University of Amsterdam

Risk Management
Academic Year 2021/2022
Exam March 2022

Instructions:

 You have 120 minutes for 5 equally-weighted questions.

 Please be to the point and write legibly. Do not provide irrelevant information.

Good luck!

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1 2 3 4 5 TOTAL

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Question 1

(a) Describe the potential gains from risk management (provide your answer in no
more than 2 pages).

(10 points)

(b) Define and explain the two alternative measures: VaR and Expected Shortfall.
What is the difference between them? What is the theoretical advantage of Expected
Shortfall over VaR? (provide your answer in no more than ½ page)

(10 points)

Solution:

(a) From lecture 1: Companies are concerned about total risk. Variance (or excess
volatility) is not irrelevant because it causes “real” costs on a corporation. Earnings
stability and company survival are important managerial objectives. The potential
gains from risk management come from its ability to reduce “real” costs.

[2] It reduces the costs of financial distress.

Direct costs (e.g., lawyers’ fees)

Indirect costs (which are often much higher) (before / at liquidation)

- Customers may no longer want to buy the company’s products

- Suppliers may be less willing to extend credit
- Employees may begin to look for alternative employment (investment in
human capital cannot be recouped)
- Management’s attention may be distracted away from their main concern:
maintaining the profitability of the operating business
- Brand name all of a sudden associated with failure
- Assets customized to owner’s preferences (new owner may have a lower
valuation for these assets)

[2] It helps in avoiding the corporate underinvestment problem.

Without hedging, the equity holders do not have an incentive to invest in the project
even if it is clearly profitable. The equity holders do not want to invest in the project
because all the additional returns are captured by the bondholders when the firm is
in financial distress.
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[2] It reduces the tax liabilities.

Risk management can help firms to fully take advantage of tax credits by stabilizing
income.

[2] It increases the corporate debt capacity.

There is a trade-off between tax reduction and an increase in the probability of

distress.

The value of the firm is a non-linear function of the amount of outstanding liabilities.

[2] It leads to better disclosure of information to investors.

Risk management reduces expected payments to corporate “stakeholders”

(including higher rates of return required by owners of closely-held firms)

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(b) VaR vs. Expected Shortfall

[3] VaR refers to the value that can be lost on a certain portfolio, over a given period,
and with a certain confidence level.

[3] Expected Shortfall is the expected loss conditional that the loss is worse than the
VaR level.

[4] Expected shortfall has the advantage that it always satisfies the subadditivity (i.e.,
diversification is good) condition (while monotonicity, translation invariance and
homogeneity are satisfied by both measures).

Question 2

(a) Consider a portfolio manager who manages a portfolio that consists of a single
asset. Suppose that the change in the value of the portfolio (return) over a one-day
time period is normal with a mean of zero and a standard deviation of 20%. The
value of the portfolio today is $10 million.

- What is the probability of a loss of more than $2 million by the end of the
day?
- What is the one-day VaR at the 97.5% confidence level?
- What is the five-day VaR at the 97.5% confidence level?

(10 points)

(b) Consider a position consisting of a $10 million investment in gold and a $5

million investment in silver. Suppose that the daily volatilities of these two assets
are 2% and 1%, respectively, and that the coefficient of correlation between their
returns is 0.3. The mean changes are assumed to be zero.

- What is the 10-day 99% VaR for the portfolio?

- Calculate the diversification effect on VaR and explain the role of correlation
in achieving this reduction.
(10 points)

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Solution:

(a) [4] Given that 2m/10m is 20%, we need to calculate the probability of losing
more than that, i.e., Prob(return < -20%). We can transform return to a standard
normal variable z and examine the z-table. If return = -20% then z= (-2-0)/2= -1.
And we can rewrite: P(return < -20%) = P(z < -1). From the table associated with
the standard normal distribution, we can see that the corresponding probability is
15.87%.

[3] 2*1.96 = $3.92 million.

