ACFI342 Financial Risk Management

QUESTIONS

1)

Consider a no-interest loan with current rating BB, maturity of 3 years and amount to be repaid at maturity of $100 million. The recovery rate in case of default is 50% of the repayment value. Assume a default probability of 4.95% and the following yield curve for a BB-rated corporate:

Required

(i) Calculate the future expected value and volatility 1 year ahead for this loan

(ii) Assuming that the future returns of the borrower’s assets follow a standard normal distribution, compute the default threshold of the borrower and explain how it can be used to generate future rating scenarios and loan values

[18 marks]

2)

ABC Bank has the following balance sheet:

Required

(i) Assuming a 3-month planning period, calculate the repricing gap and the impact on net interest income if interest rates on RSAs increase 50 basis points and on RSLs increase 60 basis points

(ii) Comment on the possible effect of a central bank’s policy of setting negative nominal interest rates on the bank balance sheet

[14 marks]

3)

Consider the following returns for a portfolio of stocks that replicates the S&P 500 index that has a current market value of £250,000:

Required

(i) Assuming mean returns of zero, calculate the daily VAR using the RiskMetrics approach and a 95% confidence interval

(ii) Assuming that returns are independently and identically distributed, compute the weekly VAR and comment on the difference with the 1-day VAR

[12 marks]

4)

Consider a commercial bank with the following portfolio of loans:

Required

(i) Calculate the credit risk capital requirement for the bank under the standardized approach in Basel II

(ii) Comment on the possible shortcomings of the standardized approach and discuss how the credit risk capital requirement could be computed if the bank could create its own credit risk model (IRB approach) to quantify the risk of its portfolio of loans

[14 marks]

5)

ABC Bank has the following balance sheet (in millions):

ABC Bank’s largest customer decides to exercise a $15 million loan commitment.

Required

(i) How will the new balance sheet appear if ABC Bank uses purchased liquidity management as its main risk management strategy? Comment on the potential impact of this strategy on the bank’s interest margins

(ii) Using the Northern Rock case, explain how liquidity risk can lead to default risk

[14 marks]

6)

The following are the foreign currency positions of an FI, expressed in the foreign currency.

The exchange rate of dollars per SFs is 0.9301, of dollars per British pounds is 1.6400, and of dollars per yen is 0.010600.

Required

(i) Determine the FI’s net exposure in Swiss francs stated in SF and in dollars ($)

(ii) Compute the expected loss or gain if the SF exchange rate appreciates by 1 percent. State you answer in SFs and $s

[12 marks]

7)

Consider a firm that from a previous investment expects to generate an income of £700 with probability 1/2 and £250 with probability 1/2. The firm has £400 debt outstanding (to be paid back at Time 2). After the income of the firm is realized, and before the debt is due, the firm is presented with a risk–free investment project: investing £550 yields £750 in return

Required

(i) Determine the shareholders’ wealth at the end of Time 2 in all possible scenarios

(ii) Identify whether the firm is affected by the underinvestment issue and discuss, in general, how risk management can help avoid the underinvestment problem

[16 marks]

TOTAL: 100 marks