Professional Documents
Culture Documents
PART I
Financial risk management is the process of detecting, assessing, and managing financial risks.
Liquidity risk is the risk of sustaining significant losses due to the inability to take or exit a position at a fair
price.
Settlement risk is the risk that a counterparty will fail to deliver its obligation.
Since the portfolio is well diversified, the assumed level of unsystematic risk is zero. The addition of ABC
Inc will increase the portfolio beta, and, hence, the level of systematic risk.
Since Hilbilees correlation coefficient with the existing portfolio is less than 1, there are benefits to
diversification, and adding it to the existing portfolio would reduce the variance below the current level of
0.024. (See calculations below). The other choices are correct.
ERPortfolio = (wDrysdahl ERDrysdahl) + (wClampett ERClampett) = (0.40 10.5%) + (0.60 16.55%) = 14.13%.
2
1/2
The equation for the standard deviation = 1,2 = [(w1 )(1 ) + (w2 )(2 ) + 2w1w2121,2] ,
Here stock 1 = Drysdahl and stock 2 = Clampett, and r1,2 = cov1,2 / (1 2) = 0.001 / (0.085 0.25) =
0.047
2
1/2
Portfolio = [(0.40 0.085 ) + (0.60 0.25 ) + (2 0.40 0.60 0.085 0.25 0.047)]
0.155 = 15.5%. (The variance is 0.024).
1/2
= 0.024 , or
The easiest way to approach this problem is to determine the value of each stock two years in the future
and to sum up the total values of each stock.
Stock
Market Value
Expected
= Total
Annual Return
$4,500
1.14 1.14
= 5,848.20
$6,300
1.09 1.09
= 7,485.03
$3,700
1.12 1.12
= 4,641.28
Total = 17,974.51
Given a progressive tax rate structure, risk management activities can reduce the firm's tax liability by
shifting the realization of taxable income from years when it is high to years when it is low.
Strategies I and II both suggest risk management to reduce the cost of bankruptcy and financial distress
may be value enhancing.
Both the Treynor measure and the Jensen's alpha assume that the CAPM is the underlying riskadjustment model. The Sharpe measure on the other hand does not make this assumption. It uses total
risk of a portfolio, unlike the Treynor measure and Jensen's alpha, which use the systematic
(undiversifiable) risk as measured by beta to compute the risk-adjusted return of a portfolio.
Answer 10:
Part 1) Correct answer is C
LTCMs models underestimated the extent to which securities prices would move together in times of
economic crisis. The models also failed to anticipate that multiple economic shocks might occur in
clusters through time (i.e., be positively autocorrelated) as economic history suggests. Poor management
oversight and financial reporting standards are not issues in the LTCM case.
Metallgesellschafts long stack-and-roll hedge strategy created interim cash outflows that triggered a
liquidity crisis for the firm because petroleum prices dropped dramatically and because the market shifted
from backwardation to contango. Requiring periodic cash settlements from its customers on the fixed rate
contracts would have mitigated this cash flow crunch. Another solution would have been to purchase put
options, which would have generated cash to offset marked-to-market losses and margin calls as spot
prices declined. Selling puts would have further exposed the firm to declining petroleum prices. Selling
calls would have offer only limited protection against small movements, not the large price drops that
triggered the liquidity crisis.
Normal backwardation exists when futures prices are generally less than spot prices, with the difference
being larger for longer-term contracts. Contango exists when futures prices are greater than spot prices.
As a market shifts from normal backwardation to contango, futures prices rise above the spot price, and
rolling a long hedge involves selling relatively cheap short-term contracts and buying relatively expensive
long-term contracts, thereby increasing the cost of rolling the hedge.
According to Standard 2.2, GARP members shall make full and fair disclosure of all matters that could
reasonably be expected to impair independence and objectivity or interfere with respective duties to their
employer, clients, and prospective clients.
GARP Members shall make full and fair disclosure of all matters that could reasonably be expected to
impair independence and objectivity or interfere with respective duties to their employer, clients, and
prospective clients.
Both of the suggestions are methods for testing the specification of an econometric model. The point is to
find if other variables have significant explanatory power and if the relationships are correctly measured.
Since the probability of the coin landing on its edge is 0.02, the probability of each of the other two events
is 0.49. The expected payoff is: (0.02 $50) + (0.49 $1) + (0.49 $2) = $2.47.
Covariance is a statistical measure of the linear relationship of two random variables, but the actual value
is not meaningful because the measure is extremely sensitive to the scale of the two variables.
Covariance can range from negative to positive infinity.