[3] SQRT (5)*2*1.96 = $8.77 million.

(b) From lecture 3:

[5] The standard deviation of the change in the value of the portfolio consisting of
both assets over one-day period is given by the square root of:
200,000^2+50,000^2+2*0.3*200,000*50,000, which equals 220,227.

(note that 200,000 is the volatility of changes in the value of the position in gold over
a one-day period, and 50,00 is the volatility of changes in the value of the position
in silver over a one-day period)

The one day VaR is : 220,227 * 2.33 ~ $ 512,300. This means that the 10-day VaR
is 10^(1/2) * 220,227 * 2.33 ~ $1,622,657.

[5] The benefits of diversification come from a reduction in VaR (when we consider
the VaRs of standalone investments in gold and silver):

For gold: the 10-day VaR is 10^(1/2) * 200,00 * 2.33 = $1,473,621

For silver: the 10-day VaR is 10^(1/2) * 50,000 * 2.33 = $368, 405

Thus: (1,473,621+368, 405) – 1,622,657= $ 219, 369.

Less than perfect correlation between gold and silver allows for some of the risk
being “diversified away”.

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Question 3

(a) A bank uses an EWMA model to forecasting volatility. It decides to change

parameter λ from 0.95 to 0.85. Explain the likely impact on the forecast.

(10 points)

(b) Suppose that the parameters in a GARCH (1,1) model are: omega (ω) =0.000004,
alpha (α)=0.05, and beta (β) =0.92. What is the long-run average volatility?

(10 points)

Solution:

From lecture 3:

(a) [10] Reducing λ from 0.95 to 0.85 means that more weight is given to recent
observations of squared returns and less weight is given to older observations.
Volatilities calculated with λ = 0.85 will react more quickly to new information and
will bounce around much more than volatilities calculated with λ=0.95.

(b) [10] The long-run average variance rate is ω/(1- α- β)=0.0001333. The long-run
average volatility is squared root of 0.0001333, or 1.155%.

Question 4

Consider the case when your bank will pay you $250 000 once a year for 3 years.
The first payment starts precisely 10 years from now. The current term structure is
flat and the interest rate is 5%. The bank wants to immunize its position by duration
matching investing now in 5-year and 15-year zero-coupon bonds.

(a) Given the bank’s future payment schedule, how much the bank has to invest
today?
(6 points)

(b) What is the duration of the bank’s liability?

(7 points)

(c) To immunize its position, how much should the bank invest in 5-year and 15-
year zero-coupon bonds?

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 (7 points)

Solution:

From lecture 4:

(a) [6]
(b) [7]
(c) [7]

We need to derive first the present value of liability, which will tell how much to be
invested by the bank today.

Question 5

(a) What is the repricing gap?

(5 points)

(b) What are the weaknesses of the repricing (funding) gap model?
(10 points)

(c) A risk analyst at an insurance company has determined that a counterparty to the
company has a constant default probability of 5% per year. What is the probability
of this counterparty defaulting in the third year?
(5 points)

Solution:

From Lecture 4:

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(a) [5] The repricing gap is the difference between the rate-sensitive assets and the
rate-sensitive liabilities calculated at their book values. Rate sensitivity means that
the asset / liability will be repriced at current market interest rates within a specific
time horizon.

(b) [10] Weaknesses of the model:

1. Ignores market value effects on the assets/ liabilities due to interest rate
changes (i.e., ignores capital losses)
2. Overaggregative: The distribution of assets & liabilities within individual
buckets is not considered. Mismatches within maturity buckets can be
substantial
3. Ignores effects of runoffs: Bank continuously originates and retires consumer
and mortgage loans. Runoffs may be rate-sensitive
4. Ignores off-balance sheet (OBS) cash flows

(c) [5] The probability of default in year 3 = (1–0.05)(1–0.05)(0.05) = 0.0451 =

4.51%

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