N1569 FINANCIAL RISK MANAGEMENT
THE UNIVERSITY OF SUSSEX
FINANCIAL RISK MANAGEMENT
N1569
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N1569 Financial Risk Management
There are FIVE questions, each has FOUR parts. Each part carries 5 marks.
1. (a) Outline how to estimate a time series of daily historical Value-at-Risk (VaR),
explaining the key model parameters. Also list one advantage and one limitation of
the historical approach.
(b) Describe the concepts that are illustrated by the VaR Comparison Excel spreadsheet.
(c) Using the appropriate Excel spreadsheet, select only the daily returns between 1
Jan 2005 and 31 July 2024 to calculate the 1% daily normal and historical VaRs for a
long position of 1000 USD per point on the S&P 500 index, giving your results in
USD. Explain how and why the results from these two models differ.
(d) Also calculate the 1% daily normal and historical VaRs for a short position of 1000
USD per point on the S&P 500 index, giving your results in USD, and explain why
the results are the same or different from those in part (c).
2. (a) Explain the terms present value (PV) and present value of a basis point (PV01) of a
cash flow, both verbally and by using properly-defined mathematical notation.
(b) In 54 months time you expect a cash flow of $3 million. Use the appropriate Excel
spreadsheet to calculate the PV and the PV01 of this cash flow, given the 54-month
interest rate is currently 4%.
(c) Explain, using equations with properly-defined mathematical notation, how to map
this cash flow to vertices at 4 years and 5 years, in such a way that (i) PV is
invariant, and (ii) volatility is invariant.
(d) Suppose the 54-month interest rate has a volatility of 120 basis points (bps), 4-year
rate has a volatility of 110 bps and the 5-year rate has a volatility of 150 bps, and
their correlation is 0.9. How much is mapped to each vertex by the volatility-
invariant mapping? Give your answer in PV terms and round your answers to whole
$ values.
3. (a) Outline, in your own words, the concepts illustrated by the output of the Greeks
Excel spreadsheet.
(b) Use hand-drawn diagrams to describe how the quantities in that spreadsheet vary
with the time to expiry of the option.
(c) Explain, in your own words, the concepts illustrated by the output of the
Delta-Gamma-Vega Approximation Excel spreadsheet.
(d) Describe in detail how a delta-gamma approximation may be used to measure
the Value-at-Risk (VaR) of a large portfolio of options on the same underlying.
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N1569 Financial Risk Management
4. (a) You are managing a crypto portfolio whose current value is $100 million. You expect
the portfolio to return 5% more than a risk-free portfolio over the next year, albeit
with a volatility of 40%. Using the appropriate standard normal functions in Excel,
calculate the 1% 10-day Value-at-Risk (VaR) and Expected Shortfall (ES) for this
portfolio.
(b) What are the key differences between Basel II and Basel III regarding minimum
capital requirements for market risk. Why were these changes implemented?
(c) Briefly describe the backtesting methodology that was covered in this module.
(d) Use the appropriate Excel workbook to backtest the 2.5% daily VaR, using
unconditional coverage and independence tests, of a position on the USD price of
bitcoin (BTC) based on the (almost) ten years of price data given in that
spreadsheet. Employ the normal VaR model with an exponentially weighted moving
average (EWMA) volatility derived using a smoothing constant of 0.95. Your answer
should report and interpret the relevant numerical results generated by the Excel
workbook.
5. (a) A UK asset manager owns a large and diverse portfolio of US mortgage-backed
securities, having maturities up to ten years and S&P credit ratings between A and
B. What, in your view, are the investor’s three most important risk factors?
(b) The mortgage payments are based on LIBOR plus a fixed spread, which depends on
the maturity of the loan and the credit rating of each counterparty. Given the
LIBOR spot curve {r1, r2, ...., r10} where i = 1, ..., 10 are the maturities of the
rates in years, explain using a formula and a numerical example how the manager
should calculate the 1-year LIBOR forward curve {f1,2, f2,3, , f9,10} which
determines the
loan repayments each year.
(c) Do you recommend that the manager hedges either their currency risk or
their default risk, or both? What hedging instruments would you
recommend?
(d) How could the investor securitise, and thereby sell, some of the mortgages in this
portfolio, in order to reduce his credit default risk? What would be the effect on the
yield he obtains as a result?
END OF PAPER