Calculating z-values, z1 = (110 120) / 20 = 0.5. z2 = (170 120) / 20 = 2.5. Using the z-table, P(0.5) =
(1 0.6915) = 0.3085. P(2.5) = 0.9938. P(0.5 < X < 2.5) = 0.9938 0.3085 = 0.6853. Note that on the
exam, you will not have access to z-tables, so you would have to reason this one out using the normal
distribution approximations. You know that the probability within +/ 1 standard deviation of the mean is
approximately 68%, meaning that the area within 1 standard deviation of the mean is 34%. Since 0.5 is
half of 1, the area under 0.5 to 0 standard deviations under the mean is approximately 34% / 2 = 17%.
The probability under +/ 2 standard deviations of the mean is approximately 99%. The value $170 is mid
way between +2 and +3 standard deviations, so the probability between these values must be (99% / 2) =
2%. The value from 0 to 2.5 standard deviations must therefore be (99% / 2) (2% / 2) = 48.5%. Adding
these values gives us an approximate probability of (48.5% + 17%) = 65.5%.
Ho: = 16; Ha: 16. Do not reject the null since |t| = 1.09 < 1.96 (critical value).
E(X)=np=5(0.60)=3.0. Var(X)=np(1-p)=5(0.60)(0.40)=1.2.
The dependent variable is the variable whose variation is explained by the other variables. Here, the
variation in ri is explained by the variation in the other variables, rf and rm.
When correlation exists, autocorrelation is present. As a result, residual terms are not normally
distributed. This is inconsistent with linear regression.
The expression:
degrees of freedom.
0.5
0.5
0.5
= (0.009216)
= 9.6%
If we transform two independent random variables, 1 and 2, by defining 1 = 1 and 2 = 1 + (12 1/2
) 2, 1 and 2 will have a correlation of .
A stop buy order is an order to buy a stock if the price rises to the stop price. This type of order is often
used to limit losses on a short position. A limit buy order specifies a maximum price and a limit sell order
specifies a minimum price.
When a futures trader receives a margin call, he/she must deposit variation margin to bring the account
up to the initial margin value.
Prior to expiration, a futures position (long or short) is closed out by an offsetting/reversing trade. The
other methods are used to settle positions at contract expiration.
Because the manager is considering hedging his S&P 400 exposure with S&P 500 contracts, his primary
concern should be basis risk between the two.
Answer 32: Correct answer is B
The portfolio managers target equity exposure sensitivity measure is 1.05, while its current measure is
0.92. The number of futures contracts can be determined as [(1.05-0.92) $15 million] / ($250 x 1205)] 6
contracts. The portfolio manager wants to buy six S&P 500 contracts to increase his exposure.
Imperfect correlations between the futures price and the underlying spot price decrease the effectiveness
of a hedged position. When the hedging horizon is long relative to the maturity of the futures used in the
hedging strategy, the hedge has to be rolled prior to expiration. As maturity of the hedging instrument
approaches, the hedger must close out the existing position and replace it with another contract with a
later maturity. Rolling the hedge forward exposes the hedger to the basis risk of the new position each
time the hedge is rolled.
Payoff = $5,000,000 (0.02 0.05)(0.25) = -37,500. The negative sign means the investor will make a
payment of $37,500.
The change in assets would be an increase of ($100)(8.5)(0.005) = $4.25 million, whereas the change in
liabilities would be an increase of ($90)(6.5)(0.005) = $2.925 million. The net effect would be an increase
in equity of $1.325 million.
At the inception of the forward contract, the delivery price would have been:
(0.026 - 0.012)
1,100e
= $1,115.51.
(-0.012)(0.5)
(-0.026)(0.5)
The value to the long position after six months is: [1,125e
] - [1,115.51e
1,101.10 = $17.17. Therefore, the value of the short position is -$17.17.
1015e
= 1020.34
] = 1,118.27
At the inception of the forward contract, the delivery price would have been:
(0.044-0.018)(0.5)
1,150e
= $1,165.05.
(-0.018)(0.25)
(-.044)(.25)
The value to the long position after three months is: 1,075e
- 1,165.05e
1,152.31 = -$82.41. Therefore, the value of the short position is $82.41.
= 1,070.17 -
The flat price is the bond price without the accrued interest, so it is equal to the quoted price of 105 7/32 =
$1,052.19.
Accrued interest is found by simply dividing the coupon rate by two and then multiplying the result by
$1,000. The full price or dirty price of the bond is the price of the bond plus accrued interest, if any.
Since the bond is trading ex-coupon, the buyer will pay the seller the clean price, or the price without
accrued interest. So, Stone will pay the quoted price. The choice $105.19 plus accrued interest
represents the dirty price (also known as full price). This bond would be said to trade cum-coupon.
