where the increase was relatively mild (to 2%). It's possible that the length matching technique utilized

in hedging isn't completely protective against sharp and quick changes in interest rates.

Potential Solution
 Actively managing the hedged portfolio by routinely rebalancing the asset allocation and

modifying the hedge positions in response to shifts in market circumstances is one method to deal with

this problem. To further offer protection against unforeseen interest rate fluctuations, the bank may

further utilize a combination of derivatives or more advanced hedging techniques. Frequent scenario

analysis and stress testing can also be used to find possible weaknesses and guide changes to the

hedging plan.

(g) [20 marks] During the module we discussed interest rate derivatives that financial insti
tutions can trade, long or short, simply by paying small margins on their trades. Explain
why and how the bank could engage in (potentially imperfect) risk sharing using deriva
tives instead of reducing (part of) their asset side portfolio or issuing any debt.
1. The bank has more flexibility in controlling its risk exposure thanks to derivatives. In

contrast to debt issuance or portfolio adjustments, which may entail substantial expenses and

administrative overhead, derivatives are simply purchased or sold with comparatively modest

transaction costs.

2. Compared to changing the asset portfolio or issuing debt, the bank can potentially use

less capital with derivatives to achieve targeted risk exposures. This is so because most trading

in derivatives is done on margin, requiring only a small portion of the contract value to be

deposited as collateral.

3. Numerous instruments that can be customized to certain risk exposures are available

through derivatives. Interest rate swaps, for instance, can be used as a hedge against changes in

interest rates, whilst options offer protection against unfavorable market movements while still

enabling participation in possible benefits.

4. The bank can diversify its risk exposure across several markets and instrument types by

trading derivatives. This diversity may increase profits while lowering total risk.
 5. Preserving Liquidity: The bank's liquidity may be affected by debt issuance or asset

portfolio adjustments. The bank can efficiently control its risk exposures while maintaining

liquidity by utilizing derivatives for risk management.

(Continued ... /)
Question 2. [100 marks]

Let us denote today by t = 0. A European T-period bull spread on a stock is constructed as

a portfolio that buys one call option with strike price Ki and sells one call option with strike
price K2, where K2 > Ki. A European T-period bear spread on a stock is constructed as a
portfolio that buys one put option with strike price K 2 and sells one put option with strike
price Ki, where K2 > Ki.

(a) [20 marks] Write down formulas for the payoffs of bull and bear spreads as functions of
the stock price ST, and illustrate them on payoff diagrams. Provide at least one reason
why a trader (e.g. a hedger or a speculator) would take a long position in a bear spread.

(b) [20 marks] Suppose that the net risk-free interest rate with continuous compounding is
denoted by r. Demonstrate that the current prices of bull and bear spreads are related
as follows:
Bullo+ Bearo = (K2 - K1)e-rT_ (1)

(c) [20 marks] A client would like to use bull and bear spreads when delta- and gamma
hedging their portfolio. Discuss how the deltas and the gammas of these two spreads
behave, and explain how they are related to each other.

(d) [20 marks] Consider a T-period call and a T-period put option written on the same
stock with the same strike price. Suppose that the net risk-free rate with continuous
compounding is r > 0 and does not change in the near future, and that the current stock
price happens to be equal to the strike price of the options (i.e., the options are at the
money). Moreover, suppose that the call and put options trade at the same price.

- Show that there exists an arbitrage opportunity in the market, and write down a
strategy that takes advantage of the mispricing.
- Discuss at least one way of relaxing the assumptions of the Black-Scholes-Merton
framework that would mean that the call and put trading at the same price does
not necessarily imply the existence of a tradable arbitrage opportunity.

(e) [20 marks] Briefly explain the role of options in portfolio insurance and how portfolio
insurance can create endogenous risk. Refer to real-world examples discussed during the
course.

(Continued ... /)
Question 3. [80 marks]

(a) [20 marks] Briefly explain in your own words how the following parameters of the Merton
model affect the probability of default and provide intuition:

- Face value of debt F

- Market value of assets V
- Asset volatility CT

- Time to maturity (T - t)

(b) [20 marks] What are the main challenges in the practical implementation of this model?
Compared to the original Merton model, what are the two main features of the KMV
methodology?

(c) [20 marks] Fannie Mae and Freddie Mac were put under conservatorship by the U.S.
Government on 7 September, 2008. The figure below shows KMV EDFs (Expected
Default Frequencies; volatile, solid line) and the S&P ratings (dashed line at AAA in
the bottom) for Fannie Mae from October 2007 until October 2008. Discuss a possible
reason why the S&P rating of Fannie Mae was at AAA for the whole time period even
though the EDF indicated a much higher risk associated with Fannie Mae debt.

(d) [20 marks] Explain briefly and in your own words how ratings-based models and reduced
form models work, and provide at least one benefit and at least one drawback for the use
of each.
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(End of Paper)