INTRODUCTION TO ENTERPRISE RISK MANAGEMENT

Book 2: Valuation And Risk Model

CHAPTER 1

MEASURES OF FINANCIAL RISK

Exercise 1.1: An investment has probabilities and giving one-year returns equal to:

Returns (R1) -10% 0% 10% 20% 30%

Probabilities 0.1 0.3 0.2 0.3 0.1
1. What is the mean return and the standard deviation of the return R1

2. Suppose that a portfolio P includes two investments (R1 and R2) with the equally
weightings. The mean return R2 of 8% and the standard deviation of 0.1%. What is the total
mean and standard deviation of returns if the correlation between them is 0.2?

3. What are the risk-return combinations if the correlation is 0.15 instead of 0.2 and the
combination form two investments?

w1 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

w2 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0

Example 1.2: A risk management officer at a bank is interested in calculating the VaR of an
asset that he is considering adding to the bank’s portfolio. If the asset has a daily standard
deviation of returns equal to 1.6% and the asset has a current value of $5 million, calculate
the VaR(5%) on both a percentage and dollar basis.

Example 1.3: A risk management officer at a bank is interested in calculating the VaR of an
asset that he is considering adding to the bank’s portfolio. If the asset has a daily mean of 1%
and standard deviation of returns equal to 1.6% and the asset has a current value of $5 million,
calculate the VaR at 5% significance.

Exercise 1.4: An investment has a uniform distribution where all outcomes between -40 and
+60 are equally likely. What are the VaR and expected shortfall with a confidence level of
95%?

Exercise 1.5: The distribution of the losses from a project over one year has a normal loss
distribution with a mean of -10 and a standard deviation of 20.

1. what is the one-year VaR when the confidence level is 95%, 99% and 99.9%
Page 1|3
 INTRODUCTION TO ENTERPRISE RISK MANAGEMENT
2. The change in the value of the project over two years? Assume that changes in successive
years are independent.

3. The one-year expected shortfall with a confidence level of 95%, 99% and 99.9%?

Exercise 1.6: A one-year investment has a 2% chance of losing USD 9 million, 9% chance
of losing USD 4 million, and a 89% chance of gaining USD 1 million.

1. What are the VaR and the expected shortfall when the confidence level is 95% and the time
horizon is one year?

2. Suppose that there are two independent identical investments mentioned. What are the VaR
and the expected shortfall for a portfolio consisting of the two investments when the
confidence level is 95% and the time horizon is one year?

Exercise 1.7: Multiple Choice Questions

Your colleague has defined a discrete loss distribution. The tail of the loss distribution is
shown below, for example, the worst loss of $9 will happen with a probability of 0.50% and
a loss of $8 will occur with a probability of 1.00%.

loss $9 $8 $7 $6 $5 $4
Prob 0.50% 1.00% 1.50% 2.00% 2.60% 3.50%
The entire distribution spans 25 outcomes ranging from a $9 loss to a $15 gain, although only
the six worst losses are shown. Which is nearest to the 95% expected shortfall (ES)?

a. $5.0

b. $6.5

c. $7.0

d. $8.0

Practice Questions in textbook

1.11 An investment has probabilities of 0.1, 0.3, 0.2, 0.3, and 0.1 of giving one-year returns
equal to 30%, 20%, 10%, 0%, and -10%.

1. What is the mean return and the standard deviation of the return?

Page 2|3
 INTRODUCTION TO ENTERPRISE RISK MANAGEMENT
2. Suppose that there are two investments with the same probability distribution of returns.
What is the total mean and standard deviation of returns if the correlation between them is
0.2?

1.14 The argument in this chapter leads to the surprising conclusion that all investors should
choose the same risky portfolio. What assumptions are necessary for this result?

1.15 The distribution of the losses from a project over one year has a normal loss distribution
with a mean of -10 and a standard deviation of 20. What is the one-year VaR when the
confidence level is:

(a) 95%,

(b) 99%,

(c) 99.9%

1.16 The change in the value of a portfolio over one day is normally distributed with a mean
of 0.5 and a standard deviation of 2. What are the mean and standard deviation over ten days?
Assume that changes in successive days are independent.

1.17 An investment has a uniform distribution where all outcomes between -40 and +60 are
equally likely. What are the VaR and expected shortfall with a confidence level of 95%?

1.18 A one-year project has a 3% chance of losing USD 10 million, a 7% chance of losing
USD 3 million, and a 90% chance of gaining USD 1 million. What are (a) the VaR and (b)
the expected shortfall when the confidence level is 95% and the time horizon is one year?

1.19 Suppose that there are two independent identical investments with the properties
specified in question 18. What are (a) the VaR and (b) the expected shortfall for a portfolio
consisting of the two investments when the confidence level is 95% and the time horizon is
one year?

1.20 Check whether (a) VaR or (b) expected shortfall satisfy the subadditivity axiom for a
coherent risk measure for the investments in Questions 18 and 19.

Page 3|3