The value of a plain vanilla swap at inception is zero as the swap fixed rate (SFR) is set to make the PV
of both the fixed and expected floating rate payments equal.
The institution is paying USD and receiving JPY, so the value of this swap will equal the current exchange
rate times the value of the JPY portion minus the value of the USD portion. The JPY portion of this swap
is:
According to put-call parity we can write a riskless pure-discount bond position as:
T
X/(1+Rf) = P0 + S0 C0.
We can then read off the right-hand side of the equation to create a synthetic position in the riskless purediscount bond. We would need to buy the European put, buy the same underlying stock, and sell the
European call.
The upper bound on a European call option is the stock price, so it cant be worth $55.
The call option value will decrease since the payment of dividends reduces the value of the underlying,
and the value of a call is positively related to the value of the underlying.
Answer 49:
Part 1) Correct answer is C
Long butterfly is the choice as this combination produces gains should stock prices not move either up or
down, while not producing much in loss if prices are volatile. None of the other positions produce gains
should stock prices not move much. The protective put guards against falling prices, the bull call limits
losses and gains should prices move, and the 2:1 ratio spread gains should prices move up.
2010 Finstructor. All Rights Reserved
Long straddle produces gains if prices move up or down, and limited losses if prices do not move. Short
straddle produces significant losses if prices move significantly up or down. Long Butterfly also produces
losses should prices move either up or down. The condor is similar to the long butterfly, although the
gains for no movement are not as great.
Part 3) Correct answer is C
Long put positions gain when stock prices fall and produce very limited losses if prices instead rise. Short
calls also gain when stock prices fall but create losses if prices instead rise. The other two positions will
not protect the portfolio should prices fall.
If two securities have identical payoffs regardless of events, the process of arbitrage will move prices
toward equality. Arbitrageurs will buy the lower priced position and sell the higher priced position, for an
immediate profit without any future liability. The law of one price (for securities with identical payoffs) is
not a process; it is enforced by arbitrage.
Market efficiency is achieved when all relevant information is reflected in asset prices, and does not refer
to the cost of trading. One necessary criterion for market efficiency is rapid adjustment of market values to
new information. Arbitrage, trading on a price difference between identical assets, causes changes in
demand for and supply of the assets that tends to eliminate the pricing difference.
When a convenience yield is associated with a commodity, the futures price on that commodity becomes
a range, rather than a single value. The range is expressed in the following formula:
(r + - c)T
S0e
(r + )T
F0,T S0e
Using this formula, we can calculate the range of futures prices acceptable for the soybean and soybean
oil futures contracts as follows:
(0.11 + 0.63 0.06)0.25
Soybeans: 5.83e
(0.11 + 0.63)0.25
F0,0.25 5.83e
(0.11 + 0.03)0.5
F0,0.5 0.27e
For a crush spread, the investor goes long (short) a soybean futures contract and then takes a short
(long) position in a soybean meal futures contract.
Interest rate parity is a situation in which the differential between spot and forward exchange rates is
equal to the differential between interest rates for the two different currencies.
Answer 57: Correct answer is C
F0 = S0e
(0.05-0.065) 3
= 1.25e
= 1.195
The concessionality is then the difference between the original loan and the MYRA loan value = 100
99.003 = $0.997 million = $997,000.
When bonds are redeemed to comply with sinking fund provisions, the call price is known as the special
redemption price. When bonds are redeemed according to the call provisions specified in the bond
indenture, the call price is known as regular redemption price.
A deferred call provision means the issue is initially (say, for the first 5 to 7 years) non-callable, after
which time it becomes freely callable. In other words, there is a deferment period during which time the
bond cannot be called, but after that, it becomes freely callable.
Callable bonds are called when interest rates have declined. A deferred call provision means that the
bond is initially not callable; it does not allow the investor to postpone having his bond called. Callable
bonds may be called at par. The indenture specifies the call premium and the rate at which the call
premium declines over time.
Principal STRIPS typically trade at fair value. Shorter term coupon STRIPS typically trade rich. Longer
term coupon STRIPS tend to trade cheap.
Reinvestment risk is the risk that if rates fall, cash flows will be reinvested at lower rates, resulting in a
holding return lower than that expected at purchase. Here, the investor will likely have to reinvest the
coupon at the lower market interest rate, negatively impacting his holding period return.
Prepayment risk (and call risk) is the risk that the issuer will repay principal prior to maturity. Prepayments
are most likely in a declining interest rate environment because it is cheaper to issue replacement debt.
