lOMoARcPSD|18632687
MS4226 Test 2020
Risk Management Models (City University of Hong Kong)
Scan to open on Studocu
Studocu is not sponsored or endorsed by any college or university
Downloaded by gu gu (
[email protected])
lOMoARcPSD|18632687
Test for MS 4226: Financial Risk Analytics
Time allowed: 1 hour 15 minutes. Date: 29 Oct 2020. Total: 50 marks.
Attempt all questions, each carries unequal marks.
You may correct your answers to at most 5 decimals, where applicable.
Show sufficient steps to reach the required answers for each question.
Question 1 (3 marks)
An investment has probabilities 0.15, 0.25 and 0.6 of giving returns equal to 25%, 15% and 10%.
What are the investment's mean return (in %) and standard deviation of returns (in %)?
Answers:
The investment's mean return is
0.15 ( 25 % )+ 0.25 (−15 % ) +0.6 ( 10 % )=6 % [1]
The investment's standard deviation of returns is
√ 0.15(25 % )2 +0.25 (−15 %)2 +0.6(10 % )2−(6 %)2 [1]
¿ √ 210 % −36 % =13.19 % [1]
2 2
Question 2 (3 marks)
There are two investments: one investment has a mean return of 5% and a standard deviation of
returns of 7%, and the other has a mean return of 20% and a standard deviation of returns of 25%.
The correlation between the investments is 0.3. What are the mean return (in %) and standard
deviation of returns (in %) from a portfolio where 30% of all money is put in the second
investment?
Answers:
Equation (1) gives the portfolio's mean return
0.7 ( 5 % ) +0.3 ( 20 % ) =9.5 % [1]
Equation (2) gives the portfolio's standard deviation of returns
√ 0.72 (7 % )2+ 0.32 (25 %)2−2(0.3)( 0.7)(0.3)(7 %)(25 %)[1.5]
¿ 7.63 % [0.5]
Question 3 (3 marks)
The return from the market last year was 10% and the risk-free rate was 5%. A mutual fund
manager with a beta of 1.2 has an alpha of 4%.
(a) What return (in %) did the mutual fund manager earn? (2 marks)
(b) What assumption have you made in computing (a)? (1 mark)
Answers:
1
Downloaded by gu gu ([email protected])
lOMoARcPSD|18632687
(a) Equation (7) gives
4 %=R− (1−1.2 ) 5 %−1.2(10 % ) [1]
Solving yields the actual return R = 15% earned by the hedge fund manager. [1]
(b) The assumption is the interest rate of the borrowed money = the risk-free rate of 5%. [1]
Question 4 (4 marks)
Given that the daily returns on a certain stock at the end of the past 3 days were 2.392%, 0.490%
and 0.488%, and yesterday's and today's closing prices of the stock are respectively $20.60 and
$20.30. Estimate tomorrow's volatility (in %) using the approximate approach.
Answers:
Today's return is (20.60−20.3)÷ 20.6 ×100 %= 1.456% [1]
Equation (2) gives tomorrow's variance rate
^ 2=¿ ¿ [1.5]
❑5
2
¿ 2.08 % [0.5]
Tomorrow's volatility is
^ =√ 2.08 %2 =1.44 % [1]
❑5
Question 5 (5 marks)
The most recent estimate of the daily volatility of an asset is 6.30% and the price of the asset at the
close of trading yesterday was $50.00. The parameter in the EWMA model is 0.25. Suppose that
the price of the asset at the close of trading today is $48.00. How will this cause the volatility to be
updated by the EWMA model?
Answers:
In this case, 2n−1=(6.3 %)2=39.69 % 2 [0.5]
2
48−50
and u2n−1=( 2 2
×100 % ) =(−4 %) =16 % [1.5]
50
Equation (4) with = 0.25 gives
2
n =0.25× 39.69 %2 +0.75 ×16 % 2=21.9225 % 2 [2]
Thus, tomorrow's volatility estimate is
❑n=√ 21.9225 % =4.68 % [1]
2
Downloaded by gu gu ([email protected])
lOMoARcPSD|18632687
Question 6 (4 marks)
The principal assigned to the senior, mezzanine and equity tranches for an ABS is 74%, 16% and
10%. The principal derived from the mezzanine tranche of the ABS and assigned to the senior,
mezzanine and equity tranches for an ABS-CDO is 85%, 10% and 5%. What are the loss (in %) to
the mezzanine tranche of the ABS, and the losses (in %) to the equity, mezzanine and senior
tranches of the ABS-CDO, when the loss on the underlying assets is 18%?
