2013-11-07

Practice Set and Solutions #41

What to do with this practice set?
Practice sets are handed out to help students master the material of the course and prepare for
the final exam. These sets contain worked-out problems in corporate finance and investments,
with a bias toward quantitative problems. These sets are not graded, and there is no need to
hand-in the solutions. Students are strongly encouraged to solve them, discuss the solutions with
other course participants, and discuss any problems with their teacher. Some questions in the
final exam might resemble the problems given here.

Question 1
Next Bank has a 5m position in 3 a year zero coupon bond with face value 5,955,080. The
bond is trading at an YTM of 6%. The historical mean change in daily yield is 0.00% with a
standard deviation of 8 basis points (0.0008).
a) What is the duration, and the modified duration of the bond?
b) What is the maximum adverse bad daily yield change given that we do not want no
more than 5% change that yield changes will be greater than this maximum?
c) What is the daily earning at risk for this bond? Use modified duration
d) What is the 10 day VaR for this bond?

Solution 1
a) D = 3 years, MD = 3/1.06 = 2.83 years.
b) Assuming a normal distribution, a potential bad adverse change of 5% in the yield
corresponds to a 10% risk level, where 5% will be good changes and 5% will be
adverse changes; 1.65 x = 1.65 x 0.0008 = 0.00132.
c) DEAR is defined as DEAR = (Dollar value of position) x (Price volatility)
Price volatility = -MD x potential adverse move in yield = -2.83 x 0.00132 =
0.0037356 or 0.37356 %.
DEAR = (Dollar value of position) x (Price volatility) = 5m x 0.0037356 =
0.018678m = 18,678.
d) VaR = DEAR x 10 = 18,678 x 3.1623 = 59,065.44
1 This document was put together in a non-windows machine. Some fonts might be a bit strange.

The VaR is telling is how much we stand to loose if we experience 10 days in a row of
adverse price movements.

Question 2
Mybank has an inventory of 20 million Euros (EUR) and 25 million British pounds
(GBP), which are subject to market risk. The spot exchange rates are EUR1.4/USD and
USD1.28/GBP, respectively.
The expected change (in per cent) of these foreign currencies are zero. (= The historical
mean over say the last 6 months). The standard deviation () of the spot exchange rates
of the EUR is 65 bp and for GDP it is 45 bp.
a) Determine the banks 10-day VAR for each currency individually. Use adverse rate
changes in the 95th percentile (=10 per cent risk level in a normal distribution). How
much could they loose on the individual currencies if tomorrow is a really bad day on
the foreign exchange markets?
b) What is the VaR of the portfolio of the two foreign accounts, if the correlation
between the exchange rates is 0.15 (Not an exam question 2011)

Solution 2
a) What is the VaR of the portfolio if the correlation between the exchange rates is 0.15
1) Calculate the dollar positions:
FX position of
= 20m $1.40/ = $28 million
FX position of
= 25m $1.85/ = $46.25 million
2) Calculate the possible bad adverse move (given zero mean in historical changes):
FX volatility (adverse move) = 1.65 0.0065 = 0.010725 or 1.0725%
FX volatility (adverse move) = 1.65 0.0045 = 0.007425, or 0.7425%
These we have position in foreign currencies, translated into the accounting currencu
USD, thus there is no need for duration because he relation between the dollar values
and the changes in exchange rates are 1:1. Duration is necessary the effect of interest
changes on bond (and debt) positions.
On a day to day basis, or week to week, there is no trend in exchange rate movements so
the mean of the changes will zero.
3) Calculate the DEAR
DEAR

= ($ Value of position) x (Price volatility (=adverse move))

DEAR of
DEAR of

= $28m 0.010725 = $0.3003m, or $303,300

= $46.25m 0.007425 = $0.3434m, or $343,406.25

VaR of

= $303,300 10

= $303,300 x 3.1623 = $959,125.59

2

VaR of

$343,406.25 10 = $343,406.25 x 3.1623 = $1,085,953

The values at risk is for the individual positions are given above, but they are not really
correct because the two exchange rates are correlated with each other. If there was only one
foreign asset, the above would be correct for that currency. Since the exchange rates have a
correlation of 0.15, we need to take that into account.
b) The DEAR of the portfolio is found by taking the correlation of the two foreign positions
into account. Unfortunately, this means the calculation more complex,
[DEAR of portfolio] =
[ DEAR2 + DEAR2 + 2 corr DEAR x DEAR ] =
[ $303,3002 + $343,406.25 2 + (2 0.15 303,300 $1,085,953) ]
= big number
(DEAR portfolio) = $314,341.95 (Take the square root of DEAR2)
10 day VaR = 315,341.95 10 = $99,403.56

Question 3
Consider the balance sheet (in millions of $) for an FI:
Assets
$790 with duration 7.5 years

Liabilities and Owners Equity

$650 with duration 1.5 year
Equity $?

a) What is the FI's duration gap?

b) What is the FI's interest rate risk exposure? What type of interest rate risk is it?
(What happens if r goes up)?
c) What is the equity value?
d) What is the impact on the FI's equity value if the interest rate is 5 % and the change in
the interest rates is 1 percent? That is, r/(1+r) = 0.0095.
e) What is the VaR for five days calculated for the 2% +/- potential adverse moves? The
expected change interest rate is zero, and the standard deviation is now 50 basis points?
The interest rate is still 5%.