Here, the bond is a Treasury and is noncallable, so the investor can eliminate prepayment risk by holding
the bond until maturity. Liquidity risk addresses how quickly and easily an investor can sell a bond. A
bond that trades thinly or in small amounts exposes an investor to liquidity risk. Liquidity risk is not a
concern with Treasury bonds. Credit risk is the risk that the issuer will be unable to make coupon or
principal payments as scheduled. Any change in the timing of the receipt of cash flows affects the bonds
holding period return. Credit risk is not a concern with Treasury securities.
D = effective duration
Given an up probability of 1.15, the down probability is simply the reciprocal of this number 1/1.15=0.87.
2
Two down moves produce a stock price of 38 0.87 = 28.73 and a put value at the end of two periods of
6.27. An up and a down move, as well as two up moves leave the put option out of the money. The value
2
2
of the put option is [0.32 6.27] / 1.06 = $0.57.
It is found as follows:
-.rt
(.4404) - 90(.3632)=$5.01
The delta of forwards is one. The delta of futures is not usually one. Two problems using stop-loss trading
on naked options are transaction costs and stock-price certainty. Gamma is largest when options are atthe-money. For a delta-neutral portfolio, although opposite in sign, theta can serve as a proxy for gamma.
Subadditivity the risk of the sum is less than or equal to the sum of the risks. Risk-free condition riskfree assets should be risk less.
Answer 70: Correct answer is D
The general equation assumes the underlying asset is normally distributed returns with a mean of and a
standard deviation of . The simulation equation is as follows:
An advantage of the SMC approach is that it is able to address multiple risk factors by generating
correlated scenarios based on a statistical distribution. A disadvantage of the SMC approach is that in
some cases it may not produce an accurate forecast of future volatility, and increasing the number of
simulations will not improve the forecast.
Answer 71: Correct answer is B
The structure Monte Carlo (SMC) approach to estimating VAR simulates portfolio or asset returns using a
+z
stochastic process: st+1,i = ste
.
Z in the formula is a random draw from a normal distribution. An advantage to the SMC approach is that
multiple risk factors can be modeled by assuming an underlying distribution and incorporating correlations
among assets. A disadvantage is that inaccurate future volatility forecasts may occur.These inaccurate
forecasts cannot be improved by running a greater number of simulations. Also, if the covariance matrix
used to model the returns is drawn during normal times, then the SMC approach will not accurately
predict a scenario involving a correlation breakdown (sudden increase in volatility coupled with a sudden
increase in correlations). Increasing the number of simulations does not help solve the correlation
breakdown problem either.
The use of scorecard data usually results in a lower capital charge than the use of historical loss data.
Due to their predictable nature and small size, the risks that are unlikely to jeopardize the future of the
firm are high-frequency, low-severity events. Note that risks related to fraud and business practices tend
to create the largest unexpected losses and can therefore jeopardize the firm.
Stress testing is able to identify key input variables that impact the portfolio. However, predicting regime
shifts and structural changes is more difficult with stress tests. Also, the effect that one variable has on
others is difficult to gauge with stress testing.
Prior to crisis, stress testing methodologies were based on the underlying assumption that risk is
generated by known and non-random processes (which would mean that historical statistical relationships
can be useful in predicting future stress events, an assumption which was certainly disapproved by the
recent turmoil).
Basis is the difference in the prices (or interest rates) between the cash and the futures markets and
basis risk is the change in basis between the opening and closing of a futures position.
Bonds rated Baa and above are considered investment grade, and those rated Ba and below are noninvestment grade.
Country risk may be defined as the likelihood of delayed, reduced, or omitted payment of interest and
principal attributable to conditions of the country of the borrower. It is the broadest measure of credit risk
and includes sovereign risk, political risk, and transfer risk. One of the most unfortunate aspects of
country risk is that it is contagiouswhat affects one country tends to affect others.
Note that a recovery rate of 60% implies a loss given default of 40%. We can calculate the expected loss
as follows:
EL = AE EDF LGD
Adjusted exposure = OS + (COM OS) UGD = $20,000,000 (0.6) + ($8,000,000) (0.75) =
$18,000,000.
EL = ($18,000,000) (0.02) (0.40) = $144,000.
An indication of multicollinearity is when the independent variables individually are not statistically
significant but the F-test suggests that the variables as a whole do an excellent job of explaining the
variation in the dependent variable.
A slope coefficient in a multiple linear regression model measures how much the dependent variable
changes for a one-unit change in the independent variable, holding all other independent variables
constant. In this case, the independent variable size (= ln average assets under management) has a
slope coefficient of 0.6, indicating that the dependent variable ARAR will change by 0.6% return for a oneunit change in size, assuming nothing else changes. Pay attention to the units on the dependent variable.