Answers:
Losses on the Losses to Losses to Losses to Losses to Senior
Underlying Mezzanine Equity Tranche of Mezzanine Tranche of Tranche of ABS-
Portfolios Tranche of ABS ABS-CDO ABS-CDO CDO
18% 50% [1] 100% [0.5] 100% [0.5] 41.18% [2]
Let a loss be 18% on the underlying portfolio.
All 10% principal of the ABS's equity tranche is wiped out and only 8% principal of the ABS's
mezzanine is wiped out.
8%
Thus, a loss on the ABS's mezzanine is =0.5 or 50% of its principal.
16 %
The first 15% is absorbed by the ABS-CDO's equity and mezzanine tranches, and the remaining
35% is absorbed by the ABS-CDO's senior.
35 %
Thus, a loss on the ABS-CDO's senior is =0.5 or 41.18% of its principal.
85 %
Question 7 (7 marks)
A bank's profit next year will be normally distributed with a mean 0.7% of assets and a standard
deviation of assets. The bank's equity is 4.5% of assets.
(a) If ¿ 0.016 , what is the probability that the bank will have a non-negative equity at the end of the
year (ignore taxes)? (3 marks)
(b) If the probability that the bank will have a non-negative equity at the end of the year (ignore
taxes) is 98%, what is the value of (in decimals)? (4 marks)
Answers:
(a) This is the probability that profit X is no worse than 4.5% of equity, namely
Pr ( X ≥−4.5 % )=1−Pr ( X ←4.5 %)
Standardizing yields
Pr (X ← 4.5 %)=Pr Z< ( −4.5 %−0.7 %
0.016 ×100 %
=Pr ( Z←3.25) [1])
3
Downloaded by gu gu ([email protected])
lOMoARcPSD|18632687
Referring to the Z-table, we have
Pr ( Z ←3.25 )=0.00058 [1]
Thus, the required probability is 1 0.00058 = 0.99942 or 99.942% [1]
(b) The probability that profit X is no worse than 4.5% of equity is 98% , namely
Pr ( X ≥−4.5 % )=1−Pr ( X ←4.5 % )=0.98 [1]
Standardizing yields
Pr (X ← 4.5 %)=Pr Z< ( −4.5 %−0.7 %
×100 %
=0.02 [1])
Referring to the Z-table, we have
−4.5 %−0.7 %
=−2.055 [1]
× 100 %
Thus, the value of is 0.0253 [1]
Question 8 (3 marks)
The four bidders in a Dutch auction are A (35,000 shares, $110), B (25,000 shares, $106), C
(15,000 shares, $112) and D (40,000 shares, $108). The number of shares being auctioned is
80,000. What is the price paid by each successful bidder? How many shares does each successful
bidder receive?
Answers:
The bidders when ranked from the highest price bid to the lowest are: C, A, D, B.
Bidders C, A have bid for 50,000 shares. [1]
D has bid for 30,000.
The price that clears the market is the price that was bid by D at $108. [1]
At $108 per share, C, A get all their required shares, and D gets 30,000 shares. [1]
Question 9 (4 marks)
An investment bank has been asked to underwrite an issue of 7 million shares by a company. It is
trying to decide between a best-efforts deal where it charges a fee of $0.15 for each share sold and a
firm-commitment deal where it buys the shares for $13 per share. For the latter deal, the bank
considers that the selling price per share is $12.9, $13.3 or $13.5, with respective probability 0.3,
0.6 or 0.1.
What is the bank's average gain or loss, if the bank chooses the best-efforts deal to sell 3 million
shares and the firm-commitment deal to sell the rest (assume that all 7 million shares are sold out)?
