7. (9 points) The graph below shows the distribution of the daily returns of a particular
equity portfolio in one year with a total of 254 trading days. For example, there were 65
days with daily return between 0.00% and 0.50%. The average daily return is 0.04% and
the standard deviation of the daily return is 1.07%. The current value of the portfolio is
$10 million.
(a) Explain the objective of a Value at Risk (VaR) calculation
(b) Calculate:
(i) The one day VaR at a 95% confidence level using the above histogram.
(ii) The 10 day VaR at a 95% confidence level assuming a normal
distribution.
(c) Evaluate the advantages and disadvantages of these methods of calculation and
the Monte Carlo Simulation approach.
(d) Describe how to test the accuracy of the alternative models.
(e) List the limitations of VaR as a measure of risk, and explain how the Conditional
Tail Expectation approach and stress testing might complement VaR as a risk
measure.
(f) Calculate the 95% Conditional Tail Expectation based upon the distribution in the
graph above using interval midpoints as estimates of average values.
COURSE 8: Fall 2004 -8- STOP
Investment
Morning Session
8. (4 points) Acme Motors offers the following investment options to the participants in its
Defined Contribution plan:
1. A U.S. equity fund
2. An international equity fund
3. A fixed income fund
You are considering adding a Stable Value Fund option.
(a) Explain why a Stable Value Fund would be offered as an option.
(b) List the risks to Acme Motors and its participants associated with the Stable
Value Fund option.
(c) List the risks to the issuer of the underlying GIC or BIC contracts that support
Acme Motor’s DC plan’s stable value fund.
(d) Propose ways the issuer can manage these risks.
**END OF EXAMINATION**
MORNING SESSION
COURSE 8: Fall 2004 -9- GO ON TO NEXT PAGE
Investment
Afternoon Session
**BEGINNING OF EXAMINATION**
INVESTMENT
AFTERNOON SESSION
Beginning With Question 9
9. (3 points) You are given a 5-year, BB rated zero-coupon bond with par value of 100.
You are given the following information
The 1-year transition matrix is:
Rating Initial at Year end (%)
Rating AA A BB B C Default
AA 95 3 2 0 0 0
A 2.5 93.5 2.5 1.5 0 0
BB 1 2 95.75 0.75 0.5 0
B 0 2 5 85 7 1
C 0 0 3 7 85 5
The 1-year forward zero-coupon curve is:
Category 1-Year 2-Year 3-Year 4-Year
AA 3.5 4.1 4.7 5.0
A 3.7 4.3 4.9 5.3
BB 4.0 4.7 5.3 5.7
B 5.6 6.0 6.8 7.4
C 10.0 12.0 11.0 9.0
Using the CreditMetrics approach:
(a) Calculate the possible 1 year forward values of the bond.
(b) Calculate the credit VaR at the 99% confidence level.
(c) Calculate the capital charge using the value obtained in (b).
COURSE 8: Fall 2004 -10- GO ON TO NEXT PAGE
Investment
Afternoon Session
10. (3 points) DM Life is considering hedging its credit risk with Credit Default Swaps
(CDS).
(a) Explain FAS 133’s rules for qualifying for hedge accounting.
(b) Formulate a hedge strategy that would qualify for hedge accounting under FAS
133.
COURSE 8: Fall 2004 -11- GO ON TO NEXT PAGE
Investment
Afternoon Session
11. (3 points) An associate at your firm follows a select group of options. From time to time
he feels he can develop information and views in terms of expected return and risk that
are not reflected in current market prices.
(a) Explain why observed option prices might differ from those predicted by the
Black-Scholes model.
(b) Explain whether a Black-Scholes option model would be useful in evaluating a
specific option investment strategy.
COURSE 8: Fall 2004 -12- GO ON TO NEXT PAGE
Investment
Afternoon Session

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