Managing Market and Credit Risks- Spring 2023 Assignment 1
Due date: June 23, 2023
1. (Question 1.1) An investment has probabilities 0.1, 0.2, 0.35, 0.25, and 0.1 of giving returns equal
to 40%, 30%, 15%, -5%, and -15%. What is the expected return and the standard deviation of returns?
Answer:
2. (Question 1.2) Suppose that there are two investments with the same probability distribution of
returns as in Question 1.1. The correlation between the returns is 0.15. What is the expected return and
standard deviation of return from a portfolio where money is divided equally between the investments?
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3. (Question 1.18) A portfolio manager has maintained an actively managed portfolio with a beta
of 0.2. During the last year, the risk-free rate was 5% and major equity indices performed very badly,
providing returns of about -30%. The portfolio manager produced a return of -10% and claims that in
the circumstances it was good. Discuss this claim.
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4. (Question 8.9) A bank’s position in options on the dollar–euro exchange rate has a delta of 30,000
and a gamma of -80,000. Explain how these numbers can be inter- preted. The exchange rate (dollars
per euro) is 0.90. What position would you take to make the position delta neutral? After a short period
of time, the ex- change rate moves to 0.93. Estimate the new delta. What additional trade is necessary
to keep the position delta neutral? Assuming the bank did set up a delta-neutral position originally, has
it gained or lost money from the exchange- rate movement?
Answer:
5. (Question 8.17) A financial institution has the following portfolio of over-the-counter options on
sterling:
Type Position Delta of Option Gamma of Option Vega of Option
Call -1,000 0.50 2.2 1.8
Call -500 0.80 0.6 0.2
Put -2,000 -0.40 1.3 0.7
Call -500 0.70 1.8 1.4
A traded option is available with a delta of 0.6, a gamma of 1.5, and a vega of 0.8.
(a) What position in the traded option and in sterling would make the portfolio both gamma neutral
and delta neutral?
(b) What position in the traded option and in sterling would make the portfolio both vega neutral
and delta neutral?
Answer:
6. (Question 9.7) A five-year bond (The face value of the bond is 100.) with a yield of 11% (contin-
uously compounded) pays an 8% coupon at the end of each year.
(a) What is the bond’s price?
(b) What is the bond’s duration?
(c) Use the duration to calculate the effect on the bond’s price of a 0.2% decrease in its yield.
(d) Recalculate the bond’s price on the basis of a 10.8% per annum yield and verify that the result
is in agreement with your answer to (c).
Answer:
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7. (Question 9.11) Estimate the delta of the portfolio in Table 9.6 with respect to the first two factors
in Table 9.7.
Answer:
8. (Question 9.17) Portfolio A consists of a one-year zero-coupon bond with a face value of $2,000
and a 10-year zero-coupon bond with a face value of $6,000. Portfolio B consists of a 5.95-year zero-
coupon bond with a face value of $5,000. The current yield on all bonds is 10% per annum (continuously
compounded).
(a) Show that both portfolios have the same duration.
(b) Show that the percentage changes in the values of the two portfolios for a 0.1% per annum increase
in yields are the same.
(c) What are the percentage changes in the values of the two portfolios for a 5% per annum increase
in yields?
Answer:
9. (Question 9.18) What are the convexities of the portfolios in Problem 8? To what extent does (a)
duration and (b) convexity explain the difference between the percentage changes calculated in part (c)
of Problem 8?
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10. (Question 10.11) Assume that an index at close of trading yesterday was 1,040 and the daily
volatility of the index was estimated as 1% per day at that time. The parameters in a GARCH(1,1)
model are ω = 0.000002, α = 0.06, and β = 0.92. If the level of the index at close of trading today is
1,060, what is the new volatility estimate?
Answer:
11. (Question 10.16) Suppose that GARCH(1,1) parameters have been estimated as ω = 0.000003,
α = 0.04, and β = 0.94. The current daily volatility is estimated to be 1%. Estimate the daily volatility
in 30 days.
Answer:
