Question 1

Carl Cramer is a recent hire at Derivatives Specialists Inc. (DSI), a small consulting firm that advises a variety

of institutions on the management of credit risk. Some of DSI's clients are very familiar with risk management

techniques whereas others are not. Cramer has been assigned the task of creating a handbook on credit risk,

its possible impact, and its management. His immediate supervisor, Christine McNally, will assist Cramer in the

creation of the handbook and will review it. Before she took a position at DSI, McNally advised banks and other

institutions on the use of value-at-risk (VAR) as well as credit-at-risk (CAR).

Cramer's first task is to address the basic dimensions of credit risk. He states that the first dimension of credit

risk is the probability of an event that will cause a loss. The second dimension of credit risk is the amount lost,

which is a function of the dollar amount recovered when a loss event occurs. Cramer recalls the considerable

difficulty he faced when transacting with Johnson Associates, a firm which defaulted on a contract with the

Grich Company. Grich forced Johnson Associates into bankruptcy and Johnson Associates was declared in

default of all its agreements. Unfortunately, DSI then had to wait until the bankruptcy court decided on all claims

before it could settle the agreement with Johnson Associates.

McNally mentions that Cramer should include a statement about the time dimension of credit risk. She states

that the two primary time dimensions of credit risk are current and future. Current credit risk relates to the

possibility of default on current obligations, while future credit risk relates to potential default on future

obligations. If a borrower defaults and claims bankruptcy, a creditor can file claims representing the face value

of current obligations and the present value of future obligations. Cramer adds that combining current and

potential credit risk analysis provides the firm's total credit risk exposure and that current credit risk is usually a

reliable predictor of a borrower's potential credit risk.

As DSI has clients with a variety of forward contracts, Cramer then addresses the credit risks associated with

forward agreements. Cramer states that long forward contracts gain in value when the market price of the

underlying increases above the contract price. McNally encourages Cramer to include an example of credit risk

and forward contracts in the handbook. She offers the following:

A forward contract sold by Palmer Securities has six months until the delivery date and a contract price of 50.

The underlying asset has no cash flows or storage costs and is currently priced at 50. In the contract, no funds

were exchanged upfront.

Cramer also describes how a client firm of DSI can control the credit risks in their derivatives transactions. He

writes that firms can make use of netting arrangements, create a special purpose vehicle, require collateral

from counterparties, and require a mark-to-market provision. McNally adds that Cramer should include a

discussion of some newer forms of credit protection in his handbook. McNally thinks credit derivatives

represent an opportunity for DSL She believes that one type of credit derivative that should figure prominently in

their handbook is total return swaps. She asserts that to purchase protection through a total return swap, the

holder of a credit asset will agree to pass the total return on the asset to the protection seller (e.g., a swap

dealer) in exchange for a single, fixed payment representing the discounted present value of expected cash

flows from the asset.

A DSI client, Weaver Trading, has a bond that they are concerned will increase in credit risk. Weaver would like

protection against this event in the form of a payment if the bond's yield spread increases beyond LIBOR plus

3%. Weaver Trading prefers a cash settlement.

Later that week, Cramer and McNally visit a client's headquarters and discuss the potential hedge of a bond

issued by Cuellar Motors. Cuellar manufactures and markets specialty luxury motorcycles. The client is

considering hedging the bond using a credit spread forward, because he is concerned that a downturn in the

economy could result in a default on the Cuellar bond. The client holds $2,000,000 in par of the Cuellar bond

and the bond's coupons are paid annually. The bond's current spread over the U.S. Treasury rate is 2.5%. The

characteristics of the forward contract are shown below.

Information on the Credit Spread Forward

Determine whether the forward contracts sold by Palmer Securities have current and/or potential credit risk.

Options :

A :

The contract has current credit risk only.

B : The contract has potential credit risk only

C : The contract has neither potential credit risk nor current credit risk.

Answer: B

Question 2

Paul Dennon is senior manager at Apple Markets Associates, an investment advisory firm. Dennon has been

examining portfolio risk using traditional methods such as the portfolio variance and beta. He has ranked

portfolios from least risky to most risky using traditional methods.

Recently, Dennon has become more interested in employing value at risk (VAR) to determine the amount of

money clients could potentially lose under various scenarios. To examine VAR, Paul selects a fund run solely

for Apple's largest client, the Jude Fund. The client has $100 million invested in the portfolio. Using the

variance-covariance method, the mean return on the portfolio is expected to be 10% and the standard deviation

is expected to be 10%. Over the past 100 days, daily losses to the Jude Fund on its 10 worst days were (in

millions): 20, 18, 16, 15, 12, 11, 10, 9, 6, and 5. Dennon also ran a Monte Carlo simulation (over 10,000

scenarios). The following table provides the results of the simulation:

Figure 1: Monte Carlo Simulation Data

The top row (Percentile) of the table reports the percentage of simulations that had returns below those

reported in the second row (Return). For example, 95% of the simulations provided a return of 15% or less, and

97.5% of the simulations provided a return of 20% or less.

Dennon's supervisor, Peggy Lane, has become concerned that Dennon's use of VAR in his portfolio

management practice is inappropriate and has called for a meeting with him. Lane begins by asking Dennon to

justify his use of VAR methodology and explain why the estimated VAR varies depending on the method used

to calculate it. Dennon presents Lane with the following table detailing VAR estimates for another Apple client,

the York Pension Plan.

To round out the analytical process. Lane suggests that Dennon also incorporate a system for evaluating

portfolio performance. Dennon agrees to the suggestion and computes several performance ratios on the York

Pension Plan portfolio to discuss with Lane. The performance figures are included in the following table. Note

that the minimum acceptable return is the risk-free rate.