Answers:
Downloaded by gu gu ([email protected])
lOMoARcPSD|18632687
Selling 3 million shares in the best-efforts deal obtains $0.45 million. [1]
The average selling price is $ 12.9× 0.3+ $ 13.3× 0.6+ $ 13.5 ×0.1=$ 13.2 [1]
Selling 4 million shares in the firm-commitment deal gains $0.8 [= 4($13.2 $13)] million. [1]
The bank's average gain is $1.25 million. [1]
Question 10 (6 marks)
What is the break-even yearly premium an insurance company should charge for a $4 million two-
year term life insurance policy issued to a woman aged 40? Assume that the premium is paid at the
start of each year, and the payout is paid at the end of each year with yearly discount rate of 5%.
Answers:
Step (1):
The probability that the woman will die during the first year is 0.001345.
Hence, the 1st year payout is $5380 (= 4,000,000×0.001345) [0.5]
and its present value is $5123.81 (= 53801.05, discounted for one year). [0.5]
The probability that the woman will die during the second year is
(1−0.001345)0.001477 = 0.001475 [0.5]
Hence, the 2nd year payout is $5900 (= 4,000,000×0.001475) [0.5]
and its present value is $5351.47 (= 59001.052, discounted for two years). [0.5]
Thus, the total present value of the two payouts is $10,475.28 (= 5123.81 + 5351.47). [0.5]
Step (2):
The probability of the 1st premium being made at the start of the 1 st year is 1.0 (i.e. certain), because
it is made now. [0.5]
The probability of the 2nd premium being made at the start of the 2 nd year is the probability that the
woman does not die in the 1st year, which is 0.998655 (= 1−0.001345). [0.5]
When the yearly premium is $X, the total present value of the two premiums is
0.998655 X
$ 1.9511 X (¿ X + ) [1]
1.05
Step (3):
Downloaded by gu gu ([email protected])
lOMoARcPSD|18632687
Solving $1.9511 X = $10,475.28 gives the break-even yearly premium $5368.91 [1]
Question 11 (5 marks)
An investor holds the hedge fund “A” charging ‘2 plus 20%’, and wants a return after fees of 18%.
(a) How much does “A” have to earn (in %), before fees, to provide the investor with this return?
(2.5 marks)
(b) How large is the total fee of “A” (in %) paid by the investor with this return? (0.5 mark)
(c) What is the break-even incentive fee (in %) so that the hedge fund “A” charging ‘2 plus 20%’
is indifferent to another hedge fund “B” charging ‘3 plus Y%’, given that “B” earns 24.18%.
(2 marks)
Answers:
(a) If the return is X, the investors pay 0.02 + 0.2(X − 0.02) in fees. [1]
It must be the case that
X − 0.02 − 0.2(X − 0.02) = 0.18 [1]
so that 0.8X = 0.196 or X = 0.245
A return of 24.5% is necessary. [0.5]
This implies that the fees are 6.5% (= 24.5% − 18%) of the return. [0.5]
(c) It must be the case that
0.2418 − 0.03 − Y(0.2418 − 0.03) = 0.18 [1]
so that 0.2118Y = 0.0318 or Y = 0.1501
The break-even incentive fee is 15.01%. [1]
Question 12 (3 marks)
An investor enters into a short forward contract to sell US$1,000,000 for HK$ at an exchange rate
of HK$7.78 per US$. How much does the investor gain or lose (specified in which currency), if the
exchange rate at the end of the contract is (a) 7.73 and (b) 7.81?
Answers:
(a) The investor can sell at HK$7.78 per US$, when they are worth 7.73.
His gain is HK$50,000 [= 1,000,000(7.78 – 7.73)] [1.5]
(b) The investor must sell at HK$7.78 per US$, when they are worth 7.81.
His loss is HK$30,000 [= 1,000,000(7.81 – 7.78)] [1.5]
Downloaded by gu gu ([email protected])
lOMoARcPSD|18632687
- End -
Downloaded by gu gu ([email protected])