Part 2) Correct answer is A
The t-statistic for testing the null hypothesis H0: i = 0 is t = (bi 0) / i, where i is the population
parameter for independent variable i, bi is the estimated coefficient, and i is the coefficient standard
error. Using the information provided, the estimated coefficient standard error can be computed as bIndex /
t = Index = 1.1 / 2.1 = 0.5238.
Part 3) Correct answer is A
The t-statistic for testing the null hypothesis H0: i = 0 is t = (bi 0) / i, where i is the population
parameter for independent variable i, bi is the estimated coefficient, and i is the coefficient standard
error. Using the information provided, the t-statistic for size can be computed as t = bSize / Size = 0.6 /
0.18 = 3.3333.
The t-statistic for testing the null hypothesis H0: i = 0 is t = (bi 0) / i, where i is the population
parameter for independent variable i, bi is the estimated parameter, and i is the parameters standard
error. Using the information provided, the estimated intercept can be computed as b0 = t 0 = 5.2
0.55 = 2.86.
Part 5) Correct answer is B
At 5% significance and 97 degrees of freedom (100 3), the critical t-value is slightly greater than, but
very close to, 1.984. The t-statistic for the intercept and index are provided as 5.2 and 2.1, respectively,
and the t-statistic for size is computed as 0.6 / 0.18 = 3.33. The absolute value of the all of the regression
intercepts is greater than tcritical = 1.984. Thus, it can be concluded that all of the parameter estimates are
significantly different than zero at the 5% level of significance.
The mean is the average return computed by summing the returns and dividing by the number of
investments: 75 / 7 = 10.71%.
The median is the mid-point or central number of returns arranged from highest to lowest or lowest to
highest. In this case: 7, 8, 9, 12, 12, 13, 14. The median return is 12%.
The mode is the return that occurs most frequently. In this case, 12% is also the mode.
b1 gives the slope coefficient which indicates the average change in the dependent variable given a unit
change in the independent variable.
You need to use a two-step binomial model and consider the possibility of early exercise. First calculate
the stock price tree. You have S0=20, so the first step results in either SU=20(1.2)=24 or SD=20(0.8)=16 at
the end of year one. At the end of the second year the possible outcomes are SUU=24(1.2)=28.80, SUD=
SDU=24(0.8)=19.20, or SDD=16(0.8)=12.80. The PV of the expected payoff in the up node is e
0.05
[0.00(0.65)+4.80(0.35)]=$1.60. The payoff from early exercise in the up node is max{24-24, 0}=0.
Since the PV of the expected payoff exceeds the payoff from early exercise, early exercise in the up node
-0.05
is not optimal. In the down node the PV of the expected payoff is e [4.80(0.65)+11.20(0.35)]=$6.70.
The payoff from early exercise in the down node is max{24-16, 0} = $8.00. So early exercise is optimal in
the down node. The value of the option can now be calculated as the PV of the expected payoffs at the
-0.05
end of the first year, or as e [1.60(0.65)+8.00(0.35)]=$3.65.
If the option is exercised early at the initial node it is worth $4 (=$24 - 20). This value is greater than
$3.65, thus, the option should be exercised early at Node 0 and will be worth $4.
T=145/365 = 0.39726
2
PT = 30e
(1-.2843) 27(1-.352)
= (29.527056 .7157) 17.496
= 21.1325 17.496
p = $3.64
CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services
offered by Finstructor. CFA Institute, CFA and Chartered Financial Analyst are trademarks owned by
the CFA Institute.
GARP does not endorse, promote, review or warrant the accuracy of the products or services offered by
Finstructor of FRM related information, nor does it endorse any pass rates claimed by the provider.
Further, GARP is not responsible for any fees or costs paid by the user to Finstructor nor is GARP
responsible for any fees or costs of any person or entity providing any services to Finstructor. Financial
FRM, GARP and Global Association of Risk Professionals are trademarks owned by the Global
Association of Risk Professionals, Inc.
CAIAA does not endorse, promote, review or warrant the accuracy of the products or services offered by
Finstructor nor does it endorse any pass rates claimed by the provider. CAIAA is not responsible for any
fees or costs paid by the user to Finstructor nor is CAIAA responsible for any fees or costs of any person
or entity providing any services Finstructor. CAIA, CAIA Association, Chartered Alternative Investment
Analyst, and Chartered Alternative Investment Analyst Association, are service marks and trademarks
owned by CHARTERED ALTERNATIVE INVESTMENT ANALYST ASSOCIATION, INC., of Amherst,
Massachusetts, and are used by permission.