Figure 3: Performance Ratios for the York Pension Plan

Using the historical data over the past 100 days, the 1-day, 5% VAR for the Jude Fund is closest to:

Options :

A : $11 million.

B : $12 million.

C : $15 million.

Answer: B

Question 3

Jack Mercer and June Seagram are investment advisors for Northern Advisors. Mercer graduated from a

prestigious university in London eight years ago, whereas Seagram is newly graduated from a mid-western

university in the United States. Northern provides investment advice for pension funds, foundations,

endowments, and trusts. As part of their services, they evaluate the performance of outside portfolio managers.

They are currently scrutinizing the performance of several portfolio managers who work for the Thompson

University endowment.

Over the most recent month, the record of the largest manager. Bison Management, is as follows. On March 1,

the endowment account with Bison stood at $ 11,200,000. On March 16, the university contributed $4,000,000

that they received from a wealthy alumnus. After receiving that contribution, the account was valued at $

17,800,000. On March 31, the account was valued at $16,100,000. Using this information, Mercer and

Seagram calculated the time-weighted and money-weighted returns for Bison during March. Mercer states that

the advantage of the time-weighted return is that it is easy to calculate and administer. Seagram states that the

money-weighted return is, however, a better measure of the manager's performance.

Mercer and Seagram are also evaluating the performance of Lunar Management. Risk and return data for the

most recent fiscal year are shown below for both Bison and Lunar. The minimum acceptable return (MAR) for

Thompson is the 4.5% spending rate on the endowment, which the endowment has determined using a

geometric spending rule. The T-bill return over the same fiscal year was 3.5%. The return on the MSCI World

Index was used as the market index. The World index had a return of 9% in dollar terms with a standard

deviation of 23% and a beta of 1.0.

The next day at lunch, Mercer and Seagram discuss alternatives for benchmarks in assessing the performance

of managers. The alternatives discussed that day are manager universes, broad market indices, style indices,

factor models, and custom benchmarks. Mercer states that manager universes have the advantage of being

measurable but they are subject to survivor bias. Seagram states that manager universes possess only one

quality of a valid benchmark.

Mercer and Seagram also provide investment advice for a hedge fund, Jaguar Investors. Jaguar specializes in

exploiting mispricing in equities and over-the-counter derivatives in emerging markets. They periodically engage

in providing foreign currency hedges to small firms in emerging markets when deemed profitable. This most

commonly occurs when no other provider of these contracts is available to these firms. Jaguar is selling a large

position in Mexican pesos in the spot market. Furthermore, they have just provided a forward contract to a firm

in Russia that allows that firm to sell Swiss francs for Russian rubles in 90 days. Jaguar has also entered into a

currency swap that allows a firm to receive Japanese yen in exchange for paying the Russian ruble.

Regarding their statements about manager universes, determine whether Mercer and Seagram are correct or

incorrect.

Options :

A :

Only Mercer is correct.

B :

Only Seagram is correct.

C : Both are correct.

Answer: C

Question 4

Mark Stober, William Robertson, and James McGuire are consultants for a regional pension consultancy. One of their clients, Richard Smitherspoon, chief investment officer of Quality Car Part Manufacturing, recently attended a conference on risk management topics for pension plans. Smitherspoon is a conservative manager who prefers to follow a long-term investment strategy with little portfolio turnover. Smitherspoon has substantial experience in managing a defined benefit plan but has little experience with risk management issues. Smitherspoon decides to discuss how Quality can begin implementing risk management techniques with Stober, Robertson, and McGuire. Quality's risk exposure is evaluated on a quarterly basis. Before implementing risk management techniques, Smitherspoon expresses confusion regarding some measures of risk management. "I know beta and standard deviation, but what is all this stuff about convexity, delta, gamma, and vega?" Stober informs Smitherspoon that delta is the first derivative of the call-stock price curve, and Robertson adds that gamma is the relationship between how bond prices change with changing time to maturity. Smitherspoon is still curious about risk management techniques, and in particular the concept of VAR. He asks, "What does a daily 5% VAR of $5 million mean? I just get so confused with whether VAR is a measure of maximum or minimum loss. Just last month, the consultant from MinRisk, a competing consulting firm, told me it was ‘a measure of maximum loss, which in your case means we are 95% confident that the maximum 1-day loss is $5.0 million." McGuire states that his definition of VAR is that "VAR is a measure that combines probabilities over a certain time horizon with dollar amounts, which in your case means that one expects to lose a minimum $5 million five trading days out of every 100." Smitherspoon expresses bewilderment at the different methods for determining VAR. "Can't you risk management types formulate a method that works like calculating a beta? It would be so easy if there were a method that allowed one to just use mean and standard deviation. I need a VAR that I can get my arms around." The next week, Stober visits the headquarters of TopTech, a communications firm. Their CFO is Ralph Long, who prefers to manage the firm's pension himself because he believes he can time the market and spot upcoming trends before analysts can. Long also believes that risk measurement for TopTech can be evaluated annually because of his close attention to the portfolio. Stober calculates TopTech's 95% surplus at risk to be S500 million for an annual horizon. The expected return on TopTech's asset base (currently at S2 billion) is 5%. The plan has a surplus of $100 million. Stober uses a 5% probability level to calculate the minimum amount by which the plan will be underfunded next year. Of the following VAR calculation methods, the measure that would most likely suit Smitherspoon is the:

Options :

A : variance-covariance method.

B : historical simulation method.

C : Monte Carlo simulation method.

Answer: A

Question 5