Solution 3

a)

The duration gap is

[DA k DL ] = [7.5 - (650/790) (1.5) ]= 7.5 - 0.82 1.5 = 6.27 years.

b)

The FI is exposed to interest rate increases. It is a refinancing risk since the duration of
assets is longer than for liabilities. The market value of equity will decrease if interest
rates increase.

c)

The value of equity is $790 650 = $140.

d)

Apply the formula for a change in equity value; E = - (DA kDL) A (r/(1+r)
= -6.27 x $790m x 0.0095 = -6.27 7.505 = -$13.77m. Thus, the loss is -13.77.
e) First we need to calculate the adverse move. Given the info the adverse move s given
by
0 + 2.33 = 2.33 0.005 = 0.01165
DEAR = [D A kDL ] A

0.001165
= 6.27 $140 0.0011 = 0.9659
(1.05)
The loss tomorrow could be -0.9659 (or more).
The VaR is
VaR = DEAR 5 = 0.9659 2.236 = 2.1598

Question 4
A bank has the following asset and liabilities:
Liability one three-year certificate of deposit, time to maturity is 3 years, coupon is 3%, and
YTM is 2%, Face value (or nominal value) = 100 000.
Assets 1: 200 one-year zero coupon TBills with face value 1,000, YTM =1%
Asset 2: 100 five-year bond, with annual coupons with coupon 3%, YTM =3% and face
value 10,000.
a) What are the duration and value of the liability and of the assets individually?
b) What is the value of equity?
c) What is the duration of the asset portfolio?
d) What can you do to set E = 0, protect equity from interest rate risk.

Solution 4
Solution a) + b)

Liability
Calculate the duration and market price of the Liability:

Time (t)
1
2

CF
3000
3000

DF
(1 / (1.02)) = 0.9804

103000

1 / (1.02 ) = 0.9423

1 / (1.02 ) = 0.9612
2

Sum

CF x DF
2,941.18
2,883.51

DF x CF x t
2,941.18
5,767.01

97,059.20

291,177.60

102,883.89

299,885.79

Duration = 299885.79/102883.89 = 2.91

The market value comes automatically in the Duration calculation, and is 102,883.89

Assets
Value of TBill:

P=

1,000
= 970.87
(1.03)

The duration of a zero coupon bond is equal to time to maturity. Duration is 1 year.
Value of five year bond, using the annuity formula,

1
10,000
1
+
= 300[33.33 28.75] + 8626.09 = 300 4.58 + 8629.09
P = 300

5
5
0.03 0.03(1.03) (1.03)
= 1373.91 + 8626.09 = 10000.
Duration of the five-year bond
V
Time (t)
1
2

CF
300
300

DF
(1 / (1.03)) = 0.9709

300

1 / (1.03) = 0.9151

300

10300

1 / (1.03) = 0.9426
2

1 / (1.03) = 0.8885
4

1 / (1.03) = 0.8626
5

Sum
Duration = 47,170.98/10,000 = 4.71 year

CF x DF
291.26
282.78

DF x CF x t
291.26
565.56

274.54

823.63

266.55

1066.18

8884.87

44,424.35

10,000

47,170.98

The balance sheet and the equity of the bank is

Liability = 102,883.89
Asset portfolio = 200 970.87 + 100 10,000= 194,174 + 1,000,000 = 1,194,174
Equity value = A L = E = 1,194,174 102,883.89 = 1,091,290.2
Solution c)
The duration of the asset portfolio is given by
DA =

MV1
MV2
D1 +
D2
MVP
MVP

where MV1 is the market value of asset 1 and MV2 is the market value of asset 2, MVP is the
market value of the whole portfolio.
DA =

194,174
1,000,000
1 +
4.71 = 0.16 1 + 0.84 4.71 = 4.12 years
1,194,174
1,194,174

Solution d)
The duration Gap is

[D A kDL ] = 4.12 102,883.89 1 = 4.12 0.086 = 4.03

1,194,174
If we want to close this gap to get E = 0, we must set duration so that DA = kDL. This can be
done by changing the portfolio allocation in such a way that the duration of assets equals kDL.
In this particular example this is not possible to achieve with a one-year TBill you cannot get
to a duration below one-year. Thus, you would need to purchase one-month TBills instead.
A better solution is to use derivatives, unless the liabilities side cannot be changed in such a
way that its duration goes up.